7. Conclusions
This paper examines how perceived weaknesses in the licensee’s accounting system, reporting flexibility, and incentives to self-enforce influence the design of two key audit terms in technology licensing contracts—(1) scope of audit rights, and (2) penalties for negative audit results. This paper shows that perceived weaknesses in the licensee’s accounting system lead to broader audit rights and lower reliance on penalties. These findings are consistent with licensors demanding broader audit rights and relying less on penalty terms, when licensees’ accounting systems are perceived to be less reliable and produce more unintentional errors. When the licensee has high reporting flexibility due to the inclusion of more allowed deductibles, penalties are more likely to be used as a deterrent, while broader audit rights that increase the threat of more frequent, intrusive audits are less likely to be employed. These findings are consistent with penalties being more cost-effective deterrents to intentional misreporting. I also show that licenses covering more territory and having longer durations are associated with less stringent audit scope terms, consistent with the self-enforcement theory that the higher opportunity cost of early termination associated with greater expansion opportunities induces the licensee to self-enforce, thereby reducing the licensor’s need for audits. These results are not driven by the licensors priceprotecting themselves against the misreporting risk via higher royalty rates. Overall, my findings suggest that audit scope and penalties can improve contracting efficiency differentially, depending upon the contractual parties’ concerns regarding unintentional and intentional misreporting.
