Unreported Royalty Bearing Products
Royalty License Investigations Case Study
When our firm performs mutually agreed-upon procedures designed to determine the propriety of royalty payments (commonly referred to as a "royalty audit", one of the most typical findings is sales of new or existing products utilizing licensed technology for which no royalty is being paid. There are several reasons licensees fail to report sales of these products.
In many instances the marketing or engineering departments fail to inform the accounting department of a new product and its related product number so that it can be captured for royalty computation purposes. In other cases, a new royalty-bearing product number has been assigned and the old product number has erroneously been deleted from the sales database, although the licensee continues to sell remaining inventory under the old product number. In several cases we have found that the personnel responsible for computing the royalty report have not read the license agreement and therefore do not fully understand what constitutes a licensed product.
The following are three case studies that depict unreported sales of new or existing licensed products:
- Case 1: The licensee had coded standard products in its sales database with a unique identifier if the product was subject to the terms of the license agreement. While inspecting the licensee's product catalog, we noted two standard products that were not designated as licensed products but did utilize the licensed technology. (These products were introduced after the licensee set up its original coding system and the royalty designator was erroneously omitted.) Additionally, we discovered sales of customized products in the licensee's sales records that utilized the licensor's technology. After conferring with its legal department, the licensee acknowledged that these standard and custom products should have been royalty bearing. The additional royalty due the licensor amounted to $148,000, plus interest.
- Case 2: The licensor believed its licensee had underreported sales of a significant product line. We inspected the licensee's books and records and noted sales of the licensed product under a different product number than the item being reported. Upon internal investigation, the licensee acknowledged that they had acquired the product line from another manufacturer and continued using the original manufacturer's product number for a period of time before switching to their own product number. When preparing the royalty reports, they did not check for sales under the previous product number. The additional royalty due the licensor amounted to $73,000, plus interest.
- Case 3: The licensee had gone through several reorganizations following various acquisitions. The accounting personnel at its west-coast headquarters were unaware of which products were subject to royalty and the minimum annual royalty amounts. They acknowledged that their legal department was on the east coast, and they had never read or seen the agreement. We inspected their product listing and determined that they were selling two additional royalty-bearing products and owed $22,000 of additional royalties, plus interest.
In summary, most technologies can be used in more than one product. The case studies above demonstrate that there are a number of situations that give rise to the underreporting of sales. You cannot be certain that even with the best of intentions the licensee's personnel are treating your license agreement with due care. If you suspect there may be inaccuracies in the royalty reports you receive, it may be time to consider applying agreed-upon procedures to your license agreements.
To learn more about McGladrey's royalty audit services, contact Sidney Rattner at 847.517.7070.