Royalty auditing is a best practice that can strengthen the relationship between licensors and licensees. The key is building a customized audit program that ensures that licensors are getting what they signed up for in a contract agreement.
“The tendency is to audit the poor performing or problem licensees, but even well performing licensees with good systems for managing financial records should be audited if those licensees are very large or geographically dispersed, or have complex language in their contracts between the two parties,” says Dean Bower, CPA, Manager of Royalty & Contract Compliance Services for RBZ.
“There can be errors in the system that can go undetected and will not be found any other way except through a royalty audit. Sometimes it gets down to differing interpretations of the license agreement, which result in significant underpayments.”
Smart Business spoke with Bower about what licensors stand to gain through an effective royalty audit program and how it can lead to a stronger partnership with licensees.
What is the best time to conduct an audit?
Ideally, licensors should adopt a rotating cycle of audits as part of an overall program. However, circumstances might accelerate the need to audit a licensee, such as a change in ownership or major changes in personnel. Suddenly records or the knowledge of how your royalty statements were prepared become unavailable to audit. If a licensee implements new accounting software, it can take up to a year to get all the bugs out of the system, which can also affect your royalties.
Licensees with contracts approaching expiration should be audited so you know what issues to address in a contract renewal. Finally, many license agreements have a time limit on contesting royalty statements. After that, statements become final and can no longer be audited. Licensors should mark their calendars for these important dates.
What is the best way to approach a licensee when you are considering an audit?
Keep in mind that a licensing agreement is a partnership built upon mutual needs. The licensee needs a brand or an idea, and the licensor needs commercialization. Licensors rely on receiving regular streams of royalties. It is a standard practice for licensors to audit royalties in the course of managing their businesses. Large consumer product licensors have royalty compliance programs and actors, directors and creative talent, and recording artists all conduct royalty audits.
You are just making sure you receive the money owed under the provisions of your contract with the licensee.
What are some non-monetary reasons to do a royalty audit?
Advertising and marketing should be approved by the licensor to ensure that it is consistent with the brand’s identity and is reaching an appropriate audience. Distribution channels are another area. Territories and retail stores should be defined in a license agreement or you might find your high-end brand selling at a discount retailer, resulting in a lower sales price and royalties. But the larger issue is the image of the brand can be compromised.
What is an audit cost recovery provision?
This is contract language that specifically provides for a reimbursement to the licensor for audit fees if an inspection of the licensee’s records reveals underpayments over a certain defined amount or percentage of reported royalties. The licensee would pay the licensor for the cost of the audit. Audit cost recovery should be in all license agreements. Royalty audits usually pay for themselves and over time become self-funding.
How is the licensor/licensee relationship strengthened through the audit process?
A royalty audit can bring to light a wide variety of issues from differing contract interpretations, to faulty systems and basic misunderstandings. The inspection process allows for a thoughtful discussion of these issues, allowing both parties to have a better sense of their relationship so they can proceed with confidence.