Contracting in the Self-reporting Economy
Executive Summary — Intellectual property can be used by its owner directly, licensed to a third party for a fixed royalty, or licensed to a third party for a variable royalty. The variable royalty arrangement depends on self-reporting by the licensee, which in turn induces demand for auditing by the licensor. This research studies a setting with the following features: a production cost advantage on the part of the outside party that creates gains from licensing; a limited liability constraint that prevents the licensee from owing more royalties than the gross profits of licensing the intellectual property and prevents the licensor from capturing all of the economic surplus via a fixed royalty agreement; and accounting and auditing costs that reduce the benefits of a variable royalty agreement. Key concepts include:
- The owner of intellectual property will enter into a variable royalty agreement with an outside party if—and only if—the accounting and auditing costs are sufficiently low.
- With higher cost levels, the owner will use the property directly if the owner can do so profitably. Otherwise, the owner will prefer to license the property in exchange for a fixed royalty.
- The expected aggregate accounting system and audit costs are minimized when the licensor can compel the licensee to bear the audit costs in case underreporting is detected.
- Internal control provisions within the Sarbanes-Oxley Act make variable royalty arrangements based on self-reporting and auditing relatively more attractive than such arrangements prior to Sarbanes-Oxley. Sarbanes-Oxley effectively lowers the licensor's audit costs even though the licensor must audit all low reports, because auditing all low reports deters the licensee from underreporting in the first place.
This paper examines the licensing of intellectual property in exchange for royalties that depend on the self-report of the licensee. The self-reporting aspect of the problem gives rise to demand for auditing by the licensor. We characterize the optimal royalty contract, accounting system choice by the licensee, and audit strategy choice by the licensor. We show when the owner prefers to license the property in exchange for a royalty and when it prefers to use the property directly. We also show that the internal control provisions of section 404 of Sarbanes-Oxley make royalty arrangements based on self-reporting more attractive.