There is a common misconception that a license and royalty audit only needs to be performed if a licensor is experiencing problems with a licensee. However, there are many benefits to implementing a regular license and royalty compliance program. Below, we’ve broken down everything you need to know about license and royalty audits.
What is a License and Royalty Audit?
A license and royalty audit is a thorough risk assessment and evaluation of the accounting records between licensors and licensees.
During a license and royalty audit, you should expect:
- A risk assessment of environments
- Identification of audit targets and business case
- A review of budget and audit approach
- Development of audit approaches with licensing management
- Audit execution
- A review of results and formulation of next steps
Over 70% of licensees have errors in their royalty reporting and almost 90% of license agreements are underpaid. Here's what you need to know about license and royalty audits and how they can provide assurance.
When Should I Perform a License and Royalty Audit?
Determining which licensees to audit is dependent upon a multitude of risk assessment attributes. The risk assessment should diagnostically evaluate each agreement to determine the risk level and identify necessary audits. Organizations may perform license and royalty audits as a result of:
- Royalty payments that are missing supporting schedules or necessary documents
- New licensees who may be developing their information collection and reporting processes
- A major accounting system change at the licensee’s organization
- Licensees with limited or no history of entering royalty-bearing license agreements
- Lax or deficient reporting practices by licensee in the past
- Past discord or lack of communication in the relationship with the licensee
- Licensee reporting product volumes trending lower than the overall trend in a growing industry
- Significant financial deterioration or distress experienced at the licensee organization
- Analysis by licensor of licensee’s product line suggest unreported licensed products
- Indication from other participants in the industry that the license has new, unreported products incorporating the licensed technology
As part of a formalized license and royalty compliance program, a licensor should be evaluating agreements at the inception and regular intervals.
Why Should I Implement a Regular License and Royalty Audit Program?
When you have a regular license and royalty audit program in place, you will experience higher compliance with your licensees. Because the licensees know that they are on a regular audit program, they are not only less likely to attempt circumventing the system, but they are more likely to maintain solid systems for managing financial records.
We had a client who requested verification of reported sales and inventory totals of pharmaceuticals sold by the manufacturer and product distributor. Through onsite examination of accounting records, invoices and inventory calculations, we determined the calculations matched to reported totals and the royalty payments made. However, variances in the agreed pricing were discovered on the actual invoices. Sales data for two consecutive years totaled $12.1 million and royalties paid agreed to $3.2 million. The variance in agreed pricing under the contract resulted in additional damages under the contract agreement. Prices exceeded the agreed amount in the millions.
Because of this, the client requested a forensic royalty audit to recur every two years, ensuring that the manufacturer and product distributor remain in compliance going forward.
- Increased Revenue
Because 75%-85% of licensees have errors in royalty reporting or payments, performing a license and royalty audit is a way to maximize your revenue with minimal cost.
In one instance, a patent holder requested a review and examination of royalty calculations received from both international and U.S. sales. We found that European market sales were inaccurately reporting sales related to several unique product codes. Overpayments of royalties were discovered in years 2007 through 2010 and underpayments were discovered in years 2011 through present.
Global sales of devices utilizing the patent were $190 million, European royalties were calculated at $13.2 million, and actual paid royalties were $12.7 million, resulting in a $500,000 underpayment(or 4%) of total royalties earned. Additional damages for interest were calculated at $148,000,resulting in a total damage calculation of $648,000.
- Better Relationships
Performing regular license and royalty audits often leads to better relationships with licensors and licensees. Having a compliance program in place means that licensors and licensees are in regular communication with one another, thus increasing the feelings of being in a true partnership together. Fostering this relationship also plays an important part in ensuring licensees remain in compliance.
Building a trusted relationship from the beginning with a compliance program ensures the opportunity to collect true upfront payments of licensing revenues vs. confrontational settlement negotiations against a large audit finding, which may necessitate expensive litigation and result in a significant lower monetary amount recovered.
- Peace of Mind
Regular license and royalty audits give you the opportunity to maintain oversight of your intellectual property. Unauthorized use of intellectual property (like patents or trademarks) leaves your brand and reputation vulnerable to being misrepresented.
A licensor’s trademark placed on a low quality and poorly manufactured product not only tarnishes brand reputation, but it can expose a licensor to liabilities and lawsuits from a large recall of a product (e.g., a branded toaster that catches fire due to faulty wiring).
The Benefits of License and Royalty Audits
A formal license and royalty compliance program drives profitability, efficiency and management of license and royalty data before the license agreement even begins. Because the licensee will often consider their information proprietary and may be reluctant to share information that’s not considered directly relevant to the licensed property with the licensor, the benefit of using an independent third-party to perform the audit becomes more apparent. Without a direct stake in the outcome of the royalty audit, the third-party auditor may be able to elicit more timely and cooperative assistance from the auditee.
If you are looking to implement a full license and royalty compliance solution, we can help.