Auditing in the self reporting economy

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.