Royalty Audits unravelled
A royalty audit or licensee audit is a financial inspection that determines whether a licensee (user of a license) is paying the licensor (owner of the license) the correct amount of fees that were agreed upon in the contract they have in place for use of the license. The licensor and licensee have entered into an agreement regarding use of the license, and the contract will state what the fees are for use of the license and the frequency that payment is due to the licensor.
Who Needs to get a Royalty Audit?
Royalty audits can occur in many industries but are especially prevalent in media and entertainment. Any company that is engaged in a licensing agreement could be subject to audit if a right to audit clause exists in their contract. A few reasons that a licensor would want to instruct an audit could include:
To obtain money or royalties they are owed by the licensee.
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 aka ‘the policing effect’).
To determine if a licensee is paying correctly.
There can be many different reasons why royalties are reported incorrectly, either intentionally or not by the licensee. These are just some of the reasons we have encountered in our many years of royalty auditing:
Intentional underreporting by the licensee to get away with paying less.
Genuine mistakes by the licensee when preparing the reporting to the licensor.
A misunderstanding of definitions of what is covered in the license agreement between the licensee and the licensor.
New media types that are royalty bearing are not included in the reporting (either intentionally or unintentionally).
Media type and service names being changed of which those preparing the royalty reports are unaware of and therefore exclude them from reporting.
Human errors in the manual preparation of the reporting to the licensor.
Royalty-bearing products being part of a bundle, and the bundle is unintentionally left out of the reporting.
Free media or value not being counted and reported, even though they are royalty bearing.
Differing opinion on what is included in the licensing agreement.
Who can Complete a Royalty Audit?
A licensor can use an internal team to conduct royalty audits of their licensees, but generally an outside audit firm with this specialised expertise is hired to perform the royalty audit. An outside firm performing the audit provides an independent, unbiased party to the licensee and licensor. The audits generally include managing large amounts of data and completing data analytics on the data, which is best completed by a specialised firm with experience with these types of audits and the large amount of data.
In our opinion it is critical to use an audit firm who is fully independent of both the licensee and licensor. This avoids all bias and awkwardness should findings arise. The merits of outsourcing your royalty audits are that the licensor/licensee relationship is less likely to be strained as the auditor deals with the challenges throughout the audit and only once all the facts are agreed and cleared does the licensor need to be involved.
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 use data analytics to review the data and products to assists assessing completeness and accuracy.
A recalculation of what should have been paid by the licensee is completed after we have agreement with the licensee on all the products and services that are royalty bearing. 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.
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.