Royalty Audits – What is Involved?

A royalty audit is a financial inspection that determines whether a licensee (user of a patent/license/franchise) is paying the licensor (owner of the patent/license/franchise) the correct amount of royalty fees. The licensor and licensee have entered into an agreement regarding use of the patent/license/franchise, and the agreement will have an explicit or implied audit right to check that royalties are being paid correctly. Also, in most agreements if underreporting is identified above a certain threshold (generally 2% – 5%), the licensee will have to pay all of the audit costs.

Who needs royalty audits? Royalty agreements span across most industries. A few common industries where royalty audits occur (but not limited to), include technology, music, merchandising, and franchises. Companies that are engaged in a licensing agreement may want to have an audit completed for the following reasons:

  1. To obtain all royalties they are entitled.
  2. To induce further compliance by the licensee (a licensee is less likely to underreport if they know the licensor is going to check periodically).
  3. To determine if there is material noncompliance with an existing licensing agreement.

What is reviewed as part of a royalty audit? To complete a royalty audit, there are a number of data requests that are made to verify that royalties have been paid correctly. This data is generally extracted directly from the licensee’s accounting system. To be able to rely on the data, we first tie the data provided back to the financial statements of the licensee for the years being audited. This gets us comfortable that we are starting from a full and complete set of data. From there we can start using data analytics to sift through the data. Generally, we already know a population of products that have the technology in question, but the analytics help identify other products that may need to be researched.

Once we have an additional list of products to test, we work with the licensee to obtain technical specs or other information about the product to help determine if the product uses the technology in question. In some cases, running tests on the finished product is necessary to reach a conclusion. Once we have agreement with the licensee on all the products, a recalculation can be completed that compares what was reported and paid by the licensee and what was recalculated by Linford & Company.

Who completes royalty audits? A licensor could have an internal compliance function that conducts royalty audits of the licensee. Generally, though, a third party audit firm with this specialized expertise is hired to conduct the audit. Hiring a third party to complete the audit provides an outside, unbiased party to the licensee and licensor. The audits generally include managing massive amounts of data and completing data analytics on the data.

At Linford & Company, we have a team that completes these specialized audits on a continuous basis, all over the world. If you have additional questions about royalty audits, please contact us or check out our website.

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