Organizations typically license their trademarks with several partners in different channels, product categories or geographies. While the overall trademark licensing business process should be part of your internal audit risk assessment along with all other business processes; trademark licensing requires a sub-assessment of risk using a different process due to the inclusion of many business partners, the reliance on accurate data reported from external parties using their systems, and the characteristics of the agreements.
The starting point is to identify all the licensees, obtain all the agreements and develop an agreement extract template to complete for all agreements. The template will likely expand as you proceed through the agreements and you identify unique clauses that are of interest to audit. I typically perform the initial abstract in a Word table. There are numerous clauses in these agreements that are arguably all important, however, this process requires determining which clauses are important for Internal Audit to consider. For example, the agreement should include social compliance requirements (i.e., factory audits designed to ensure no child labor, no prison labor, environmental compliance, etc.). These are only relevant for inclusion if your organization does not have a factory compliance function which includes licensees in their scope. Typically, product approval and product quality considerations are not relevant for the Internal Audit risk assessment, but the absence of such oversight in your organization may bring these considerations into scope. Certainly, gross sales and the permissibility of/limitations on deductions to arrive at net sales for royalty purposes is relevant. Advertising spend requirements are relevant because validation via audit sampling is necessary to verify compliance. Territory restrictions are particularly important if your organization has agreements with more than one licensee for the same channel or product category. Agreements typically restrict certain channels (i.e., wholesale, retail, internet, military bases, corporate gifts programs) and the magnitude of the opportunities in these channels dictates the relative importance of these to your organization, and your risk assessment.
Once the agreement extracts are complete, transfer certain key data from these to a spreadsheet for risk-scoring and scheduling of the licensee audit plan for the next three years. The completed risk-assessment will determine how many audits per year are expected, the estimated total audit cost and allow you to plan/schedule resources accordingly. Involve the Licensing Team every step of the way because their input and agreement are invaluable. You also need to demonstrate the service internal audit provides to their division to ensure compliance, maximize revenue and advertising spend, and identify the licensees that require the most oversight. I’ve had more than one audit year where licensee audit recoveries pushed the licensing divisions earnings into a higher bonus tier for the licensing team.
After all the licensees are added to the spreadsheet, the risk scoring can proceed. I suggest you consider scoring of the following Risk Factors:
- Prior Audit Results – the number of issues, their importance (monetary or not) and the amount of recoveries. Certainly, a recovery of greater than $50,000 or an issue that negatively impacts the brand earns an elevated risk score typically leading to annual audits.
- Sophistication of Systems – a licensee with multiple divisions on more than one system earns an elevated risk score. Licensees that migrated to new systems also earn an elevated risk score.
- Sophistication of Reporting – a licensee that must compile the information for royalty reports offline in EXCEL earns an elevated risk score due to the introduction of spreadsheet error.
- Recording of Activity – establishing the completeness and accuracy of the detail sales data supplied by the licensee and agreeing this to the general ledger are critical activities for the auditor. Reasonably agreeing the sales in units from an inventory roll-forward to these sales reports also establishes confidence in the completeness of the data. The licensee recording activity by brand into a separate “division” typically makes these reconciliations easy. Recording activity by product category for multiple brands, especially for retail location sales, typically makes such reconciliation and agreement to financials difficult to impractical. The latter circumstance earns an elevated risk score.
- Drop Shipment (Back-to-Back) Activity – circumstances where the licensee never takes physical possession of goods but rather releases them directly to customers or sub-licensed distributors significantly increases the risk of un-reporting error and fraud. Reconciliation to the inventory roll-forward discussed above will not identify this under-reporting. Drop shipment activity earns an elevated risk score.
- Use of Foreign Distributors (sub-license) – the sales transactions of the licensed product occur in the systems of an entity other than your licensee which increases the risk of intentional or unintentional under-reporting by the licensee or sub-licensee. Permission of sub-licensees earns an elevated risk score.
- Sales to Licensor at Required Pricing – licensors that purchase products from their licensees (e.g., to sell in direct-to-consumer channels) typically include a “most favored nation” clause in the agreement to ensure that they always receive the lowest price. This makes sense to those negotiating the agreement, however, in practice the order processing team of the licensee does not readily have the information and resources to identify and process pricing that complies with these terms. Inclusion of such clauses earns an elevated risk score.
- Multiple Currency Reporting – conversion of sales data from more than one currency earns an elevated risk score.
