Licensing And Royalty Audits Deserve Greater Attention

November 2008

In an economic downturn, “business as usual” won’t work. Every company is (or at least should be) looking for ways of being more efficient and competitive. However, no company has ever saved its way to success. Ultimately, success requires revenue growth.

An often overlooked area for revenue growth is one’s patent and license portfolio. Many companies have technology, trademarks, and merchandising opportunities that are not fully exploited. Unlike almost any other business transaction, additional royalties drop to the company’s bottom line, so greater attention here often yields disproportionate results.

Once a license is obtained, many companies fail to keep close tabs on their licensees. Grateful to get whatever is reported, many companies forget that the larger but hidden issue is what their licensees do not report. Practically all license agreements have an explicit or implied audit right, yet many companies do nothing to ensure that they receive the full amount to which they are entitled. Under most license agreements, if the audit identifies additional royalties (usually with a threshold of around two to five percent of what was initially reported), the licensee pays for the audit’s cost.

Our first-time audits generally identify significant additional royalties not timely reported to our clients. It is rare when we do not find additional royalties that exceed the cost of our work. Reasons to perform an audit include:

1. Most obviously, to obtain all royalties to which you are entitled
2. To help ensure future compliance – A licensee is less likely to underreport if the licensor engages in a regular audit program. Licensees who are not audited are also likely to be deterred from underreporting once the licensor is known to have audited others.
3. A licensor may want to modify or terminate the existing licensing agreement. Past material noncompliance with the existing agreement is often necessary for any such termination.

Common Licensee Errors

Areas of underreporting can be as numerous as the licensee’s imagination. This requires an experienced auditor who is not wedded to a narrow list of preconceived notions of what could be wrong. We anticipate that in the current downturn, a combination of (i) reduced accounting resources at licensees and (ii) temptation caused by tough economic times will cause royalty misreporting to increase to even greater levels.

Here is a partial list of the errors that we frequently see:

1. Purposeful, otherwise unexplained underreporting of what is owing (i.e., the licensee lied).
2. A “misunderstanding” occurs regarding what is covered by the technology being licensed. New products/SKUs that should be royalty bearing are not reported.
3. Product numbers/SKUs get altered. Those preparing the royalty repots in a mechanical manner do not report all products that are royalty bearing.
4. Sublicense revenue is not reported.
5. Accounting reports (which are often generated for purposes other than compliance with a specific contract) are relied upon to prepare the royalty reports, but the computer algorithm that generates the report fails to add all relevant transactions.
6. The licensee over relies on manual processes and/or spreadsheets for royalty reporting, which allows clerical errors to occur.
7. Royalty-bearing products are bundled with non-royalty products. Sometimes the bundle is not reported at all. In other cases, the allocation of revenues and/or costs is more favorable to the licensee than what the underlying value and economics are.
8. Transactions (usually with related parties) are reported at prices or terms that do not reflect market conditions.
9. Promotional uses, samples, employee theft, and other transactions that do not generate revenue are not reported at all, even though the underlying definition(s) contained in the license agreement provides for compensation to the licensor for all uses of the technology.
10. For international sales, incorrect exchange rates are used.
11. Unreported transactions occur at international or subsidiary locations because (i) the remote units do not report transactions in the same way as the parent or primary entity, and (ii) the accounting personnel preparing royalty reports do not address such discrepancies.
12. Use of “standard”, “convenience”, average or other revenue rates that are different than actual transaction values. A licensee’s desire to streamline the reporting process is rarely allowable under the license agreement.
13. Differences in opinion exist regarding terms contained in the licensing agreement.
14. Licensee-favorable interpretations as to what can be deducted from the royalty base for various “allowances”.
15. On agreements that allow certain costs to be deducted from the royalty base, the licensee uses unfair cost allocations that lower the royalty base.
16. On agreements that allow certain costs to be deducted from the royalty base, the licensee applies a more lenient view of what direct costs are included in the calculation.
17. The licensee fails to incorporate agreement-based limitations to deductions (not-to-exceed amounts or percentages) in the royalty calculation.

Do you really think that your licensee is incapable of making any of these (or numerous other) errors? Finding these errors requires specialized audit experience and related data processing skills. For more advice, see Best Practices in Royalty Audits.

Fulcrum Inquiry performs forensic accounting and investigations. We have substantial experience and success performing royalty audits.