What are Royalty Audits and Who Gets Them?

Our business cards at Linford & Company state that we conduct royalty audits. I get asked all the time what that means, and even was asked within the past couple of weeks if that meant royalty, as in the royal family. Nope, not even close.

So what are royalty audits? In its simplest form, 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.

There are a number of reasons why royalties are reported incorrectly, either intentionally or unintentionally. The following is a list of reasons we have experienced through the audits we have completed:

  1. Purposeful, otherwise unexplained underreporting of what is owed by the licensee.
  2. Unintentional mistakes in reporting by the licensee.
  3. A misunderstanding occurs regarding what is covered in the license agreement.
  4. New products/SKUs that should be royalty bearing are not being reported.
  5. Product numbers/SKUs get altered. Those preparing the royalty reports in a mechanical manner do not report all products that are royalty bearing.
  6. The licensee over-relies on manual processes and/or spreadsheets for royalty reporting, which allows errors to occur.
  7. Royalty-bearing products are bundled with non-royalty products. Sometimes the bundle is then not reported at all.
  8. Promotional uses, samples, employee theft, and other transactions that do not generate revenue are not reported at all, even though the license agreement provides for compensation to the licensor for all uses of the technology.
  9. Differences in opinion exist regarding terms contained in the licensing agreement.

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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