Contracting in the self-reporting economy

This paper examines the effect of accounting on the use of intellectual property. We analyze the licensing of intellectual property in exchange for royalties that depend on the self-report of the licensee. The self-reporting aspect of the environment gives rise to demand for auditing by the licensor or third-party attestation by the licensee. 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 find that variable royalty arrangements that depend on either audited self-reports or third-party attestation become more attractive as accounting information system costs decrease and as the benefits from outsourcing the use of intellectual property increases. We also examine how different licensing arrangements affect the relation between the variance of the returns to the intellectual property and the payoff to the owner.