If your business licenses any type of brand, patent, or other intellectual property rights for which it receives royalty income, a royalty audit can help ensure you’re receiving accurate reporting and payments from licensees. Also known as a licensing audit, a royalty audit is an analysis of the royalty income a licensor is contractually owed. In addition to helping the licensor identify underreported and unpaid royalties, the findings of a royalty audit can have various far-reaching benefits.
Common reasons for underpaid royalties in license agreements
Understatements in royalty reporting and underpayments are not uncommon, and they can occur for several reasons, not only fraud. While it can be difficult to discern whether an understatement is attributable to deceit or an honest mistake, the following examples illustrate why licensees may fail to report all royalties due to the licensor:
Lack of oversight
Since requirements for royalty reporting are often much lower than other types of financial reports, scrutiny tends to be less and licensees may be incentivized to underreport royalties to licensors, especially if the license agreements aren’t being monitored for compliance.
Human error in calculating royalties is also common, and without proper controls in place, these errors may go unnoticed.
Omission of products or sales
Products or sales may be omitted from royalty reports for several reasons, including newly created or bundled products that weren’t specified in the licensing agreement, an internal change in product numbers that disrupts product tracking, or timing differences from when the licensee closes its books to when they report royalty sales.
Misinterpretation of contract language
License agreements can be complex, and a lack of understanding of the details or differing interpretations of contract language may cause errors in royalty payments.
What are the benefits of conducting a royalty audit?
Discovering a royalty underpayment provides an immediate and obvious financial benefit to licensors. Underpayments uncovered during a royalty audit often result in a correcting payment to the licensor and renegotiation of the license agreement to more favorable terms for the licensor or termination of the license agreement. Additionally, many license agreements require the licensee to reimburse the licensor for the cost of royalty audits when they identify variances above certain thresholds.
Royalty audits can also provide other immeasurable benefits. They can:
- Deter future royalty underpayments.
- Convey a consistent message about the licensor’s intent to protect its intellectual property rights.
- Facilitate quicker reporting and collecting of royalty fees going forward.
- Build stronger business relationships based on clear and regular communication.
The process of performing a royalty audit often reveals aspects of license agreements that can be renegotiated and improved upon during the renewal process, such as:
- Clarifying language to avoid misinterpretations by the licensee or licensor and strengthening the licensor’s right to audit.
- More closely aligning license agreement terms with each party’s intentions.
- Adjusting the royalty calculation to address changes in expectations and economic trends.
- Modifying language regarding the reporting process to improve the timeliness and transparency of royalty reports.
- Ensuring the licensor’s accounting team has adequate processes for tracking royalties, collecting royalties, and reconciling its revenues to royalty reports.
When should you conduct a royalty audit?
The timing and intensity of each royalty audit will depend on the needs of the licensor and the relationship dynamics with each of its licensees. Certain audit procedures can be performed with minimal to no input from the licensee — for example, if performing analytics or if underlying inputs to the royalty calculation are publicly available. Other procedures may require cooperation from the licensee to provide backup support for its royalty reports or to allow the licensor to obtain the data directly from its systems. It’s best practice to have royalty audits frequent and comprehensive enough to achieve contract compliance while maintaining a healthy business relationship between licensor and licensee.
Should you perform a royalty audit in-house or outsource?
While it’s possible to perform royalty audits in-house, for the best results, we recommend partnering with a forensic accountant who has experience and expertise in performing royalty audits and detecting anomalies within large datasets.