- Reported Sales as Compared to GMS – most agreements have Guaranteed Minimum Sales (GMS) that the licensee must achieve. Guaranteed Minimum Royalties typically follow from the GMS. If the licensee is well below the GMS it is unlikely an audit will identify unreported sales to the extent that additional royalties are due and, as such, this factor earns a reduced risk score. A licensee well above the GMS earns a moderate risk score. A licensee that is just below the GMS earns the most elevated risk score because they are in a position that may motivate under-reporting and avoidance of royalty on the incremental sales that push them past the GMS.
- Deductions from Gross Sales to Arrive at Net Sales – the magnitude of deductions typically taken as a percentage of gross sales drives the magnitude of the risk score. Licensees that sell to department stores and Amazon typically have higher deductions. If the agreement specifies limits on deductions and the deductions are at/near this limit, an elevated risk score is assigned.
- Advertising Requirements – agreements typically require spending a certain minimum percentage of sales on advertising and promotion. Some agreements further break down what types of advertising satisfy these requirements and may further specify percentages of the total that must be spent on each category. The more the complex the agreement requirements, the more elevated the risk score.
- Co-operative Advertising – the agreement treatment of co-operative advertising as either a deduction or as part of required advertising is an important distinction. Licensees typically do not properly segregate these amounts. Agreements where the co-operative adverting is classified as adverting rather than as a deduction earn an elevated risk score.
- Territory – a world-wide license has no risk for this factor, whereas a territory specific license increases the risk, and a circumstance where either your organization or another licensee sells the same product category in a different territory earns an elevated risk score.
- Channel Restrictions – like territory, channel risk increases as there are others permitted to sell in the restricted channels (e.g., Corporate Gift Programs).
- Complexity of the Agreement – the more clauses in the agreement subject to audit the more elevated the risk score.
- Years Since Last Audit – change occurs over time (new systems, customers, management, persons compiling the royalty reports) and the passage of time earns an elevated risk score.
- Right to Audit – agreements specify the number of prior years that are subject to audit. Typically, this is three years. The closer to this limit earns an elevated risk score. Before an audit year is permitted to lapse, both the licensing team and internal audit must explicitly agree to allow the year to lapse.
- Club Sales – Restrictions on sales to Clubs (e.g., Costco, Sam’s Club) requiring special arrangements and permissions are rather typical. In many cases sales to these customers do not count against GMS. Such clauses increase risk of underreporting or underpayment of royalties and earn an elevated risk score.
- Off-Price Channel Limitations – Limitations on sales to “Off-price” channels as either an outright exclusion, an exclusion on current season product, or an upper cap on these sales as a percentage of total sales increase complexity and risk and thus lead to an elevated risk score.
As you proceed through this exercise, the categories of low, moderate, and high-risk licensees become apparent. Include the high risk on the current audit plan, the moderate on a two-year schedule and the low on a three-year rotation. The risk-assessment should occur annually, but you need to be cognizant of the initial assessment and especially the limitations on how many years the agreements allow you to audit. Therefore, you need to “lock in” the two/three year from the prior assessment and only adjust these if circumstances have changed. The focus of year two and future assessments is the high-risk licensees and if circumstances have improved to migrate them to a two-year rotation.
The main goal of the licensee audit program is to improve compliance. It is far better for your organization to collect all royalties due timely and to ensure the brand is properly protected. The financial recoveries of a successful program should diminish over time. You must emphasize this goal up front because there may be those in management who see reduced financial recoveries as an indication of complacency or lack of focus. Reduced recoveries indicate reduced risk and a program that is well managed. As the program succeeds over time, the frequency of licensee audits will decrease as their risks scores also decrease. Proper communication allows the licensing team and your senior management to realize how you leverage compliance to maximize revenues, protect the brand and reduce risk.
About the Author
Glenn Murphy, the co-founder of BestGRC and founder of GRC Management Consulting LLC, primarily focuses on empowering entities to leverage their compliance activities through the BestGRC “cloud” software, his consulting work, publications, and the “Leverage Compliance” blog. In addition, Glenn provides licensee compliance audits in conjunction with Licensing Compliance Group and Cybersecurity/NIST/Penetration Tests/SOC for Cyber/SOC 2/3 Assessments in conjunction with Ra Security Systems. Find Glenn’s full profile at http://www.linkedin.com/in/glenntmurphy/, follow him @GlennMurphyGRC and subscribe to the Leverage Compliance blog at http://www.bestgrc.com/blog/