What is a Royalty Audit and Who Needs One?

What is a royalty audit?

While most of our business at Linford & Company includes attestation engagements (SOC 1, SOC 2, HIPAA, HITRUST, FedRAMP), we do complete a very specialized audit called a royalty audit or licensing audit for some of our clients. So what are these audits and who are we completing them for? Read on to find out.

What is a Royalty Audit?

A royalty audit is a financial inspection that determines whether a licensee (user of a patent or license or franchise) is paying the licensor (owner of the patent or license or franchise) the correct amount of fees that were agreed upon in the agreement they have in place for use of the patent or license or franchise. The licensor and licensee have entered into an agreement regarding use of the patent or license or franchise, and the agreement will state what the fees are for use of the patent or license or franchise and the frequency that payment is due to the licensor.

Who Needs to get a Royalty Audit?

Royalty audits can occur in many industries, including, but not limited to, franchises, technology, merchandising, and entertainment. Any company that is engaged in a licensing or patent agreement could be subject to either being audited or requesting an audit. A few reasons that a licensor would want to have an audit complete could include:

  1. To obtain money or royalties they are owed by the licensee.
  2. To encourage licensees to pay correctly and on time (a licensee is less likely to pay incorrectly if they know they are being checked on).
  3. To determine if a licensee is paying correctly.

There can be many different reasons why royalties are reported incorrectly, either on purpose or not by the licensee. The following is an example list of reasons we have experienced through the royalty audits of licensees we have completed:

  1. Intentional underreporting by the licensee in an effort to get away with paying less.
  2. Unintentional mistakes by the licensee when preparing the reporting to the licensor.
  3. A misunderstanding of what is covered in the license agreement between the licensee and the licensor.
  4. New products that are royalty bearing are not included in the reporting (either intentionally or unintentionally).
  5. Product numbers/SKUs being changed and then the people preparing the royalty reports are unaware of this and therefore leave them out of reporting.
  6. Human errors in the manual preparation of the reporting to the licensor.
  7. Royalty-bearing products being part of a bundle, and the bundle is unintentionally left out of the reporting.
  8. Free of charge units not being counted and reported, even though they are royalty bearing.
  9. Differing opinion on what is included in the licensing agreement.

Who completes a royalty audit?

Who can Complete a Royalty Audit?

A licensor could use an internal group to conduct royalty audits of their licensees, but generally an outside audit firm with this specialized expertise is hired to perform the royalty audit. An outside firm performing the audit provides an outside, unbiased party to the licensee and licensor. The audits generally include managing very large amounts of data and completing analytics on the data, which is best completed by a specialized firm with experience with these types of audits and the large amount of data.

Royalty Audit Procedures: What gets Reviewed During a Royalty Audit?

To start a royalty audit engagement, requests are made of the licensee for data directly from their accounting system to verify that royalties have been reported to the licensor and paid correctly. To be able to rely on the data provided by the licensee from the accounting system, we first tie the data to the financial statements of the licensee for the years being reviewed. This helps us know we are starting from a complete set of sales data. Once we are comfortable with the data, we can start using data analytics to review the data and products. Usually, we know a population of products that have the technology in question (those that have already been reported to the licensor), but the analytics we run help identify additional products that may need to be reviewed.

We come up with a population of products that need to be review and then work with the licensee to get additional information about the product. This could be through obtaining technical specification or interviewing engineers familiar with the products. Sometimes running tests on the products is necessary to determine if the product is royalty-bearing.

A recalculation of what should have been paid by the licensee is completed after we have agreement with the licensee on all the products that are royalty bearing (for full royalty compliance). Sometimes there are large findings, sometimes there are no findings (the licensee paid exactly what they were supposed to), and sometimes we find that the licensee overpaid, and are owed a credit or money back from the licensor.

How much does a royalty audit cost?

How Much Does a Royalty Audit Cost? How is it Billed?

There are two different methods that royalty auditors can use to bill for their review. The first method, and the method that we use at Linford & Company, is to bill a set hourly fee for all time incurred on the audit plus any expenses. The second method is to receive an percentage of the findings at the conclusion of the audit.

At Linford & Company we feel that billing an hourly rate is more fair and impartial to the licensee and licensor. If an audit firm is collecting based off of findings, they will be more likely to dig deeper than needed to try to find something, and put pressure on the licensee.

Does the Licensee or Licensor Pay for the Royalty Audit?

The agreement between the licensee and the licensor will generally include a section stating that the licensor has an explicit or implied audit right to check that royalties are being paid correctly. As a general rule, it will be clearly stated in the agreements between the licensee and the licensor that if underreporting occurs outside a threshold (generally 2% – 5%), the licensee will have to pay for the audit costs incurred by the auditors. This will include the hourly rate for the time incurred by the auditors in addition to the travel expenses incurred to travel to the licensees location.

Summary

We have a team that completes royalty audit reports on behalf of licensors all over the world. Our team is available to answer any questions about royalty audits or any of the other types of audits we provide. Please contact us or check out our royalty and licensing audit services for additional information.

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