External Verifiability of Accounting Information and Intangible Asset Transactions

Firms commonly use disaggregated accounting information to facilitate efficient contracting over intangible assets. However, reliance on accounting measures creates information asymmetries and thus a role for contract audits. Using a hand-collected sample of technology licensing agreements with royalties based on product-line revenues, I investigate how perceived weaknesses in the licensee's accounting system and reporting flexibility affect the design of two key audit terms — (1) the scope of audit rights, and (2) penalties for adverse audit outcomes. I find that perceived weaknesses in the licensee's reporting system lead to the granting of broader audit rights to the licensor, consistent with licensors demanding broader auditor rights when the licensee's accounting system is believed to be less reliable. However, when the licensee has greater reporting flexibility, the contracting parties are more likely to include penalties in their agreements, consistent with the deterrence theory that penalties are a more cost-effective means to discourage intentional misreporting. Licenses covering more territory and having longer durations are associated with narrower audit scope terms, consistent with the self-enforcement theory that the greater the opportunity cost of early termination, the greater the licensee's incentives to self-enforce. Overall, my results suggest that audit scope and penalties can improve contracting efficiency in two ways