Case Study One
Our procedures at a toy manufacturer revealed that the licensee had included only the manufactured cost of the licensed product in the royalty base rather than the net sales of the product as required by the agreement. In addition, due to the way the product was packaged and marketed the licensor was entitled to a royalty on the net sales of the entire set. Additional royalties due were in excess of $900,000.
Case Study Two
A toy manufacturer sold licensed product and non-licensed product together under one item number. The licensee did not calculate the mix of the assortment properly which resulted in underreported sales of the licensed product. Additional royalties due to underreported sales totaled $105,000. The licensee also created separate item numbers for different retailers that purchased the assortment. The item number for one retailer did not get flagged as royalty bearing even though the item number description clearly listed the licensed product. Additional royalties due to unreported sales were $25,000.
Auditor’s note: In this case addressing the other violations of the agreement was as valuable to the licensor as the additional monies due.
A similar situation occurred at a software licensee when they combined both licensed and non-licensed products together and sold the bundle as a unique item number. The item number did not get flagged as royalty bearing in the licensee’s royalty accounting system. Additional royalties due to unreported sales were $125,000.
Auditor’s note: These situations are rather common particularly at licensee’s that prepare reports using a manual or spreadsheet system. This is why we always review master item listings, websites and catalogs as part of our procedures.
Other Common Occurrences
Incorrect Discounts and Deductions – We find that discount caps are often exceeded or types of discounts not permitted are included in the royalty base. For example one licensee had an actual discount cap of 10%. Rather than reporting actual discounts up to 10%, which was the intent of the agreement, the licensee simply deducted a flat 10% from every sale reported. In reality actual discounts averaged 5% over the three year audit period.
Incorrect Royalty Rates – Some agreements provide for royalty rate changes at certain intervals. Often the person responsible for preparing the royalty report may not have access to the agreement and is unaware of the rate changes or the rate simply does not get changed in the system.
Unreported Free Goods – Many agreements provide for a royalty to be paid on free goods. Frequently free goods and samples do not flow through the normal sales invoicing system and are not captured in royalty reports.