Eight Common Questions About Royalty Audits

Royalty fees are at the heart of the financial relationship between a franchisor and a franchisee, so it’s no surprise that they’re often the source of disagreement. The concept is simple enough: a franchisee agrees to pay a franchisor periodically during the term of a franchise agreement in exchange for using the franchisor’s brand and operating methods and benefitting from the franchisor’s established goodwill.

This simple concept, however, often leads to complications in the franchisor-franchisee relationship. A disagreement that starts as a basic fee dispute can lead to ugly allegations by both parties. Accusations of wrongdoing leave both sides running for their lawyers and the franchise system with a distracting dispute on its hands. Making royalty audits a consistent part of a franchise system can obviously reduce royalty leakage but, perhaps more importantly, audits can also help franchisors and franchisees avoid the escalation of fee disputes into issues that spread distrust throughout a brand.

Here are eight common questions about royalty audits along with some ideas for making a royalty compliance program an effective part of your healthy franchise system.

What is a royalty audit?
At its core, a royalty audit is a financial inspection that determines whether a franchisee is paying the franchisor the correct amount of royalty fees. Royalty audits are often part of a larger franchise compliance program, which can include site visits and evaluations, interviews with customers and employees, and written reports being delivered to franchisees and managers. Royalty audits may also include inquiries into the payment of advertising fees and any other continuing fees that franchisees are required to pay to franchisors under the franchise agreement.

How is a royalty audit conducted?
Royalty audits can take many forms, but it’s often useful to break them down into at least two levels of review. The first level is a system-wide review of selected financial information designed to highlight anomalies in certain franchisees’ data. First-level audits often consist of the comparison of a franchisee’s financial information against benchmarked data aggregated from other franchisees, similar outlets in the same industry segment, and suppliers in the franchise system. The second level of review consists of a more detailed review of a franchisee’s financial records, with the target franchisee selected based on the results of the first level inquiry. As part of this second-level review, auditors will often want to visit a franchisee’s location(s) and will request to interview key personnel.

Why should franchisors conduct royalty audits?
For some franchisors, the simple answer is to make sure franchisees are paying all amounts due under the franchise agreement. While this simple view of royalty audits is often meaningful for a franchisor, consider the broader benefits to the system as a whole. A franchisee who suspects other franchisees are underpaying continuing fees, whether willfully or inadvertently, loses trust in the system and may start adopting the practices of the less scrupulous franchisees. This may be particularly true with advertising fees paid into a fund for the benefit of all franchisees. Knowing that a franchisor conducts royalty audits will encourage all franchisees to comply with the reporting and payment obligations and will boost a franchisee’s confidence in the overall system.

When should franchisors conduct royalty audits?
Ideally, a franchisor will make royalty audits a key component of its periodic franchisee compliance inspections. In addition to providing franchisees with the peace of mind that everyone is playing by the same rules, consistent royalty oversight helps maintain trust between a franchisor and the franchisee being audited because the franchisee is less apt to believe he or she is being singled out or picked on. If resources or other factors limit a franchisor’s ability to conduct regular royalty audits, franchisors should develop a system to spot red flags and to investigate complaints about a franchisee’s record-keeping made by suppliers, other franchisees, or a franchisee’s current or former employees. A franchisor may also establish a system of random compliance audits.

Who conducts royalty audits?
Franchisors can conduct royalty audits using in-house personnel or by hiring outside forensic accountants, lawyers, or business advisors qualified to review and analyze financial records. For most, the type of audit being conducted and the scope of the records being reviewed will drive staffing and resource allocation decisions.

What errors commonly contribute to royalty fee underpayment?
Math errors, misreported sales, unreported sales, and misinterpretation of the franchise agreement account for a large percentage of royalty underpayments.

  • A math error is usually an inadvertent miscalculation based on human error or a mis-coded formula in a spreadsheet. A franchisor should conduct a review of the franchisee’s periodic reports and supporting calculations to determine whether this issue exists.
  • Misreported sales sometimes occur in systems that ascribe different royalty rates to different products and services. In these situations, the mis-coding of a sale or an issue with the point-of-sale software can lead to the miscalculation of the correct royalty amount. Careful review of product and service descriptions in historical sales data can help address this concern.
  • Unreported sales are typically revenue-generating sales of products or services that a franchisee fails to count as part of its revenue numbers reported to the franchisor. Conducting a review of a franchisee’s tax records, financial reports to landlords and lenders, customer count information, and supplier purchase records can often reveal whether sales are going unreported.
  • The definition of “gross revenues” in the franchise agreement (or whatever term the agreement uses to calculate royalty payments) is sometimes the subject of disagreement. Franchisors advocate making this category as broad as possible, while franchisees fight to exclude certain sales of products and services. Disputes over off-site sales, Internet sales, and gift card sales/redemptions are common. Careful review by legal counsel of the financial definitions and royalty calculation method in the franchise agreement can help prevent this common issue.

What legal rights and obligations do franchisors and franchisees have in an audit?
For the most part, a party’s audit rights and obligations will be controlled by the language of the franchise agreement. For a franchisor, a franchise agreement should include language that allows it and its representatives to review a franchisee’s financial, accounting, and tax records and all underlying data. Franchisors should also consider stating that they may electronically access a franchisee’s point of sale computer system and related in-store record-keeping devices. Obviously, audit rights should extend to electronic and digital versions of all financial records. Audit provisions in franchise agreements typically require that a franchisor bear the costs of the audit unless the results of the audit reveal that a franchisee has willfully understated revenues or understated by a set percentage, typically in the 2% to 5% range. A franchisee that refuses to allow a properly noticed audit will generally be in default and risks termination of the franchise agreement.

What type of financial information should franchisors collect from franchisees?
Franchisors should of course require that franchisees submit periodic royalty reports and calculation worksheets at the intervals required by the franchise agreement. Beyond those basic reports, the collection of financial information from a franchisee will vary somewhat depending on the type of business, but franchisors should consider collecting quarterly and annual financial statements formatted according to the franchisor’s standard chart of accounts, as well as copies of state and federal sales and income tax returns. Franchisors should carefully review the terms of their franchise agreements to ensure that requests for information do not exceed the scope permitted by the contract. Franchisors should also carefully note confidentiality restrictions when reviewing and sharing a franchisee’s information or when using a franchisee’s data to prepare benchmark or aggregate measurements of performance.

Done consistently and correctly, royalty audits can benefit franchisors and franchisees alike by encouraging honest reporting and, ultimately, trust among the all of the stakeholders in a franchise system.

From October 2011 Franchising World

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Ryan Palmer

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