Management Controls, Expectations, Common Knowledge, and Culture Shyam Sunder Yale University Plenary Address, American Accounting Association Management Accounting Conference, Austin TX, January 11-12, 2002

Control in Organizations Share some ideas on control in organizations Can think of control as expectational equilibrium That it, correspondence between what people choose to do, and what others expect them to do This perspective is useful accounting, and management Perspective includes a review of perspectives on Organizations, Expectations, Common knowledge, and Culture; Disruption and threats to control Strategic management: what top managers do to maintain control 9/21/2018 Management Controls

Contract View of Organizations Work of Barnard, Simon, Cyert and March, Cooper, beginning in the 1930s (“Carnegie School”) Useful to think about organizations as a set of contracts or alliance among people Simple, powerful synthesis of economic and organization theories Can sustain a robust theory of accounting and control (Sunder 1997) If organization is a set of contracts, Accounting is the operating mechanism to make the contracts work 9/21/2018 Management Controls

Contracts Participating agents promise to deliver resources In exchange for promise of inducements Agents enter contracts if they expect to get more than the opportunity cost of their contributions To succeed, an organization must have a production function to simultaneously satisfy all contracts Otherwise dissatisfied agents abandon the alliance Organization collapses unless an alternative set of contracts that satisfied the condition is assembled 9/21/2018 Management Controls

Economic Agents Has personal goals Actions are consistent with his preferences From his opportunity set, chooses preferred actions Consistency of actions is the key characteristic Difficult to model in social sciences without a minimal level of behavioral consistency 9/21/2018 Management Controls

Examples of Contracts Contract is a mutual expectation or understanding among agents Lunch date This conference Promising a delivery schedule to customer Explicit of implicit promise of relevant action Legal enforceability or written form not necessary Social conventions play an important role 9/21/2018 Management Controls

Players and the Game Individuals have goals; they are the players Organization is the game in which individuals play to seek their own goals Perspective is applicable to a broad range of organizations—business, government, society, academia 9/21/2018 Management Controls

Business Organizations For present discussion, consider business organizations Consider them as an alliance among contributors of Capital (shareholders, creditors) Labor (employees, managers) Factors (vendors) Cash (customers) Public services (government) Community (support) Each party gets resources in exchange 9/21/2018 Management Controls

Firm as a Set of Contracts 9/21/2018 Management Controls

Accounting in Organizations Operating mechanism for contracts Necessary to assemble, implement, enforce, modify and maintain the contract set Five functions Measure resource contributions from agents Monitor resource outflows to agents Relate inflow and outflow for each agent Maintain liquidity of factor markets Common knowledge to facilitate contract renegotiation 9/21/2018 Management Controls

Measuring Contributions Receivables and cashier Receiving dock for supplies Punch clock and quality control 9/21/2018 Management Controls

Measuring Outflows Payroll accounts Tax accounts Cashier Shipping 9/21/2018 Management Controls

Contract Fulfillment Matching resource inflows and outflows to contracts Performance evaluation Adjusting contracts to resource realizations 9/21/2018 Management Controls

Maintaining Liquidity of Factor Markets Individuals agents come and go Finding replacements for departing agents in appropriate factor markets Convincing new people to participate Advertising motive in all factor markets 9/21/2018 Management Controls

Facilitating Contract Renegotiation Through Common Knowledge Most contracts are finite term contracts Motive to bluff at the time of renegotiation Ex ante agreement to share some information as common knowledge Common knowledge cannot be used to bluff others Reduces dead weight losses to society 9/21/2018 Management Controls

A Taxonomy of 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 9/21/2018 Management Controls

Classification by Markets Market for managers (Hatfield, 1924)) Market for capital (Hatfield, 1924) Market for product (Sunder, 1999) 9/21/2018 Management Controls

Without Market for Managers Owners must manage themselves Classical double entry bookkeeping model for was developed for proprietorships, traders Accounting differentiated from counting through cause-effect links (Ijiri, 1975) Powerful instrument of control over resource flows Classical bookkeeping serves the simple organizations (largest number of firms in this class) 9/21/2018 Management Controls

