At the request of subscribers, Compliance Week offers a Remediation Center, in which readers can submit questions—anonymously—to securities and accounting experts. Compliance Week’s editors will review all questions and then submit them—confidentially, of course—to specialists who can address the issues. The questions and responses will then be reprinted in a future edition of Compliance Week. Below is one of the Q&As; ask your own questions by clicking here.
QUESTION
What’s the best approach to auditing royalties due on licensing agreements for tangible goods? We’re a sports apparel company that has licensed our trademarks to select overseas companies so they can create and sell certain apparel products bearing our trademark. They pay royalties based on a percent of net sales formula (varies by licensee). The licensing income typically is in the $1 million range annually. How can I best assure everything is running smoothly?
ANSWER
As companies globalize and further develop intellectual assets such as licenses and trademarks, they must establish license and trademark agreements as well as a system of legal and financial controls to provide assurance that the company receives the revenue it is due. Companies also have operational and strategic objectives for compliance, including assuring that the licensors’ trademarks are properly used.
Companies like yours have numerous options, depending on the internal controls of both your business and the licensee’s, the level of risks in the licensee’s country, and the availability of qualified third-party professionals in the licensee’s country to perform auditing and other ancillary services. In all these scenarios, we assume you have already done the due diligence to evaluate these risks and have written strong and enforceable agreements.
Among the options:
Licensee self-reports or performs self-assessment. This could be workable if you are satisfied that the licensee has good internal controls. As this method is least intrusive to the licensee, if this level of assurance is already available, it’s to the licensee’s advantage to establish this level of assurance with the licensing company.
Employ an independent third party. If the revenue flows justify the appointment of an international audit firm, there are firms that specialize in the audit of royalties. There are advantages to the choice of many third parties, including expertise in particular countries and across many countries, or those that perform such audits on a contingency basis.
Licensor performs these reviews itself. This method is used extensively, but the breadth of coverage could vary depending on the cost-benefit of the countries to be visited and the cooperation of the licensee.
Once you’ve selected an appropriate option, you need to take several validation measures to set up the objectives for the procedures to be performed.
Discuss verification process licensor undertook to establish relationship with licensee: background on the licensee, financial statements, experience with prior trademarks/licenses, years in business, etc; laws in country for repatriation of royalties or payments.
Verify that there is a right-to-audit clause and that it is not restricted by time or if it is, that the applicable time limits have not expired.
Obtain listing of all licensee royalties received: names, addresses, and amounts of royalties for all payments received together with the applicable trademarks.
Discuss the format of the audit report with legal department. Discuss with your business unit managers the internal controls they have in place to be sure they have received (and keep receiving) all royalty payments due to them. Ensure that they receive reports from the licensee on a regular basis and that those reports detail the sales on which royalty payments are being made, that the specific amounts are properly calculated, that payments are received on a timely basis as required by contract, that funds are deposited on a timely basis in the bank, and that proper accruals are being made.
If an actual audit goes forward, you’ll have a few more steps to take:
If you’ve determined that internal controls over royalties are strong, obtain copies of the audited financial statements. You can probably allow the licensee to self-report.
If these conditions do not exist, then licensor should employ any of options above. The desired option should be employed through a top-level risk and cost-benefit analysis.
Advise the licensee of the upcoming audit with specific communications to the financial officer in charge. Communicate with the licensee’s general counsel as appropriate and confirm the scope and requirements of the audit.
If the licensee has a manufacturing facility, review controls on the shop floor over production, categorization, and tabulation of items subject to royalty payments. Speak to individuals on the shop floor and in accounting to ensure that they understand the process.
Review on a select basis other product sales controls to ensure no products subject to royalty payments have been excluded.
No comments yet