2006 Audit Findings formattted
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2006 Audit Findings formattted

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The Significance of Underreported Royalties - 2007 Update The Magnitude and Meaning of Royalty Misreporting by Debora R. Stewart, CPA and Judy A. Byrd, CPA Level of Royalty Underreporting 80% of licenses have underreported royalties Improperly Reported Properly Reported The importance of IP licensing revenue continues to grow, yet unrealized revenue from misreported royalties continues to significantly impact licensors’ bottom lines. Invotex Group studies licensing relationships to measure the frequency of underreported licensing revenue and the impact of such underreporting on a licensor’s ultimate financial results. Ineffective management often results in licensors collecting much less than they are owed. The report discusses the results of a  study and examines causes of underreporting.   February 2007  The Significance of Underreported Royalties – 2007 Update Royalty Misreporting: Magnitude and Meaning By Debora R. Stewart, CPA and Judy A. Byrd, CPA*  INTRODUCTION About Invotex Group   Invotex Group provides advisory services Are  you  reaping  the  full  benefits  of  your  license for intellectual property owners, including agreements?  Does this concept concern you?  It probably licensing, technology evaluation, license should. Enormous resources are expended in drafting and compliance and royalty audits, asset negotiating license agreements, not to mention the time, management and enforcement of IP rights. The firm offers a ...

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The Significance of Underreported Royalties  2007 Update The Magnitude and Meaning of Royalty Misreporting
by Debora R. Stewart, CPA and Judy A. Byrd, CPA
February 2007
Level of Royalty Underreporting 80% of licenses have underreported royalties
Improperly Reported
Properly Reported
TheimportanceofIPlicensingrevenuecontinuestogrow,yetunrealizedrevenuefrommisreportedroyaltiescontinuestosignificantlyimpactlicensors’bottomlines.InvotexGroupstudieslicensingrelationshipstomeasurethefrequencyofunderreportedlicensingrevenueandtheimpactofsuchunderreportingonalicensor’sultimatefinancialresults.Ineffectivemanagementoftenresultsinlicensorscollectingmuchlessthantheyareowed.Thereportdiscussestheresultsofastudyandexaminescausesofunderreporting.
TheSignificanceofUnderreportedRoyalties2007UpdateRoyaltyMisreporting:MagnitudeandMeaningByDeboraR.Stewart,CPAandJudyA.Byrd,CPA*About Invotex GroupINTRODUCTIONInvotex Group provides advisory services Areyoureapingthefullbenefitsofyourlicensefor intellectual property owners, including agreements?Doesthisconceptconcernyou?Itprobablylicensing, technology evaluation, license compliance and royalty audits, assetshould.Enormousresourcesareexpendedindraftingandmanagement and enforcement of IP rights.negotiatinglicenseagreements,nottomentionthetime,The firm offers a comprehensive suite of effortandmoneyspentgeneratingoracquiringtheservices to provide the strategic and intellectualproperty(“IP”).Somepeoplemaybealtruistic,tactical expertise necessary to optimize IP onlyinterestedinpromotingsociety’scommongood.Butvalue throughout its lifecycle. Specifically, Invotex monitors licenses for compliance toothers,primarilyinvestorsandtrustees,areinterestedinhelp clients maximize the value and recoupingtheirinvestmentsthroughroyaltypaymentstorevenue generated by their IP. For more theorganization.Becauseoftheseforces,managementisinformation about Invotex Group, please taskedwiththeresponsibilityofensuringthatassetsarevisitwww.invotex.com. protectedandusedtotheirfullestearningpotential.*About the Authors ProblemsarisewhennoonetakesresponsibilityforDebora Rose Stewart, CPA, is a protectingassets.WereadaboutitinthepapersandhearManaging Director and cofounder of Invotex Group’s IP Management & Financeaboutitinthenews.Cashisembezzled.Fraudispractice, which assists clients in managing perpetrated.Machineryandotherconsumables“walk”outtheir intellectual assets. With more than 20 thedoor.Theseassetmisappropriationsarequitecleartoyears of financial and consulting everyone.Whatmaynotbesoclearareinattentiontoexperience working with corporations, universities and government entities andefficiencies,timevalueofmoney,andoperatingbelowfulltheir counsel, Ms. Stewart provides potential.IPisoftenvictimtothiscategoryofinattention.Itstrategic assistance and tactical expertise isoverlookedbecausebyitsnatureitisintangible.to help clients optimize the value of their Sometimesitisnotincomegenerating,orisit?PerhapsnoIP, primarily in the areas of License oneismonitoringtheassets.Management and Royalty Compliance. She can be reached at 410.824.0141 ordstewart@invotex.com. Eitherway,intoday’sbusinessenvironment,managementisinthespotlight.TheyarebeingaskedtodesignandJudy A. Byrd, CPAis a Director with implementsystemsandprocedurestoprotectandInvotex Group’s IP Management & Finance practice. With more than 15 years ofmaximizetheirorganization’sassets,bothtangibleandfinancial consulting and audit experience, intangible.TheyarebeingaskedtoprofessinwritingthatMs. Byrd joined Invotex to perform royalty theirfinancialstatementsaretheirresponsibilityandthataudits. In both public accounting and thestatementsarefairlystated.corporate settings, she has led financial statement and royalty audits and otherUpuntilnow,manyhaveoverlookedintellectualpropertyassurance engagements in various industries. She can be reached at 410.824.0142 or jbyrd@invotex.com.
