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Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University of Namibia, Windhoek, June 13-14, 2011 1 of 39

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Page 1: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Contract Theory of Organizations, Accounting and Control

Shyam Sunder, Yale UniversityThird International Conference on Accounting and Finance

University of Namibia, Windhoek, June 13-14, 2011

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Page 2: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Three Basic Ideas• Organizations as a set of contracts• Shared facts for conflict resolution• Control in organizations as balance and

equilibrium among various interests

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Page 3: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Organization as a set of Contracts

• Economic agents• Contracts• Contributions• Resource Entitlements• Necessary Conditions• Satisfies each individual• Aggregate feasibility

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Page 4: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Customers

VendorsGovernment

Managers

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Page 5: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Figure 1

Resource Flows in Private-Good Organization

Employees

Shareholders

Creditors

Customers

VendorsGovernment

Managers

Compensation

Skills

Resi

du

al

Rig

hts

Equit

y C

ap

ital

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Page 6: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Contributions and Entitlements of Various Agents

Type of Agent

contribution entitlement

Shareholder equity capital dividend Manager skills salary, bonus, benefits Employee skills salary, wages, benefits Vendor goods, services cash Customer cash goods, services Lender/creditor loan capital interest, principal Government public goods taxes Auditor services fees

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Page 7: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Assumptions• Economic agents• Preferences• Consistency of actions• Contract as mutual understanding or expectation• Not necessarily explicit• Role of social conventions

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Page 8: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Goals and Scope• Goals of each individual• Organization’s goals not considered– Organization as an arena– Organization as a tournament

• Applicable to all organizations• Focus here on business firm

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Page 9: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Functions of Accounting• To Help

– Assemble– Implement– Enforce– Modify– Maintain

• the contract set through five processes

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Page 10: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Five Processes of Accounting• Measuring resource inflows• Measuring resource outflows• Determination of contract performance• Information for factor markets• Common knowledge for contract renegotiation

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Page 11: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Measuring Resource Inflows• Vendors: At the receiving dock• Customers: cashier, accounts receivables• Labor: clock, inspection• Managers: intangible• Shareholders: shareholder accounts

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Page 12: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Measuring Resource Outflows

• Employees: payroll• Customers: shipping• Vendors: account payables• Government: tax accounts

• Data organized by cause-effect in double-entry bookkeeping

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Page 13: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Contract Performance• Compare resource inflows and outflows• Determine who has fulfilled contracts, how much• Comparative reports• Examples: • Customer account statement• Managerial accounting

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Page 14: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Information for Factor Markets• What resources are expected• What resources are available for disbursement• Find people who have/want them• Markets for labor, goods, and capital• Proforma financial statements, business plans and budgets by

the entrepreneur • No permanent occupants, must find replacements• Costs and benefits of occupying contractual slots

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Page 15: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Common Knowledge for Renegotiation• All contracts have finite terms (except shareholders)• Conditions Change• Potential for Empty as well as Serious Threats and

Bluffs• Public Disclosure and Common Knowledge• Cut Deadweight Losses to Society

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Page 16: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Necessary Conditions• 1) Individual Condition: Each participants expects

to receive at least the opportunity cost of contributions he/she makes to the organization

• 2) Aggregate Condition: Contributions of all participants can produce enough output to meet the expectations of all

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Page 17: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Income/Value of the Firm• Extensive income as the sum of:• To the shareholders• To customers• To Vendors• To employees• To creditors• To government• To community, etc.• Inducement from the firm – O.C. of contributions

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Page 18: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Income/Value to Investors• Residual income and corresponding

shareholder value created• Focus of current financial reports• Apply similar perspective to other

participants in the firm

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Page 19: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Income/Value to Customers• Customer’s “investment” in the form in the form of search,

learning, negotiation, payments, settlement of disputes• Expected PV of benefits from goods received should exceed the

PV of investments• Includes immediate transaction as well as the consequences of

the transaction for resource flows associated with any future transactions (reduction in time, cost, search etc. for later transactions)

• In a perfect product market, consumer’s surplus from the firm is zero (may be +ve from industry, and the economy)

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Page 20: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Value to Government• Various levels of government provide mostly non-priced

services plus some priced goods• Resources from taxation• Value of the firm to the government from providing priced

services is the same as for vendors• Value of the firm to the government from providing non-

priced services is taxes plus fees minus O.C. of resources spent on providing services

• Major challenge to put this into practice

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Page 21: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Value of the Firm to Community• Local, national and global• Most exchanges in form of externalities• Value of the firm to the community is

the sum of net externalities plus the net payments

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Page 22: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Measurement of Income/Value• J.M. Clark (1936): Three fundamental challenges

to determining the value of private enterprise– Imperfect and incomplete markets– Fundamental values not as exact as market values– Fundamental concepts should be independent of

specific institutions of exchange (generality)

