Are Your Licensees Paying the Right Royalties?

Many companies offer licenses granting others the right to use intellectual property, such as a patented design or software, in exchange for royalties. If you grant such licenses, an external audit firm can help you ensure that your licensees are paying the correct rates and amounts.

How a royalty audit works

To create a licensing agreement, the parties’ attorneys usually create a royalty contract governing the use of the intellectual property. This agreement details the terms of the arrangement, spelling out how the licensee may use the asset, the duration of the license and how much the licensee agrees to pay in royalties.

Unfortunately, royalty payments sometimes fall short of the agreed-upon amount. This may be due to a clerical error or confusion about the contract terms — or even fraud. To protect against such shortfalls, most contracts include a “right-to-audit” clause, meaning that the licensor retains the legal right to hire an outside firm to audit the licensee’s payments to confirm compliance with the contract terms.

Typical audit process

To perform a royalty audit, CPAs typically perform the following six steps:

1. Review the agreement to understand its scope, including the asset under license, the duration of the contract, prohibited uses and the royalty rate.
2. Analyze sales data used to derive royalty payments to date. Depending on the type of asset under license, the audit team may request production and inventory records.
3. Perform a detailed walk-through of the process the licensee follows to identify, track and report sales subject to a royalty payment.
4. Conduct random sampling of sales data to ensure the licensee applies the correct rate to generate the royalty payment.
5. Review sales and royalty payment trends to confirm that the licensee’s sales align with the royalty payments.
6. Gather individual invoices from key customers to locate and confirm that sales transactions subject to royalties actually generated a royalty payment.

The licensor usually assumes the cost of the royalty audit. However, some agreements include a clause that requires the licensee to pay the audit costs if significant underpayments are found.

Keep licensees on their toes

Most licensing arrangements function without a hitch. But a minor error or oversight could result in a significant shortfall in royalty payments. Periodic royalty audits can prevent small, but honest, mistakes from spiraling out of control — and help reduce the temptation for dishonest licensees to commit fraud.

Weaver often performs royalty and other contract audits, including the highly specialized “joint interest audits” performed over oil and gas ventures. In the unfortunate event that you suspect fraud, our forensic accounting and litigation support group also has experience with royalty contracts. For more information, contact us.

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