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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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• Publié par: Nufor
• Nombre de lectures: 10
• Langue: English

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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,yet unrealizedrevenuefrommisreportedroyaltiescontinuesto significantlyimpactlicensors’bottomlines.InvotexGroupstudies licensingrelationshipstomeasurethefrequencyofunderreported licensingrevenueandtheimpactofsuchunderreportingonalicensor’s ultimatefinancialresults.Ineffectivemanagementoftenresultsinlicensors collectingmuchlessthantheyareowed.Thereportdiscussestheresultsof astudyandexaminescausesofunderreporting.

TheSignificanceofUnderreportedRoyalties–2007Update RoyaltyMisreporting:MagnitudeandMeaning ByDeboraR.Stewart,CPAandJudyA.Byrd,CPA* About Invotex Group INTRODUCTION Invotex Group provides advisory services Areyoureapingthefullbenefitsofyourlicense for intellectual property owners, including agreements?Doesthisconceptconcernyou?Itprobably licensing, technology evaluation, license compliance and royalty audits, asset should.Enormousresourcesareexpendedindraftingand management and enforcement of IP rights. negotiatinglicenseagreements,nottomentionthetime, The firm offers a comprehensive suite of effortandmoneyspentgeneratingoracquiringthe services to provide the strategic and intellectualproperty(“IP”).Somepeoplemaybealtruistic, tactical expertise necessary to optimize IP onlyinterestedinpromotingsociety’scommongood.But value throughout its lifecycle. Specifically, Invotex monitors licenses for compliance to others,primarilyinvestorsandtrustees,areinterestedin help clients maximize the value and recoupingtheirinvestmentsthroughroyaltypaymentsto revenue generated by their IP. For more theorganization.Becauseoftheseforces,managementis information about Invotex Group, please taskedwiththeresponsibilityofensuringthatassetsare visitwww.invotex.com. protectedandusedtotheirfullestearningpotential. *About the Authors Problemsarisewhennoonetakesresponsibilityfor Debora Rose Stewart, CPA, is a protectingassets.Wereadaboutitinthepapersandhear Managing Director and cofounder of Invotex Group’s IP Management & Finance aboutitinthenews.Cashisembezzled.Fraudis practice, which assists clients in managing perpetrated.Machineryandotherconsumables“walk”out their intellectual assets. With more than 20 thedoor.Theseassetmisappropriationsarequiteclearto years of financial and consulting everyone.Whatmaynotbesoclearareinattentionto experience working with corporations, universities and government entities and efficiencies,timevalueofmoney,andoperatingbelowfull their counsel, Ms. Stewart provides potential.IPisoftenvictimtothiscategoryofinattention.It strategic assistance and tactical expertise isoverlookedbecausebyitsnatureitisintangible. to help clients optimize the value of their Sometimesitisnotincomegenerating,orisit? Perhapsno IP, primarily in the areas of License oneismonitoringtheassets. Management and Royalty Compliance. She can be reached at 410.824.0141 or [e-mail]. Eitherway,intoday’sbusinessenvironment,management isinthespotlight.Theyarebeingaskedtodesignand Judy A. Byrd, CPAis a Director with implementsystemsandprocedurestoprotectand Invotex Group’s IP Management & Finance practice. With more than 15 years of maximizetheirorganization’sassets,bothtangibleand financial consulting and audit experience, intangible.Theyarebeingaskedtoprofessinwritingthat Ms. Byrd joined Invotex to perform royalty theirfinancialstatementsaretheirresponsibilityandthat audits. In both public accounting and thestatementsarefairlystated. corporate settings, she has led financial statement and royalty audits and other Upuntilnow,manyhaveoverlookedintellectualproperty assurance engagements in various industries. She can be reached at 410.824.0142 or [e-mail].

February 2007

revenuesasincidentalandimmaterialto theirorganization.Theymightbewrong. Ifyouarealicensorinaroyalty‐bearing licenseagreement,chancesarehighthat youarenotreceivingfullcompensation fromyourlicensee.Sincewebegan aggregatingdatafromourroyaltyaudits, wehavefoundthatapproximately80%of licenseesbothunderreportandunderpay royaltiestotheirlicensors,frequentlyin staggeringamounts.Chart1illustratesthe magnitudeofthisunderreportingepidemic. “WHY?”VS.“HOW?” Itisimportanttoexplorethereasonswhy underreportinghappens.Theanswersare predictablebutnoteworthy.Thecynicsof thegroupwilltell youthatpeopleare dishonestandwilltrytopushtheenvelope onminimizingtheirpayments.Yes,willful misreportinghappens,but,inour

experience,itonlyhappensinaminorityof thecases.Typically,wefindmisreporting happensbecauseofinattention,oversight, oradisconnectbetweenthosewho negotiatedandwrotethelicenseagreement andthosewhoareputinapositionto interpretit,or,worseyet,thosewhohave neverseentheagreementbutareaskedto reportunderitsterms. Ratherthanfocusingonthe“why,”we thinkitismoreimportanttounderstand “how”themisreportinghappens. Understandinghowerrorsoccurandbeing abletospottheindicationsearlycanmean thedifferencebetweenahealthylicensor‐ licenseebusinessrelationshipandan adversarialorawkwardone.Thegoalofthe firstistoinitiateregularcommunication thatproducesmutualsatisfactionwith benefitsrightfullyenjoyedbybothparties, thewayitwasnegotiated.Theotheris silentandallowsabuild‐upofresentment

