Armanino Blog

Contract Audits Can Add Pure Profit to the Bottom Line

by Scott Copeland
October 09, 2010

What is a Contract Audit

If you haven’t heard the term contract audit, now is a good time to become familiar. To simplify, contract agreements with third parties are examined to determine whether all the income due is being collected and whether expenses are being overpaid. For example, say you license software to a third party and they owe you a royalty every time that software is used. How do you know the third party is really paying you every time the software is used? Also, how do you know that the investment in your intellectual property is being protected by your licensees? From a cost optimization perspective, let’s say you pay a third party to perform a service and those payments are tied to predetermined quality, performance or other milestones. If the third party’s compliance is never inspected, you could be overpaying.

Contract audits can even span outside of the direct revenue stream. For instance, they can help determine whether sales are within licensed territories, that only authorized products and/or services are being sold, that no new products and/or services are being added and other requirements determined by the licensing agreement. By examining the finest details, not only can recovery of lost revenue be realized but also procedures can be put in to place to ensure ongoing compliance.

Why Not Perform a Contract Audit?

One of the main reasons companies don’t perform contract audits is purely emotional; they don’t want to offend their licensees or other third parties with whom they do business. However, contract audits are simply a way to ensure accurate tracking procedures are in place benefiting both the licensee and the licensor. In fact, many times agreements are set up with a clause permitting audits. Having this sort of language in the agreements will help out with any hesitation to have a contract audit performed.

Signs of Reporting Issues

Taking a first step may be as simple as identifying where or how an error can occur in reporting contract or license income. Although likely not intentional, common errors with contract compliance include:

  • Sales of unauthorized products
  • Improper bundling of licensed products with unlicensed products
  • Alteration of the licensed product to circumvent the contract terms
  • Underreported sales by a sublicensee
  • Incorrect royalty volume calculations
  • Applying inappropriate exchange rates to sales or expenses reported
  • Misapplied conversion rates
  • Clerical errors, which can lead to reporting issues
  • Fraud

In many cases, these errors will manifest themselves in ways a licensor can identify, such as:

  • A third party that does not report timely
  • Late royalty payments
  • Payments not in compliance with the license agreement
  • Payments inconsistent with market expectations
  • Payments inconsistent with previous payment history

Although these are just a few of the key warning signs, there a many more signals that may not be so apparent that are tell-tale signs of misreporting that a contract audit will help uncover.

Ensuring Future Compliance

Drafting a license agreement that includes the best language possible can sometimes be tricky and enforcing it can even be more daunting, especially if those who are the enforcers of the agreement aren’t the originators. Although it can be assumed that even the best drafted agreement will still need oversight, some ways to ensure the maximum amount of income is paid is to ensure the agreement contains no terms open to misinterpretation. Using precise, specific and clear language and statements will help ensure interpretations stay within the bounds of the agreement.

Contract Audits Pay for Themselves (and then some)

Some may feel that hiring a contract auditor might be cost prohibitive; however, in the majority of cases (over 85%), the uncovering of underreported revenues or the recovered costs found, more than covers the fees paid. As an example, one client paid $50,000 to have a royalty audit performed which recovered $600,000 in underreported royalties, penalties and interest. That’s a 12/1 return ratio and was a net $550,000 positive impact to the company’s bottom line. In another example, a client paid $30,000 to find that it was overpaying its advertising agency by over $100,000.

Other side effects can include increased compliance from licensees as well as better accuracy in the future. Having clear-cut parameters in place helps foster the relationship between licensor and licensee as both can appreciate a “no surprises” outcome when royalty payments come due.

Keeping the Bottom Line Healthy

It’s vitally important to protect your intellectual property and to ensure revenue gained from that property is in line with your licensing agreements. Although negotiating new agreements is an important part of being a licensor, it should never take the place of monitoring agreements already established. Remember, any recovery of underreported revenue, or a net reduction in the amounts you pay your third parties,is applied directly to the bottom line, which makes it quite clear why contract audits are needed more and more, nowadays.

October 09, 2010

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Scott Copeland - Partner-in-Charge, Audit - San Francisco CA | Armanino
Partner-In-Charge of Audit
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