February 2007
revenuesasincidentalandimmaterialtotheirorganization.Theymightbewrong.Ifyouarealicensorinaroyaltybearinglicenseagreement,chancesarehighthatyouarenotreceivingfullcompensationfromyourlicensee.Sincewebeganaggregatingdatafromourroyaltyaudits,wehavefoundthatapproximately80%oflicenseesbothunderreportandunderpayroyaltiestotheirlicensors,frequentlyinstaggeringamounts.Chart1illustratesthemagnitudeofthisunderreportingepidemic.“WHY?”VS.“HOW?”Itisimportanttoexplorethereasonswhyunderreportinghappens.Theanswersarepredictablebutnoteworthy.Thecynicsofthegroupwilltellyouthatpeoplearedishonestandwilltrytopushtheenvelopeonminimizingtheirpayments.Yes,willfulmisreportinghappens,but,inour
experience,itonlyhappensinaminorityofthecases.Typically,wefindmisreportinghappensbecauseofinattention,oversight,oradisconnectbetweenthosewhonegotiatedandwrotethelicenseagreementandthosewhoareputinapositiontointerpretit,or,worseyet,thosewhohaveneverseentheagreementbutareaskedtoreportunderitsterms.Ratherthanfocusingonthe“why,”wethinkitismoreimportanttounderstand“how”themisreportinghappens.Understandinghowerrorsoccurandbeingabletospottheindicationsearlycanmeanthedifferencebetweenahealthylicensorlicenseebusinessrelationshipandanadversarialorawkwardone.Thegoalofthefirstistoinitiateregularcommunicationthatproducesmutualsatisfactionwithbenefitsrightfullyenjoyedbybothparties,thewayitwasnegotiated.Theotherissilentandallowsabuildupofresentment
Historical Statistics Underreported Royalties as a Percent of Reported Royalties 80% Underreported – 20% Reported Accurately
6%
9%
11%
2549%
1124%
5099%
610%
9%
20%
15%
Properly Reported
Over 100%
Chart 1
40% have underreported royalties in excess of 25%
SignificanceofUnderreportedRoyalties
25%
20%
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formoneyandtimewastedanddistrustforcurrentandpotentiallyfuturecollaborations.Whichwouldyouchoose?Despitetheclarityofthisquestion,wefindthatmanylicensorswantwhattheyperceiveasthebestofbothworlds.Theytrytopromoteafeelingoftrustwithsilence,fearingthatanyquestionraisedisperceivedbythelicenseeasanaccusationofdeceit.Areyouoffendedwhentheclerkbehindthecounterscrutinizesyour$20billforcounterfeitingindications?Don’tyouverifythatyourcreditcardstatementincludesonlyitemsthatyouchargedbeforeyoupayit?Theseactionsaregood,fiscallyresponsibleactions,andverifyingroyaltyreportsisnodifferent.Tounderstandhowmisreportinghappens,firstweneedtoexaminewherethemisreportingoccurs.Chart2isarepresentationoftheroyaltyauditsInvotex
Chart 2
Math Errors 5%
Royalty Rate Errors 4%
SignificanceofUnderreportedRoyalties
performedduring2006andshowswherewefoundvariancesbetweenwhatwasoriginallyreportedandourexaminationresults.Chart3depictsthefrequencyatwhicheachofthesecommonerrorsoccurred.Itisimportanttonotethatreportingerrorsarenotmutuallyexclusive.Infact,inmostinstanceswhereonetypeoferrorwasfound,wealsofoundatleastoneothertypeofreportingerror.TheremainderofthisarticlewilldiscussthefindingsinChart2,howtheerroroccurred,andproposeactionstolimitfuturemisreporting.MathErrors5%ErrorRateThefactofthematteristhatalthoughweusecomputersforcalculationsandtryourbesttobeaccurate,wearehuman.Atonetimeoranother,eachofusmakesmistakes.