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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formoneyandtimewastedanddistrustfor currentandpotentiallyfuture collaborations.Whichwouldyouchoose? Despitetheclarityofthisquestion,wefind thatmanylicensorswantwhatthey perceiveasthebestofbothworlds.Theytry topromoteafeelingoftrustwithsilence, fearingthatanyquestionraisedisperceived bythelicenseeasanaccusationofdeceit. Areyouoffendedwhentheclerkbehindthe counterscrutinizesyour$20billfor counterfeitingindications?Don’tyou verifythatyourcreditcardstatement includesonlyitemsthatyouchargedbefore youpayit?Theseactionsaregood,fiscally responsibleactions,andverifyingroyalty reportsisnodifferent. Tounderstandhowmisreportinghappens, firstweneedtoexaminewherethe misreportingoccurs.Chart2isa representationoftheroyaltyauditsInvotex

Chart 2

Math Errors 5%

Royalty Rate Errors 4%

SignificanceofUnderreportedRoyalties

performedduring2006andshowswhere wefoundvariancesbetweenwhatwas originallyreportedandourexamination results.Chart3depictsthefrequencyat whicheachofthesecommonerrors occurred.Itisimportanttonotethat reportingerrorsarenotmutuallyexclusive. Infact,inmostinstanceswhereonetypeof errorwasfound,wealsofoundatleastone othertypeofreportingerror. Theremainderofthisarticlewilldiscussthe findingsinChart2,howtheerroroccurred, andproposeactionstolimitfuture misreporting. MathErrors–5%ErrorRate Thefactofthematteristhatalthoughwe usecomputersforcalculationsandtryour besttobeaccurate,wearehuman.Atone timeoranother,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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Cananyofyouidentifywithanyofthe followingscenarios? •Youcreatedasimplespreadsheetthat addsacolumnofhundredsofnumbers. Unfortunatelyyouhaveforgottenan itemandyouneedtoaddarow,which youdoabovethetotal.However,when youaddtherow,youforgettochange theformulathatcalculatesthetotalso thatitincludesthenewrow.Thisisbad enough,butthen,nextmonthyouuse thissamespreadsheetandimport amountsforarollingtotal.Theproblem compounds. •YoumeanttomultiplycellC24byD27 butpointedtocellD28instead. •Youforgottomakeyourformula “absolute”beforecopyingandpasting acrosstheentirespreadsheet. •Youforgottouseparenthesesina formulatochangehowExcelreadsit. Forexample: o=5+2*3–theresultbeing11

Chart 3

50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%

SignificanceofUnderreportedRoyalties

becauseExcelcalculatesmulti‐ plicationbeforeaddition.The formulamultiplies2by3andthen adds5totheresult. o=(5+2)*3–theresultbeing21.If youuseparenthesestochangethe syntax,Exceladds5and2together andthenmultipliestheresultby3 toproduce21. Dotheseerrorssoundsilly?Well,theseare preciselytheerrorsthatcomprisethe5%in Chart2.Thelicensorsreceivingthereports weresoexcitedbytheroyaltyrevenue amountsoncheckstheywerereceivingthat theydidnotnoticethatthenumbersjust didn’tmakesense.Notoneofthereports wasmathchecked. Thelesson:Pluginthe10‐keyandmake surethearithmeticworks.Betteryet,askfor electroniccopiesofthespreadsheetssothat youcaneasilyexaminetheformulasand

Frequency of Common Underreporting Errors

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methodbehindthespreadsheets.Anadded benefitofelectronicreportsisthatyoucan combineandcomparethemfortrends, consistency,and,potentially,internal forecastingandbudgeting. RoyaltyRateErrors–4%ErrorRate Misappliedroyaltyratesaccountedfor4% ofthedollarvalueofourfindings.Alarge numberofproductswithacorrespondingly largenumberofroyaltyrateswasthe primarycauseofthisproblem.Unlessthe reportingsystemsarefullyautomatedand havebeenaccuratelyprogrammedtoapply theproperratestotheproducts,errors happen.Sucherrorsarethehardesttofind becauseyoumustbediligentwiththereview process.Dependingonvolumes,nickeland dimevariancescanadduptobigmoney. Tocomplicatematters,someagreementsare writtentoincludecomplexcalculationsof theratebasedonanindex,likethe consumerpriceindex.Itsoundssimpleand reasonabletoadjusttheroyaltyratebythe costofinflation,right?Well,unlessthe agreementspecifies,yourlicenseemightbe decidingbetweenthefollowing: •traditionalConsumerPriceIndexforAll UrbanConsumers(CPI‐U) •thenewerChainedConsumerPrice IndexforAllUrbanConsumers(C‐CPI‐ U) •CPI‐W,whichisbasedonthe expendituresofhouseholds,includedin theCPI‐Udefinitionthatalsomeettwo requirements:Morethanone‐halfofthe householdʹsincomemustcomefrom clericalorwageoccupationsandatleast oneofthehouseholdʹsearnersmust

SignificanceofUnderreportedRoyalties

havebeenemployedforatleast37 weeksduringtheprevious12months.

