Royalty Audits--A Licensee Perspective
August 26, 2021
By David Sumner
If you license intellectual property from another entity, your contract most likely contains a clause1 allowing the licensor to engage an independent accountant to evaluate the accuracy of the royalty calculation you provided to the licensor. The independent accountant’s role is to review the licensee’s confidential and proprietary data at the detail level and only report back to the licensor in summary terms which keeps the licensee’s confidential records private. Licensors initiate these exams to ensure that the licensee is remitting the correct amount of fees and is complying with contract terms.
When a licensor notifies the licensee that they are invoking the audit clause2, there are many negative reactions by the licensee to receiving such a notice including:
- Do they think we are cheating them?
- What are they really looking for?
- Are they trying to steal my customers?
- Are they looking for a reason to cancel the contract?
- This is going to be a burden to my team because this will be difficult to manage in addition to our normal workload.
These thoughts are understandable but in most cases, the licensor is simply measuring whether the licensee is complying with the terms of the agreement. Both the licensor and the licensee should view these audits as opportunities to improve the entire process including identifying potential areas for clearer language in future amendments or contracts that can benefit both parties.
Notwithstanding the licensee’s potential initial thoughts, the process can go relatively smoothly with benefits for both parties. See the call out box for a general sequence of events for a royalty audit. For each of the steps listed, here is some practical advice for the licensee:
Typical sequence of events for royalty audit:
- Licensor notifies licensee of intent to audit
- Independent audit firm is identified
- Kick-off call with audit firm
- Initial documentation requests are shared
- Detailed testing (on-site or remote)
- Findings issued
Step 1- Licensor Notifies Licensee of Intent to Audit
- Refresh your understanding of the contract including any restrictions on the time periods available for review and the independent accountant.
- Designate an individual to be the spokesperson for interacting with the independent accountant.
- Reach agreement with the licensor on the time period under review along with the expectations for the timetable for the completion of the audit.
Step 2- Independent Accountant Is Identified
- Ensure that the audit firm meets the criteria set forth in the agreement.
- Execute a non-disclosure agreement (NDA) with the independent accountant. The licensee should make sure that the NDA covers topics that are important to the licensee such as restrictions on sharing the licensee’s confidential information and the ability to review the findings in draft form.
Step 3- Kick-Off Call with the Independent Accountant
- Confirm the time frame under audit with the independent accountant. Establish a communication protocol and milestone dates. The method for transmitting your confidential data should also be agreed to (e.g., secure file sharing, password protection, and encryption).
- Understand how the independent accountant is being compensated (e.g., time and materials or a percentage of recoveries).3
- Request that the independent accountant share their draft findings before they are shared with the licensor. This will allow the licensee to correct any mistakes or misinterpretations before the licensor sees them.
Step 4- Initial Documentation Requests Are Shared
- If the independent accountant has made a request that may be incomplete or irrelevant, do not hesitate to let them know and the reasons why. If you let the independent accountant waste time, the entire process may extend beyond the agreed-upon timetable and may even result in inaccurate findings.
Step 5- Detailed Testing (On-Site or Remote)
- Provide the independent accountant with the information they need to properly evaluate your process and business records.
- Make yourself available to the independent accountant to ensure documentation is understood.
Step 6- Findings Issued
- As noted in Steps 2 and 3, you should review the independent accountant’s draft findings before they are issued to the licensor. The review should be looking for errors, inclusion of detail-level data that is confidential, and differences between contract interpretations.
- Ask the independent accountant for recommendations for improvement of the royalty calculation process or the contract if they haven’t provided any in order to take advantage of an independent evaluation of the process.
- If appropriate, you may request to have a response attached to the final report to address those areas that you have a disagreement with the independent accountant.
After the final report is issued, the licensee should determine if changes should be made to their internal processes to report on royalties. Additionally, the audit may have identified certain shortcomings in the language of the contract between the parties that could be discussed with the licensor.
The success of the royalty audit lies with the independent accountant and the licensee. If the two parties work together to ensure that all of the relevant information has been shared and considered, then the audit’s results will most likely be in line with the wording of the contract. This is not the end of the process as the licensor and licensee may choose to negotiate the amounts due to either party or both parties may mutually agree that changes to the contract wording may be needed. These audits can help strengthen the relationship between the licensor and licensee as both parties will have a clear understanding of the contract and the processes to calculate the royalties.
1 These types of clauses may also exist in rebate agreements and contracts covering large donations. For the purposes of this article, we will use the term licensor and licensee to also include these types of arrangements as well as well as other intellectual property such as trademarks and copyrights. The process for these other types of agreements would be similar to a royalty audit.
2 It is important to note that while most of these contracts have an audit clause, it is not an audit in the context of a financial statement audit. These audits are simply an examination of the calculations through the lens of the contract; these are contract compliance assessments.
3 If the independent audit firm is being compensated on a percentage of recoveries, there may be concerns about whether they are truly independent as their compensation is linked to recoveries recovered by the licensor only. Additionally, some states’ CPA societies may not allow a percentage of recoveries as a form of compensation.