Internal Audit departments are focused and staffed to effectively address the risks and compliance requirements (e.g., SOX, FCPA, PCI, GDPR) facing their entity.  Internal Audit plans emphasize documenting, testing and improving the major business processes and supporting business change initiatives.  Trademark licensing audits do not fit this focus as these are contract compliance audits of the relevant books and records of a business partner.  There is no business process documentation for planning nor is there any testing of internal controls.  The focus of these audits is to ensure that the information provided for sales, purchases, advertising, payments, etc. is complete and accurate, and then to analyze this information for compliance with the terms and restrictions of the agreement.  The testing is substantive because the licensee is only required to supply information specific to the agreement.  The licensee may also need to provide some high-level information related to their overall business to support agreeing the information provided to their financial records on a sample basis.  The “thinking on your feet” necessary to obtain evidence that the information provided is complete and accurate requires either co-sourcing with specialists or a senior/seasoned member of the audit team.

The most important risk of trademark licensing is potential damage to the brand.  Aspects of product quality and the “fit’ of product with the brand image are beyond the scope of a financial audit.  Likewise, factory/social compliance risks are also beyond the scope and require proof from the licensee of qualified factory social compliance audits or the licensor co-sourcing for such audits.  The scope of the financial licensing audit should include the identification of sales in territories or channels (e.g., clubs, off-price, deep discount) that will degrade the brand, and which violate or exceed limits in the agreement.

Other trademark licensing risks are driven by the clauses in the contract.  Some clauses may make sense to lawyers and management on paper but are difficult to impossible to effectively abide by operationally.  One common clause that comes to mind is that any sales of product to the licensor must be at the lowest price previously sold to any licensee customer or even a certain percentage off that lowest price.   It is not practical for a licensee to program their sales order system to meet such a requirement which means the licensee must manually research prices prior to filling an order for a licensor.  Is it likely the licensee will incur the cost of the time required to manually determine such prices?  Identifying such challenging agreement clauses and developing effective audit tests is critical for a comprehensive trademark licensing audit.

Considering and identifying opportunity/risk for intentional/unintentional understatement of royalties or overstatement of required spend (e.g., advertising) by the licensee remaining undetected is a critical planning aspect of a comprehensive trademark licensing audit.  For example, shipments directly from factories to customers are commonplace and increasing in frequency in many industries.  This is particularly true of consumer products and especially sales to major retailers who have much more efficient supply chains than their vendors and can save time and money importing the products using their own logistics.  In today’s highly efficient supply chains, the company that designs and sells the product is now akin to a costly “middleman”.  Such activity presents significant risks of royalty understatement for licensors.  The licensee never takes physical possession of the product and therefore may not be able to invoice customers using their normal/structured process.   In most ERP systems, shipment triggers invoicing and ensures a “clean” sales cutoff.  Because they are not shipping the product, a different workflow, perhaps even manual invoicing, is required for these direct shipments.  Alternate workflows introduce the risk of intentional/unintentional understatements of sales.  An example of a licensee overstating required expenditures is including payments for product positioning (e.g., end caps) or co-operative advertising on schedules supporting required advertising spend.  Some agreements permit these as includable items, but many do not.  Most agreements require advertising in national magazines, digital advertising and mailers but do not permit including advertising support to customers.  A comprehensive trademark audit defines the specific advertising requirements and develops testing to ensure only such advertising is included on the schedules provided by the licensee to support this spend.  Some agreements require the licensee to remit any shortfall in advertising spend to the licensor whereas others require that these amounts are added to the required spend for a future year.  Either outcome is a significant benefit to the licensor.

Licensee miscoding of product is another risk leading to understatement of sales/royalties.  Some licensees build the brand coding into the SKU number whereas others use sequential SKU numbers and utilize another field in the product master file to indicate brand.  Given that all the reporting is from the licensee systems, the auditor has no basis to rely on reports as complete and accurate.  In the former example, perhaps the reports/queries do not capture branded SKUs in certain product categories.  In the latter example, perhaps the brand designation code was left blank or input incorrectly leading to no inclusion of sales for that branded product in the reports used to report royalties or used to provide reports to the auditor.  Complexity of coding expands further for licensees that ship and invoice multiple brands on a consolidated invoice.  Product coding challenges are typically not known until the auditor is in the field at the licensee’s offices.  A keen understanding of processing and reporting is required to quickly develop audit tests to establish the completeness of sales given such product coding challenges.

We know that excellent business reporting is always a challenge, mainly due to cost and resources.  Many functions require system reporting to effectively manage their responsibilities and they must compete for such resources.  As we might expect, the priority to have excellent reporting to determine sales to pay royalties to an outside party does not rise to the top of many licensee’s priority lists.  Certainly, front line reporting to manage and maximize sales should be a primary goal.  Both the licensee and licensor benefit from effective sales management.  An ERP system report with a heading for the SKU/product and then a listing of units and dollars by customer with totals is helpful for managing sales but not very helpful for the auditor because the SKU, customer, units and dollars are not on the same line.  The reporting challenge is greater with some of the more nuanced clauses of the agreement.  One example is royalty rates tiered by sales level.  Different royalty rates for different product types is another example.  A third example is different sales minimums by product category, territory, gender, etc. or maximum sales percentages to certain channels (e.g., off-price).  The auditor typically must accumulate sales data files by invoice line item with all the appropriate information on each line to then analyze compliance with all agreement clauses.  In some cases, the auditor must develop an elegant solution in EXCEL whereas in other cases the auditor must be willing to grunt through hours of cut/paste to arrive at the complete data file required for compliance analysis.  Experience allows the auditor to determine a solution quickly and get to it.  A bias for action is critical.  Each audit is different, and an auditor likely will not return to the same licensee for years.  There is no time to search for a best solution, just a solution that works.

The skills and experience to complete comprehensive trademark licensing audits on tight budgets require co-sourcing for most companies.  The contract analysis, test development and data analytic skills required for comprehensive trademark licensing audits is unique.  Co-sourcing must be approached with caution, however, because there are many providers that offer these services that simply do not have the skills.  Use the points above in your discussions when interviewing potential co-sourcing partners.  These are typical challenges of an audit and the provider should be conversant with quick and clear strategies to handle these challenges.  Choosing the right partner is the best way to leverage compliance to identify recoveries, ensure control, and deliver value to your entity.

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 IT Governance/Cybersecurity 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/