Knowledge and Insights

Is the recapture of unpaid royalties worth the time, effort and expense that comes with an audit? As revenues are increasingly generated from licensing agreements, licensees continue to incorrectly report royalties and underpay royalty payments owed. Incorporating license management, specifically, royalty audits, into your compliance program can result in increased profits, risk mitigation and stronger relationships with licensees.

With anticipated growth in the intellectual property (IP) rights and royalty management market from $4.28 billion in 2016 to $12.68 billion by 2021 [1], a compounded annual growth rate of 24.2%, the growth of the IP market is being driven by an increasing need for protection of IP assets (IPAs). Accordingly, using various forms of licenses, the owner of the IP engages in distribution and marketing of the IP by imposing terms on the condition and use of the IPAs.  As you assess your organization’s contractual relationships, here are a few considerations you may want to evaluate as you incorporate royalty audits into your organization’s compliance program.

First, What is a Royalty Audit?

In its most basic form, a royalty audit is an inspection of financial records to determine whether a licensor (the owner of a patent/license/franchise) is being paid the correct royalty fees by the licensee (the user of a patent/license/franchise), based on the terms and conditions set forth in a licensing agreement. A royalty audit is commonly segmented into two levels of analysis. The first is an organizational assessment of patterns in licensees’ data, followed by testing of specific financial transactions. To identify patterns in the data, an auditor may develop benchmarks based on historical activity under the agreement, predictive analytics or industry trends. Any deviations from these benchmarks may provide a framework for the second level – transactional testing. The auditor will then perform transactional testing, inquiries with key personnel and inspection of source documentation, which may include profit and loss statements, detailed sales reports, inventory records and invoices.

Who Conducts Royalty Audits?

Utilization of an independent third party, specifically a Certified Public Accountant (CPA) with experience performing royalty audits, can provide for an effective and efficient audit. CPAs who perform royalty audits can adapt their knowledge of internal controls, systems of reporting and records maintained by licensees and licensors, to specific license agreements. If there are a significant amount of under-reported sales suspected or there is speculation that the process may be contentious or lead to litigation, a forensic accountant, with litigation support and testifying experience, may prove useful in such instances.

What are the Common Findings of Royalty Audits?

Due to the inherent operational nature of royalty accounting systems and the required human element in the royalty reporting process, most royalty audits will result in some amount of underreported sales and unpaid royalties. These amounts can vary by industry.

Intentional misstatements are generally rare related to royalty calculations. Instead, common causes of underreporting and unpaid royalties include:

• Mathematical errors or miscalculations, such as a formula discrepancy in calculation worksheets;
• Discrepancies in contract interpretations;
• Input mistakes because of human error; and
• Inadequate accounting systems, which may include non-automated functions.

In some instances, the findings from a royalty audit may favor the licensee, in which case the licensor must be prepared to return the overpayment. However, exemplifying to your licensee or franchisee that your organization encourages honest reporting ultimately builds trust among all the stakeholders in a licensing arrangement. In addition to monetary results, royalty audits add value to the compliance process prospectively, by identifying weaknesses in the process, affirming the integrity and competence of the licensor, and strengthening the relationship between the licensor and licensee. In the end, those are benefits that seem to make both dollars and sense.

If you or your organization need advice on audit or compliance-related issues, please contact me at  [email protected] or 609-689-9700.

[1] MarketsandMarkets™, 2016