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How Royalty and Compliance Audits Can Improve Revenue and Reduce Expenses

May 22, 2024

In the manufacturing and distribution industry, organizations often license their intellectual property to external parties, such as suppliers or distributors. These licenses come with royalty payments based on product sales that use the licensed IP.  

As businesses are operating under a challenging environment with inflation, higher interest rates and the uncertainty of what the results of the national election will mean, they seek ways to enhance revenue and reduce costs. One effective strategy is leveraging audit rights, specifically through royalty audits and contract compliance audits.  

The main benefit of these projects is that they can improve the top and/or bottom line of an organization based upon existing contracts. 

What Is a Royalty Audit? 

A royalty audit is a financial examination that assesses whether a licensee (the user of a patent, license, or franchise) is correctly paying the licensor (the owner of the intellectual property) the agreed upon fees in their licensing agreement.  

Similar to royalty license agreements another type of contract is a supply agreement where the gross profits are shared between the parties instead of a fixed royalty rate. 

While the term “audit rights” is frequently used in contracts to describe the parties’ rights and obligations, these projects are not a financial statement audit. They are typically performed under the AICPA’s consulting standards and don’t express an opinion on financial statements. 

What Is a Contract Compliance Audit? 

A contract compliance audit will analyze the costs being passed through by the vendor to the organization to see if the charges are in accordance with the contract.  

Similarly, many distribution agreements contain provisions for certain volume-based rebates, and a contract compliance audit can determine whether the rebates paid were earned in accordance with the rebate agreement. 

Benefits of Royalty and Compliance Audits 

The objectives of both the royalty audit and a compliance audit are to evaluate whether the auditee is abiding by the various terms of the contract. These can be simple contractual requirements such as whether sufficient insurance is being carried. More complex topics can be evaluated such as allowable costs, the method employed for estimated expenses and gross to net calculations in the life sciences industry. 

In addition to the possibility of identifying additional revenue or reducing expenses, these audits also identify areas for improvement in the reporting process as well as potential changes to the current contracts or future revisions that would better align both party’s intentions. We’ve also seen improvement in the relationship between the parties. 

How to Complete a Royalty or Compliance Audit  

Whether it is a royalty or contract compliance audit, both projects typically involve an accounting firm. The role of the accounting firm is to independently evaluate the support for the amounts that have been remitted to see if they are in compliance with the contract.  

The accounting firm will make sure that confidential information is not shared across the table and will interpret the contract without the biases of one side or the other. 

These projects typically follow the following steps: 

  • Step 1 – Notification of Intent to Audit
  • Step 2 - Independent Accountant is Identified
  • Step 3 - Kick-off Call with the Independent Accountant
  • Step 4 - Initial Documentation Requests are Shared
  • Step 5 - Detailed Testing (On-Site or Remote)
  • Step 6 – Confirmation of Findings with the Auditee
  • Step 7 – Findings Issued 

A royalty or compliance audit can be an important piece in your organization’s compliance culture. If you want to potentially improve your bottom line by ensuring that your critical business partners are in compliance with their contracts there is no time like the present to initiate a contract compliance audit. 

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David Sumner

David Sumner is a director in the Financial Advisory Services Group with years of auditing, forensic accounting, financial reporting and internal control design and implementation experience serving clients in a variety of industries.

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