Friday, February 08, 2008

To Audit or Not to Audit? That is the Question.

Another day, another royalty statement. February is one of those months when I get quite a few statements, which is great from an income perspective, but terrible from an administrative perspective. It's a lot of work to sort through all of those statements!

Back in my days as chairperson of the AAR's Royalty Committee, I used to attend meetings with various CFOs and Directors of Royalties at the major publishers. Our goal, consistently, was to push publishers for better statements that showed gross sales, returns, and net sales, both for the period and cumulatively. Further, we wanted them to show the reserve for returns, preferably showing the reserves released in the period and the reserves taken. And sometimes we were successful, but some publishers were resistant. One didn't want to show the reserves, but agreed that if any agent asked, they would disclose it. To me, this seemed as though the CFO knew that if they put the reserves on the statements, they would get many more requests for reconciliations to print and they didn't want that.

A reconciliation to print operates on the assumption that a publisher should be able to account for every single copy it printed, e.g.,

Printed 100,000 copies
Shipped 85,000 copies
Free 421 copies
Inventory 14,579 copies

However, in reality, that doesn't happen. Printing presses don't stop and start on a dime. If a publisher orders 100,000 copies, it may get 100,102 copies. Or it may get 99,826. Either way, it pays for 100,000. Presumably it all works out over time with some titles going long and some being short. Plus I'm sure their contract with the printer allows for such tolerances. That said, if you ask the editor what was printed, he is likely going to quote the number ordered and not the number actually received.

Further, every publisher experiences a certain amount of "shrinkage." No, this has nothing to do with the water being cold. "Shrinkage" is the terms many businesses use to describe theft. In this case, the theft usually takes place at the bindery, where the books are bound up, before they are boxed. It may also happen at the warehouse, where an entire box of books may disappear. Where do you think all of those brand new, very cheap hardcover books that are being sold on Broadway and 83rd St come from? They are stolen, pure and simple. And publishers aren't unaware of this. There's just a limit to what any business can do to control theft. And the value of what's being stolen simply isn't enough to warrant strip searches.

Then there are damaged books. A pallet is lifted wrong and a case of books tumbles to the ground eight feet below and bursts open. Even if not even one of those books was damaged, the entire carton is likely going to be dumped in the remainder bin. Because it's not cost effective to repack all the books in a new box.

And there's real damage that can take place when a box is dropped and broken and those books are going to just be destroyed.

Thus, some statements also have entries for copies that were "destroyed" and for "inventory adjustments," the latter being the aforementioned "shrinkage," or maybe just books they lost or miscounted along the way.

Because, let's not forget that the system is prone to human error. We had a meeting with a software company that developed royalty systems for at least two major publishing houses. The rep told us that when a clerk in the order center mistypes an order for 10,000 copies as 100,000 copies, she may just enter a return for 90,000 copies to balance it out. She might not just go back and correct the order. So it now looks like the author has a 10% sell-through before one copy of that order has been sold.

And sometimes a bookstore orders ten copies of one book and gets ten copies of a different book, despite what the packing list says. If those books are paperbacks, the bookstore will likely just strip the covers off and send them back, not the whole book, so that poor author, whose book was never ordered, now has a ten-copy return on his account. And my guess is those returns will get accounted for and deducted on his royalty statement, even though there was no accounting for a payment of royalties for the sale of those copies.

One of the biggest weaknesses in the publishing industry is authors' not auditing publishers. Sure, agents look at the statements, but we don't get the order information. Only an audit is going to let you see what you really need to see to make this a "zero sum" game that shows what you really should be getting paid. For example:

  • You want to see the invoice from the printer and the bindery to know exactly how many books were printed and bound and paid for by the publisher. This will also let you figure out the unit price of your book.
  • If there is receiving paperwork at the publisher's warehouse showing how many they received, you want to see that.
  • You want to see the print-outs of the actual orders by accounts to figure out how many books were shipped, and the records of the returns to know how many came back. Compare account numbers. Did any account return more than they ordered? Did any account get a different discount on the return than on the sale? Yes, some accounts profit by having two account numbers (say one for each store and one for a central warehouse). They may order them shipped to the warehouse and get a 55% discount (paying $4.50 for a $10.00 book) and return them from the store at a 50% discount (getting a credit of $5.00 for the same book for which they only paid $4.50).
  • Were books shipped to Canada accounted for at the Export royalty, even though there is a separate, higher Canadian royalty?
  • Were books shipped in the US accounted for at an Export royalty? Some of the books sold at US military bases overseas are actually sold to distributors located in the US. One could argue you should not be charged an Export royalty on those sales. Publishers will say the shipping costs warrant it. So how come sales to Alaska and Hawaii accounts are at the regular discount and royalty?
  • Was a very large number of books given away for free? A few hundred review copies is normal. Thousands is not. Ask questions.
The book business is definitely not a finely oiled machine and plenty of games are played. I worked at one publishing house that offered a major distributor extra discount points on all books ordered during the year if they kept their return percentage below a certain number, e.g., We normally give you a discount of 50% on the $10,000,000 worth of books you order every year. If you keep returns below 48%, we will give you an extra 2% discount at the end of the year on all those orders. But in January of the following year, after they got their two extra points, they returned thousands and thousands of books they had simply been warehousing to keep their return rate in the prior year below 48%. Slimey, huh?

So if authors really wanted to keep publishers and booksellers honest, they really need to conduct audits and look hard at the numbers.

Surprisingly, a lot of authors don't do this for two reasons:

First, they worry that they will damage their relationship with the publisher and that the publisher will stop licensing rights to their works if they audit. I have never seen any evidence of cause and effect in that manner.

Second, they don't want to pay for the audit.

Some publishers require that a CPA conduct the audit, but most actually do not. The authors themselves can go in and do the audit. Read your contract. There are some CPAs that will perform audits on a contingency basis, like a lawyer taking a case on contingency. The downside is that you owe them 1/3 for whatever errors they find in your favor, regardless of whether or not that error leads to income. For example, say you sold your novel for $100,000 and show $50,000 in earnings. You send in these guys and they find that you really have $80,000 in earnings. They've found $30,000 in your favor. Now you owe them $10,000. But you aren't actually getting that $30,000, because the book is still unearned by $20,000. But they need to be paid. So you have to pay them out-of-pocket and your book still may never earn out completely.

Further, these CPAs will review your statements before taking on the audit. If they don't think they can make some money off it, they won't do it.

You can pay a CPA by the hour to do an audit also. But, again, the CPA may cost more than he finds.

My personal opinion is that if your book has earned out, paying a CPA to audit your publisher once a year is as reasonable as paying your CPA to do your taxes once a year. If your book is earning thousands and thousands in royalties every year and your contract will allow it, I'd audit after each and every statement.

One other thing: Most contracts say the publisher will pay for the audit if an error of 5% or greater in the author's favor is found. So you might not have to pay at all.

On the downside, if your accountant finds an error in the publisher's favor, it will likely have to be disclosed. So it may be damned if you don't and damned if you do.

In the end, it all becomes a business decision. Are you writing as a hobby or as a business? If a business, then the answer is, audit.


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