Compliance Monitoring Just Makes Good Business Sense

April 12, 2013

If you ran a store, would you leave the cash register open, ask customers to write down items purchased, place cash in the drawer, and take the product without oversight? Of course you wouldn’t! Surprisingly, many take a similar approach when monitoring compliance with licensing, supply, manufacturing, and other third-party agreements.

Payments in these agreements may be a percentage of net sales, a formula involving actual manufacturing costs, or even a flat dollar amount per net units shipped. Each of these payment structures is within a third party’s (licensee’s) control, rendering the accuracy of the payment dependent on the licensee’s processes, controls, records, and contractual interpretation. The receiving party (licensor) can only validate payment accuracy by including a “right to audit” in the agreement and exercising this right. Audit clauses allow the licensor, or its independent designee, to perform an examination of the licensee’s inputs to test whether payment amounts were computed in accordance with the agreement.

The problem is that many licensors do not exercise their audit rights under these agreements. Below are some common excuses followed by a counter-argument.

I don’t want to damage our relationship with the licensee. 

Maintaining strong business relationships and exercising your audit rights are not mutually exclusive. In fact, exercising audit rights provides transparency that strengthens the relationship by identifying and resolving issues before they become material.

By the nature of the regulatory environment, compliance is expected, if not mandated. More licensors are exercising audit rights in their internal controls procedures, and licensees are becoming more accustomed to receiving audit notifications. To avoid singling out a licensee, exercise audit rights on a rotational basis across a category of licensees, thus subjecting all licensees to periodic examinations.

The licensee is audited as a publicly traded company, so its books and records must be in order. 

Financial statement audits test whether financial statements, as a whole, are pre-pared in accordance with the relevant generally accepted accounting principles (GAAP) and are free from material misstatement. The audit scope defines the materiality threshold at which audit testing will be performed; in most cases, that threshold is above that of individual contracts and does not identify adherence to the terms of individual agreements.

The payments made by the licensee are insignificant. Potential audit findings would not justify the time and expense. 

While it is not economically responsible to spend dollars chasing pennies, limited analysis should be performed before dismissing a contract for examination solely based on the amount of payments received. You may also have nonmonetary goals that can be achieved through an examination, including brand protection, business intelligence, or a message of compliance. Consulting with knowledgeable individuals may provide insight into whether the inconsequential payments are commensurate with market conditions.

I don’t have the personnel to run my business and exercise my audit rights at the same time. 

Agreements usually include language that allows the licensor “or its designee” to conduct the examination. This allows an independent firm to perform the examination on behalf of the licensor. Benefits include the following:
* Minimization of the licensor’s time and effort
* Independence from the findings (assuming no contingent fee structure)
* More unfettered access to the relevant records may alleviate concerns about disclosure of confidential information to a competitor

Use of a designee to conduct the examination may be worth the added expense to focus on potential exposure areas to identify more robust findings. Many agreements also include language that shifts payment responsibility for examination fees to the licensee if the findings exceed a specified amount of the total payments.

If the above arguments don’t convince you, understanding the types of compliance errors typically identified may help with your decision to exercise your audit rights. In most instances, the findings tend not to result from nefarious intent, but rather from common errors:
* Differences in contractual interpretations of key clauses and definitions
* Payment calculation errors resulting from a misunderstanding of the contractual language, often arising from turnover, a lack of understanding of the legal terms, system or reporting limitations, control issues, or otherwise
* Human error

Findings from contract compliance examinations tend to far outweigh the costs, and the benefits go beyond recovering underreported revenue. Armed with this knowledge, analyze your audit rights to ensure you do not lose periods subject to audit, set the goals you would like to achieve, and go forth and protect what is rightfully yours. 

“Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of Certified Public Accountants.” 

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