2006  Findings by Error Type Based upon Total Unreported Royalty $ Uncovered
Unreported Sublicense 17%
Royalties from Disallowed Deductions 9%
Unreported Benchmarks or Milestones 5%
Transfer Prices 4%
Royalties from Underreported Sales 16%
Questionable License Interpretation 40%
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Cananyofyouidentifywithanyofthefollowingscenarios?Youcreatedasimplespreadsheetthataddsacolumnofhundredsofnumbers.Unfortunatelyyouhaveforgottenanitemandyouneedtoaddarow,whichyoudoabovethetotal.However,whenyouaddtherow,youforgettochangetheformulathatcalculatesthetotalsothatitincludesthenewrow.Thisisbadenough,butthen,nextmonthyouusethissamespreadsheetandimportamountsforarollingtotal.Theproblemcompounds.YoumeanttomultiplycellC24byD27butpointedtocellD28instead.Youforgottomakeyourformula“absolute”beforecopyingandpastingacrosstheentirespreadsheet.YouforgottouseparenthesesinaformulatochangehowExcelreadsit.Forexample:o=5+2*3theresultbeing11
Chart 3
50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
SignificanceofUnderreportedRoyalties
becauseExcelcalculatesmultiplicationbeforeaddition.Theformulamultiplies2by3andthenadds5totheresult.o=(5+2)*3theresultbeing21.Ifyouuseparenthesestochangethesyntax,Exceladds5and2togetherandthenmultipliestheresultby3toproduce21.Dotheseerrorssoundsilly?Well,thesearepreciselytheerrorsthatcomprisethe5%inChart2.Thelicensorsreceivingthereportsweresoexcitedbytheroyaltyrevenueamountsoncheckstheywerereceivingthattheydidnotnoticethatthenumbersjustdidn’tmakesense.Notoneofthereportswasmathchecked.Thelesson:Pluginthe10keyandmakesurethearithmeticworks.Betteryet,askforelectroniccopiesofthespreadsheetssothatyoucaneasilyexaminetheformulasand
Frequency of Common Underreporting Errors
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methodbehindthespreadsheets.Anaddedbenefitofelectronicreportsisthatyoucancombineandcomparethemfortrends,consistency,and,potentially,internalforecastingandbudgeting.RoyaltyRateErrors4%ErrorRateMisappliedroyaltyratesaccountedfor4%ofthedollarvalueofourfindings.Alargenumberofproductswithacorrespondinglylargenumberofroyaltyrateswastheprimarycauseofthisproblem.Unlessthereportingsystemsarefullyautomatedandhavebeenaccuratelyprogrammedtoapplytheproperratestotheproducts,errorshappen.Sucherrorsarethehardesttofindbecauseyoumustbediligentwiththereviewprocess.Dependingonvolumes,nickelanddimevariancescanadduptobigmoney.Tocomplicatematters,someagreementsarewrittentoincludecomplexcalculationsoftheratebasedonanindex,liketheconsumerpriceindex.Itsoundssimpleandreasonabletoadjusttheroyaltyratebythecostofinflation,right?Well,unlesstheagreementspecifies,yourlicenseemightbedecidingbetweenthefollowing:traditionalConsumerPriceIndexforAllUrbanConsumers(CPIU)thenewerChainedConsumerPriceIndexforAllUrbanConsumers(CCPIU)CPIW,whichisbasedontheexpendituresofhouseholds,includedintheCPIUdefinitionthatalsomeettworequirements:Morethanonehalfofthehouseholdʹsincomemustcomefromclericalorwageoccupationsandatleastoneofthehouseholdʹsearnersmust
SignificanceofUnderreportedRoyalties
havebeenemployedforatleast37weeksduringtheprevious12months.
