Licensing touches nearly every product category in the retail industry; from Disney characters to celebrity-branded home goods and accessories, licensing has expanded across product categories and regions, making proper licensee reporting critical. While intellectual property owners earn royalties in return for granting rights to third parties to produce and sell merchandise, sustained consumer demand means licensors must closely monitor licensee reporting to ensure royalties are complete and accurate.

WHY ROYALTIES DESERVE ATTENTION 

For licensors, intellectual property is a revenue engine — but only if licensees report and pay royalties accurately. Royalty arrangements vary between gross and net sales structures and include different rates, deductions and advances. They also may cover multiple territories and distribution channels. Small differences in contract interpretation or system limitations can impact the royalties studios, creators and brand owners receive. Most often, licensors and licensees run into these issues that lead to underpayment:

  • Process gaps or inexperience at licensees: Royalty reporting is a cost center at licensees and may be handled by teams without sufficient experience or resources
  • Inadequate royalty systems: Legacy or inflexible accounting systems may not model complex calculations or new distribution models
  • Misinterpretation of contract terms: Statements are commonly prepared by people that did not draft the license agreement, which increases the risk of errors

Even sophisticated licensees can mistakenly underpay royalties to a brand owner. This is why licensors commonly have merchandise licensees independently reviewed.

WHAT AUDITS TYPICALLY FIND

When licensors decide to bring in an outside perspective to perform an independent review of their merchandise licensees, these audits look at reporting, contractual and operational issues, including:

  • Data and Reporting Anomalies: Common reporting anomalies include unreported products or sales, miscoded or duplicated expenses, incorrect foreign exchange rates and incorrect pricing
  • Contractual Issues: Certain agreement terms may be overlooked, misapplied or interpreted in licensees’ favor, resulting in underreporting of royalties. Examples of contractual issues include misapplied royalty rates, unauthorized sales and disallowed deductions, among other issues
  • Other Risk Areas: Audits can also uncover issues like statement formula errors, reconciliation variances, and excessive reserves or allowances. When it comes to sublicensees arrangement and affiliated entities transactions, there is additional complexity that may increase the potential for errors

WHEN TO CONSIDER AN AUDIT

Studios, brand owners and creators are advised to consider an audit when the following is observed, as these often signal the potential for underpayment:

  • Irregular earnings patterns
  • Recent changes in licensee reporting or corporate structure
  • Delayed royalty payments
  • Accounts near or past recoupment

Licensors should also review their license agreement for an audit fee reimbursement clause, as many contracts require licensees to reimburse audit costs when errors exceed a specified threshold.

NEXT STEPS FOR AUDITING MERCHANDISE LICENSEES

Regular monitoring of agreements and periodic audits not only help recover unpaid royalties and maintain contractual compliance, but they provide visibility into licensees’ operations and help licensors maximize the value of the licensing agreement.

Licensors that do not currently audit their agreements can consider the following action items:  

  • Tailor monitoring and audit efforts based on risk: Design your audit program based on a continual assessment of licensees’ risk profiles and operation dynamics. In general, complex royalty mechanism and deal structures (e.g., multiple versions of agreements) may pose greater risk for errors or misreporting. Additionally, changing markets — new territories or evolving distribution models — may give rise to new risks as licensee systems and processes may not have been updated to properly account for these new activities
  • Consider a tiered audit approach: Use full audits for top-tier or high-risk licensees and conduct targeted reviews or desk audits to cover medium or lower-risk licensees while keeping the costs down
  • Employ an audit rotation program: Consider a rotation strategy — for example, auditing key licensees every three years — to provide regular oversight. As a preventative measure, you can convey your audit plan at the beginning of the license term to set expectations and motivate licensees to report accurately and maintain proper records to support their calculations
  • Clarify contractual language: Clearly define in the license agreements how royalties are calculated, what counts as revenue and allowable deductions, and how specific products or channels are treated. Specificity and parameters reduce misinterpretation
  • Provide practical support to licensees: Consider offering practical support to less experienced licensees, such as simple templates or examples, to improve the consistency and accuracy of their statements 

Taken together, these steps can help licensors recover missed royalties, reduce disputes and build stronger partnerships with licensees.

Contact GHJ’s Entertainment Practice and royalty licensing specialists for help designing a risk-based monitoring program or to evaluate whether an audit of a specific licensee is warranted.