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Page 23: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Problems in Control of Managers• At the procedural hub of the contracts• Control resources, have information• Monitor and negotiate with others• Difficult to measure their contributions• Can appropriate resources and information• Misappropriation difficult to detect• Devising a scheme to induce managers to contribute what is

expected of her

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Page 24: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Organizations and Accounting By Markets• Organization operate in a variety of markets• Markets vary by the degree of development, frictions,

information conditions, competition, and characteristics of resources

• Organizations vary by the markets they operate in• Accounting, like electrical system of a building, varies by the

nature of organization• We can classify organizations and their accounting on the basis of

market characteristics

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Page 25: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Classification by Markets• Market for managers (Hatfield, 1924))• Market for capital (Hatfield, 1924)• Market for product (Sunder, 1999)

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Page 26: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Classification by Product Markets• Private good producing organizations (cars,

furniture) can be denied revenue by their customers• Shareholders delegate production decisions to hired

managers motivated by residual based contracts• Driven by developed product markets

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Page 27: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Management Controls Again• A viable concept of control from organizations as sets

of contracts, expectations, common knowledge and culture

• An organization or group is in control when its members find it in their own best interests to behave in a manner that is expected of them by the other members of the group

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Page 28: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Control In Versus Control of• Control in organizations distinct from control of

organizations• Control in emphasizes

– Balance and equilibrium – Symmetry of points of view of agents

• Control of emphasizes– Manipulation, even exploitation

• Disparity in bargaining powers of agents

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Page 29: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Comprehensive View of Control• Rules, incentives, monitoring, enforcement to align behavior

and expectations• Consider two traders on eBay

– Buyer expects to have the appropriate goods delivered– Seller expects to be paid– When expectations of both are met, the system is in control

• The concept extends well beyond the traditional scope to employees and managers to include shareholders, customers, vendors, and others

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Page 30: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Traditional Locus of Control• Processes internal to the firm• Involving people who often have social relationships• In transactions governed by social relationships, shared

norms of social exchange play an important role• E-Commerce transactions strip the social context• Scope of e-commerce has expanded well-beyond the

traditional boundaries of transactional relationships

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Page 31: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Threats to Control• Environment of organizations changes continually (factor

and product market conditions)• A contract set which is in control today, will not be in

control tomorrow if conditions change• Left to itself, the organization will collapse because a

fixed set of contracts cannot remain in expectational equilibrium except by sheer chance

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Page 32: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Functions of Top Management• This function goes by many labels (long term planning, strategic

management, etc.)• It always amounts to the same thing:

– Monitor your environment– Anticipate changes in factor and product markets– Redesign contracts to be in control under the new conditions– Renegotiate contracts– Implement new contracts

• Perpetual revision of corporate plans to retain their desirability from the point of view of all participants

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Page 33: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Let Me Summarize• Control a key concept in management• Need an appropriate model of organizations to

study control• Help do accounting and control better• Find appropriate place for control in the intellectual

structure of the discipline of management

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Page 34: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Role of Accounting• Organizations as sets of contracts or alliances among

people• Agents seeking their own goals contribute resources in

exchange for inducements• Accounting helps define, implement, enforce and

modify contracts, serving a critical function in organizations

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Page 35: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Design of Organizations and Controls• Both designs depend on conditions prevailing in the

appropriate markets• Market for managerial labor differentiated stewardship

model from bookkeeping• Market for capital differentiated financial reporting

model from stewardship• Market for products differentiates government and not-

for-profit model from private good organizations

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Page 36: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Culture and Control• Culture of a group can be thought of as

expectations its members hold about the behavior of others in the group

• An organization is in control if the behavior of its members corresponds to the expectations of others

• Control is a state of expectational equilibrium

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Page 37: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

What’s Management For• Changing environment threatens control• Top management must anticipate and deal with these threats

to control• Set of feasible corporate plans is too large to contemplate and

analyze• Due to time limitations, managers search in the neighborhood

of existing plans and settle on satisficing solutions• Simon’s boundedly rational behavior

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Page 38: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Finally …• Accounting enables organizations to function, serve all participants• Broad perspective on functions of accounting; accounting systems

designed for organizations functioning in different environments• Bookkeeping, managerial accounting, and auditing serve small

proprietorship, large proprietorship, and public corporations• Understanding accounting and control in public good-producing

organizations that do not have customers, only beneficiaries.

Page 39: Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University Third International Conference on Accounting and Finance University

Thank [email protected]

www.som.yale.edu/faculty/sunder Theory of Accounting and Control, 1997

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