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Detailed Audit Provisions Save Headaches

Expert Witness: Fulcrum Inquiry
The audit provision within many licensing agreements is nothing more than a short paragraph in what may otherwise be a highly detailed document. We provide sample audit provisions that a licensee should include in every agreement.

The audit provision within many licensing agreements is nothing more than a short paragraph in what may otherwise be a highly detailed document. We sometimes see audit provisions that are nothing more the following:

Licensor, at their own expense, shall have the right to nominate an independent certified public accountant satisfactory to Licensee, who shall have access during reasonable business hours to such of Licensee’s records as are necessary to verify the accuracy of the royalty reports and the royalty payments made under this Agreement.

This simple audit provision fails to detail how the audit
will be undertaken, what type of information will be provided, the manner in which information should be transmitted, or the consequences of a licensee’s reporting failures. If all parties cooperate, additional detail may not be required. Assuming the licensor hired a skillful auditor, the auditor will request and analyze the relevant information and complete the audit using the appropriate standard of care.

However, whether because of resource limitations or a more nefarious intent to hide information, licensors often disagree at the beginning of an audit as to what information will be provided to the auditor, and in what manner the information will be delivered. Being more explicit on these items before a dispute arises will save both money and time when the audit occurs.

Here are areas that will help avoid problems and ensure that the licensee’s payment rights are protected. Of course, the sample provisions shown below must be modified to fit your specific situation:

1. It is a best practice to include a fee-shifting provision when a royalty under-reporting occurs above an identified threshold amount. The licensee should be required to bear the cost of the audit if anything above a (i) specific amount or (ii) percentage error is found. This will also assist your auditor in gaining cooperation from the licensee, since the audit target will likely incur the cost of making the audit more difficult. An sample provision follows:

If the reporting or payment discrepancies disclosed by audit equal or exceed the lesser of (i) five percent (5%) of the amount that was reported under this Agreement or (ii) $5,000, the Licensee shall pay the reasonable costs associated with the audit.

2. The license should spell out (i) the specific routine reports that are to be received by the licensee independent of any audit requests, and (ii) the records that the licensee is required to maintain and retain. A sample provision follows:

As a material condition to the license granted hereunder and to all the benefits to Licensee of this Agreement, Licensee must provide quarterly reporting of the amount owing to Licensor no less frequently than fifteen (15) days after the end of every calendar quarter. The quarterly report shall take the form substantially the same as what is attached as Exhibit X. Each quarterly report shall show detail of all models, designs, part numbers, and/or products that use any portion of the Technology licensed hereunder.

Licensee will keep accurate, full, and complete records that support the quarterly reports and related calculation of the payments due under the Agreement. Such records shall be retained for a minimum of five years.

3. Your auditor should have the right to define the population of records needed to complete his work. He should not need to justify or explain the purpose behind his requests. To allow an audit target to decide which documents your auditor can review is to virtually guarantee your auditor will suffer a scope limitation that will not allow him do a thorough job. Requiring an auditor to explain his reasons may provide the audit target with insight that may allow the audit target to alter or hide information. A sample provision follows:

In order to verify that all royalties are being timely and accurately reported, the auditor shall have the right to inspect all of Licensee’s books and records, including without limitation financial statements, the general ledger, all journals and registers, and all supporting business records of the transactions identified on such records. The relevance of information is at the sole discretion of the auditor and is not subject to approval by the Licensee..

4. Your auditor should have the right to copies of electronic files and any hard copy documents of manageable size in advance of a site visit. This will allow the auditor to analyze the data and make follow up inquiries, thereby reducing audit costs (i.e. travel expenses) and making the site visit more productive. Additionally, your auditor should have access to the files in the native electronic format in which they are maintained. Electronic documents are NOT scanned or PDF copies of printouts of data. This provision greatly improves the speed and accuracy and cost-efficiently of the audit. A sample provision follows:

The auditor may specify the form and location in which records shall be provided for audit, including without limitation requiring electronic and computer records in their native form. The auditor may retain all records associated with the audit until such time as all of the following have occurred: (i) the results of the current audit have been completely accepted by both Licensee and Licensor, and no dispute regarding such audit results remain, (ii)the next subsequent audit has been completed, and (iii) two years.

5. Licensors often request a nondisclosure agreement (NDA) from the auditor before providing information requested by the auditor. If the auditor is a licensed CPA, this additional protection may be redundant since most states prohibit their licensed CPAs from publicly disclosing information obtained from assignments. Nevertheless, the auditor should not object to a typical NDA. However, how much information can be shared with the licensor is a frequent source of friction that should be addressed in the license agreement so that any NDA discussion is routine. The auditor needs the ability to share with his client the results of his audit, as well as report the audit findings in any subsequent dispute resolution proceeding. A sample provision follows:

Notwithstanding the foregoing, the auditor may disclose the Confidential Information to Licensor as well as the employees, consultants, legal and tax advisers, and agents of both the auditor and Licensor (each an “Authorized Recipient”) which the auditor reasonably and in good faith believes is required to be involved in performing the Audit Services or are contractually permitted to receive the results of the Audit Services, provided such Authorized Recipient is informed of the restrictions contained in this Agreement.

6. Interest at a defined rate should be applicable for any unpaid amounts. Otherwise, a licensee may be incentivized to underpay and simply hope the auditors don’t find the underpayment (or that an audit never occurs).

As with any material noncompliance with a license agreement, the licensee should have the right to terminate the agreement if the audit rights are not followed and/or payment of identified amounts are not promptly made.

See also:
Common Licensee Errors
License Audits Best Practices

Fulcrum Inquiry performs a wide range of forensic accounting, including royalty audits, and fraud investigations.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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