Thursday, May 22, 2014

Three Overlooked Points to Consider When Negotiating an Audit Clause

Here are three often overlooked points to consider when negotiating an audit clause:

1) What records will be subject to audit?
Most audit clauses allow a party's "books and records" to be audited. Typical variations include clauses that:
  • Clarify certain records that should be included in the scope of an audit (e.g., manufacturing records, contract copies)
  • Limit the records subject to audit (e.g., "only records that specifically report sales of XXX")  
One way to improve this provision for clients with an audit right is to require that the books and records be made available in unredacted and electronic format.
Often more important than the type of books and records that would be subject to audit is the matter of whose books and records can be audited. For example, if you are a licensor, you may wish to include in your audit the books and records of your licensee's wholly owned subsidiaries or foreign affiliates (or your licensee's manufacturer). As another example, if your client may be audited by an ex-spouse, you may wish to expressly limit the audit rights to the personal books and records of your client, and not extend the audit right to any business or partnership in which your client may have an interest.
The entities that are subject to audit can make an enormous impact on the audit procedures and results.

2) Who must pay for an audit?
When representing royalty recipients, I suggest including a clause that requires the licensee, business partner or ex-spouse to pay for an audit that discloses an underpayment. This is standard in many industries, but less common in the entertainment industry. However, it is the most common "penalty" for underreporting that I see in contracts.
Note that most such clauses that I see are insufficient to cover the true cost of conducting and resolving an audit, which usually includes both accounting and attorney fees. If you are representing a party who may be liable for such audit fees, adding a cap of $10,000 is a good strategy, since a thorough audit will likely cost more than $10K and the cost of an audit may dissuade your payee from conducting an audit.
In any event, when I represent clients with a provision that requires the other party to pay for an audit, I advise them that they should not assume the other party will pay for the audit. This is because the audit costs are often waived in the audit settlement process.

3) Who may conduct an audit?
Many audit clauses require an independent CPA (and at times allow for an attorney) to conduct an audit, but if you have a client who wishes to conduct an audit of a licensee, business partner or ex-spouse, he or she will be best served by hiring an experienced auditor who may or may not be a CPA or an attorney – and who will focus on finding underpayments to his or her client, not overpayments (so strike “independent” as well as “CPA” if possible).
Also, some audit clauses require than the auditor not be engaged on a contingency basis or not be currently auditing the party that is subject to audit. Although most reputable auditors work on an hourly, not contingency basis, I were a royalty recipient, I would not want any restrictions on who I could hire and on what basis, especially given the very limited number of professionals who provide high quality royalty audits.

Bonus: Never overlook the objection clause
Although an audit clause is key, the objection provisions are often more important than the audit provision itself because it typically governs the time period subject to audit. However, the objection clause is a topic for a different post.
For a personalized consultation on accounting, audit and objection provisions, as well as contractual definitions, you are welcome to email me at