Drafting and Negotiating Effective Audit Provisions

Drafting an effective audit provision in a legal contract is essential to ensuring both transparency and accountability in business relationships. Unfortunately, audit provisions are sometimes overlooked as simple ‘boilerplate’ or standard clauses, which can be a costly error, especially in sales, distribution, and licensing agreements where revenue is based on the sale of goods or services. Whether you are a legal professional or a business owner, audit provisions should be approached thoughtfully in order to protect the contractual right to inspect certain records and increase the likelihood of accurate bookkeeping by the opposing party.

Below are some key considerations to keep in mind when crafting or negotiating an audit provision as the potentially audited party: 

Define the Scope and Purpose
Clearly define the mechanism of the audit process and any limits as to what can be audited by:

• specifying the time frame, the specific financial records or transactions subject to audit, and the objective of the audit;
• being precise about the reasons for the audit, whether it’s to ensure compliance with contract terms, verify financial statements, or investigate suspected discrepancies; and
• including a ‘one and done’ provision in order to prevent revisiting specific records once a certain period of time has passed, since many provisions allow a ‘look back’ for a year or two after the agreement terminates allowing the parties to audit in case any suspicions arise.

Access and Documentation
The party with the right to audit tends to prefer a short notice period preceding their right of access while the auditing party usually seeks no limitations.

• Consider narrowing this scope to allow an audit only by a licensed accountant.
• Specify the location of records and documents subject to audit, as well as the level of cooperation expected from both parties.
• Ensure that confidentiality and data security provisions are also in place to protect sensitive information during the audit.

Reporting and Remedies
Clearly define the audit reporting process and any remedies provided under the contract based on the subsequent audit findings.

• Specify the format and timeline for audit reports, and detail the information to be included, ranging from financial statements to mandating the reporting of specific discrepancies.
• Require that you receive a copy of the report.
• Outline the actions that will be taken if irregularities or breaches are discovered, such as corrective measures, dispute resolution mechanisms, or potential penalties.
• Understand any penalties that may require the immediate payment of any under-reporting, as well as, reimbursement of audit-related costs.
• Consider limiting the amount of penalty to the amount of the under-reporting.

Compliance with Applicable Laws
Ensure that the audit provision complies with applicable laws and regulations.

• This is particularly important when dealing with sensitive or regulated industries.
• Legal counsel can help ensure that the audit provision does not infringe on privacy laws, data protection regulations, or industry-specific requirements. 

As you can discern, drafting an audit provision in a legal contract requires precision, transparency, and attention to compliance obligations. Ideally, the provision will safeguard the interests of both parties, while also promoting accountability and trust. Collaborating with legal professionals to tailor the audit provision to the specific needs and goals of the contractual relationship is always advised. If you would like help drafting or reviewing audit provisions, please contact Brad Auerbach at [email protected]

Brad Auerbach is a Partner with our California-based team, bringing over three decades of senior in-house counsel experience (at Disney, Philips, Qualcomm and HP) in the media, entertainment and technology industries. Brad has been involved in structuring many groundbreaking deals with a diverse range of rights holders, including NFL, NBA, NHL, HBO, MTV, ESPN, Sesame Workshop, Nickelodeon, Live Nation, Marvel Entertainment, International Olympic Committee, English Premier League, Screen Actors Guild, every significant Hollywood studio, each of the major record labels, many major book and news publishers, several world class photographers and Getty Images, among numerous others. 

Brad can be reached at [email protected].