Eight common questions about royalty audits: done consistently and correctly, royalty audits can benefit franchisors and franchisees alike by encouraging honest reporting.

Author:Palmer, Ryan

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 good will.

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...

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