Eachmonth,consumerpriceindexesarepublishedalongwithshorttermpercentchanges,thelatest12monthchangeand,atthenationalitemandgrouplevel,unadjustedand(whereappropriate)seasonallyadjustedpercentchanges(andseasonalfactors),togetherwithannualizedratesofchange.
Istheselectionofthisratesomethingyouwanttoleavetochance?
Thelesson:trytosimplifytheapplicationofroyaltyratesinthelicenseagreement.Wherealargenumberofproductsexistsorisexpected,groupthemandapplytheratesbytypeorpricerange,ratherthanbyindividualproduct.Ifvolumesareaconcerntothelicensee,usetiersandapplygraduatedrates.Whatevermethodisused,thelicenseagreementshouldcontainclearandpreciselanguage.Itshouldprovidedetailonhowthecalculationsaretobeperformedandincludeasamplecalculationasanexample.Ifsomepublishedindexorotherrateistobeusedinthecalculations,specifywhopublishestherateandpreciselywhichrateistobeusedandincludeacopyofthelastpublishedindextobeassuredallareconsideringthesamepieceofdata.
Ifyouhaveanexistingagreementthatcontainsunclearlanguage,clarifyingthecorrectmethodtocalculateroyaltiescouldtakesometimeandeffort.Afteryouunderstandhowtheratesarebeingapplied,thoroughlydiscussthematterinternally(todecidewhatyourlegalandpoliticalpositionsare)andthenwithyourlicenseeto
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getacommonunderstandinggoingforward.Then,consideramendingtheagreement.
TransferPrices4%ErrorRate
Transferpriceisthepricethatisassumedtohavebeenchargedbyonepartofacompanyforproductsandservicesitprovidestoanotherpartofthesamecompanytocalculateeachdivisionʹsprofitandlossseparately.Sometimesorganizationschargetransferpricestopartnersunderamarketinganddistributionagreement,providingapricebreakinexchangeforotherfinancialreturns,includingroyalties.Incontrast,armslengthpricingorthirdpartypricingisthepriceatwhichtwounrelatedandnondesperatepartieswouldagreetoatransaction.Pricesarehigherinthirdpartypricing,and,typically,thesearethepricescontemplatedinlicenseagreementswhennetsalesisusedastheroyaltybase.Evenifthelicenselanguagespecifiesthirdpartypricing,whichwerecommend,sometimesthelicenseeonlyhasaccesstothesalesgeneratedattheirlevelorentityandcannotaccessthesalesdollarsgeneratedfromthesaletotheultimateconsumer.Howdoyouspotthistypeoferror?Oftentimes,anonsiteauditistheonlymeansofreviewingthelicensee’sinternalfinancialdocumentstodiscoversuchaproblem.Mostlikely,yourlicenseewillnotprovideyouthesameaccesstothisconfidentialinformation.Youshould,
SignificanceofUnderreportedRoyalties
however,beawareofthemarketpriceofthelicensedproductsandperformanalyticsandtrendcomparisonsontheroyaltyreportstoensurethatthenumbersmakesense.
Thelesson:Thistypeoferrorisnoteasytoidentify.Evenintrendanalyses,changesinvolumesandpricingaswellasmultiplecountrysalescanmuddythedata.Doyourbestandverifywithaninternetpriceorcatalogprice.Watchpubliclyreportedinformationsuchasannualreportsandpressreleasesforsalesalliancesthatrelatetoyourlicensedproduct(s).Lastly,ofcourse,trytobespecificinwordingthelicenseagreement,particularlyinthedefinitionoftheroyaltybaseifitisrelatedtosales.
UnreportedBenchmarksandMilestones5%ErrorRateNotsurprisingly,wefindthatouruniversityandgovernmentalclientsarethehardesthitbythisreportingdeficiency,duetothedevelopmentstateofthetechnologylicensed.Becausebenchmarksandmilestonesgenerallymustbetrackedoutsideofthegeneralledgeraccountingforsales,licenseesmusthaveadditionalsystemsandchecksinplacetoensurethattheselicenserequirementsarefulfilled.Personscompilingthereportsmusthaveaccesstothelicenseagreementandbemindfultoconsiderifandwhenthesepaymentsneedtobemade.Frequently,benchmarksandmilestonesgetlostintheshuffle.Thesetypesofpaymentsmaybebasedonresearchanddevelopment,producttrialsor
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