Eachmonth,consumerpriceindexesare publishedalongwithshort‐termpercent changes,thelatest12‐monthchangeand,at thenationalitemandgrouplevel, unadjustedand(whereappropriate) seasonallyadjustedpercentchanges(and seasonalfactors),togetherwithannualized ratesofchange.

Istheselectionofthisratesomethingyou wanttoleavetochance?

Thelesson:trytosimplifytheapplicationof royaltyratesinthelicenseagreement. Wherealargenumberofproductsexistsor isexpected,groupthemandapplytherates bytypeorpricerange,ratherthanby individualproduct.Ifvolumesarea concerntothelicensee,usetiersandapply graduatedrates.Whatevermethodisused, thelicenseagreementshouldcontainclear andpreciselanguage.Itshouldprovide detailonhowthecalculationsaretobe performedandincludeasamplecalculation asanexample.Ifsomepublishedindexor otherrateistobeusedinthecalculations, specifywhopublishestherateandprecisely whichrateistobeusedandincludeacopy ofthelastpublishedindextobeassuredall areconsideringthesamepieceofdata.

Ifyouhaveanexistingagreementthat containsunclearlanguage,clarifyingthe correctmethodtocalculateroyaltiescould takesometimeandeffort.Afteryou understandhowtheratesarebeingapplied, thoroughlydiscussthematterinternally(to decidewhatyourlegalandpolitical positionsare)andthenwithyourlicenseeto

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getacommonunderstandinggoing forward.Then,consideramendingthe agreement.

TransferPrices–4%ErrorRate

Transferpriceisthepricethatisassumedto havebeenchargedbyonepartofa companyforproductsandservicesit providestoanotherpartofthesame companytocalculateeachdivisionʹsprofit andlossseparately.Sometimes organizationschargetransferpricesto partnersunderamarketinganddistribution agreement,providingapricebreakin exchangeforotherfinancialreturns, includingroyalties. Incontrast,armslengthpricingorthird partypricingisthepriceatwhichtwo unrelatedandnon‐desperate partieswould agreetoatransaction.Pricesarehigherin thirdpartypricing,and,typically,theseare thepricescontemplatedinlicense agreementswhennetsalesisusedasthe royaltybase. Evenifthelicenselanguagespecifiesthird partypricing,whichwerecommend, sometimesthelicenseeonlyhasaccessto thesalesgeneratedattheirlevelorentity andcannotaccessthesalesdollars generatedfromthesaletotheultimate consumer. Howdoyouspotthistypeoferror? Oftentimes,anon‐siteauditistheonly meansofreviewingthelicensee’sinternal financialdocumentstodiscoversucha problem.Mostlikely,yourlicenseewillnot provideyouthesameaccesstothis confidentialinformation.Youshould,

SignificanceofUnderreportedRoyalties

however,beawareofthemarketpriceof thelicensedproductsandperformanalytics andtrendcomparisonsontheroyalty reportstoensurethatthenumbersmake sense.

Thelesson:Thistypeoferrorisnoteasyto identify.Evenintrendanalyses,changesin volumesandpricingaswellasmultiple countrysalescanmuddythedata.Doyour bestandverifywithaninternetpriceor catalogprice.Watchpubliclyreported informationsuchasannualreportsand pressreleasesforsalesalliancesthatrelate toyourlicensedproduct(s).Lastly,of course,trytobespecificinwordingthe licenseagreement,particularlyinthe definitionoftheroyaltybaseifitisrelated tosales.

UnreportedBenchmarksandMilestones– 5%ErrorRate Notsurprisingly,wefindthatour universityand governmentalclientsarethe hardesthitbythisreportingdeficiency,due tothedevelopmentstateofthetechnology licensed.Becausebenchmarksand milestonesgenerallymustbetracked outsideofthegeneralledgeraccountingfor sales,licenseesmusthaveadditional systemsandchecksinplacetoensurethat theselicenserequirementsare fulfilled. Personscompilingthereportsmusthave accesstothelicenseagreementandbe mindfultoconsiderifandwhenthese paymentsneedtobemade.Frequently, benchmarksandmilestonesgetlostinthe shuffle. Thesetypesofpaymentsmaybebasedon researchanddevelopment,producttrialsor

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