With Markets for Managers With liquid market for managerial services, professional managers enter organizations Two or more levels of management (hierarchy), multiple decision makers, divergent interests Stewardship accounting developed to handle these problems (budgeting, planning, divisional performance, compensation, decentralization, transfer pricing, etc., absent in Paciolo) Hierarchical organizations, professional managers, managerial accounting, business school training 9/21/2018 Management Controls

Without Markets for Capital Single owner, friends, family supply all capital They can directly manage the firm, or give effective direction to hired managers Privately owned firms 9/21/2018 Management Controls

With Markets for Capital Number of sources of capital multiplies Large number of shareholders cannot directly give effective direction to hired managers Financial reporting model of accounting developed in response to markets for capital Publicly held corporations place new demands on accounting Investors are far-removed from operations Use rigid rules to protect their interests from managers they hardly know Want more informative reports but get less as they eliminate managerial discretion 9/21/2018 Management Controls

In Active Capital Markets Multiple competing sources of information Markets can react very fast to information Use of reserves to smooth out reported performance becomes more difficult Shift from stock to flow variables in reports Development of “pro forma” or “good” earnings Accountants have become more aware of the economics of competing sources of information Trade-offs between information (e.g. inflation accounting) and contract enforcement 9/21/2018 Management Controls

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 9/21/2018 Management Controls

Without Product Markets Public good producing organizations have beneficiaries, not customers, who cannot discipline managers by denying them revenue Managers cannot be delegated production/output decisions, cannot be motivated by residual-based contracts Bureaucratic organizations, accounting Generally, extend of development of various markets determines the design of organization and their accounting 9/21/2018 Management Controls

Expectations Thinking, anticipating a future event or object (e.g., salary at the end of the month) Tinged with hope toward our preferences First moment of a probability distribution which is Objective (e.g., value of a lottery ticket) Subjective (e.g., value of a lottery ticket) Two of these three meanings are subjective Will coincide only by chance 9/21/2018 Management Controls

Human Expectation Formation Complex Not well understood Risk of flying versus driving! Contracts defined as expectations of resource flows Customer expectations from cars Employee expectations from job Investor expectations of returns 9/21/2018 Management Controls

Mutuality of Expectations Expectations are rarely taken as a given Every action creates/influences expectations Firm must manage them (problem of participative budgeting) With unfilled expectations, people turn away With overfilled expectations, set up for disappointment later Management gurus preach maximization—of profits, growth, quality, EPS, stock prices, etc., instead of setting a target and sticking to it Pursuit of moving targets (Enron expected 91 percent growth rate in free cash flows for next 6 years) 9/21/2018 Management Controls

Common Knowledge Technical term in philosophy, statistics, game theory and economics Denotes knowledge that includes knowledge about what others know Aumann (1976): Two people 1 and 2 are said to have common knowledge of an event E if both know it, 1 knows that 2 knows it, 2 knows that 1 knows it, 1 knows that 2 knows that 1 knows it, and so on... 9/21/2018 Management Controls

Emperor Has No Clothes 9/21/2018 Management Controls

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Stock Market Stock Market is like a newspaper beauty contest John Maynard Keynes, (1936) 9/21/2018 Management Controls

Newspaper Beauty Contest Which Face is the prettiest? 9/21/2018 Management Controls

Which face will they judge to be the prettiest? 9/21/2018 Management Controls

Which face will they judge to be the prettiest? 9/21/2018 Management Controls

LIFO Inventory Accounting If your inventory prices rise, and end-of-year inventory volume is stable or rising You can delay paying taxes (higher net present value of cash flows) But have to report lower income also Many firms don’t adopt LIFO Apprehension about stock market reaction (no empirical support) 9/21/2018 Management Controls

Beliefs About Others’ Beliefs Common elements to the three stories about the emperor‘s clothes, stock market and LIFO Central role of what we believe about others, and about their beliefs 9/21/2018 Management Controls

Emperor’s Clothes The scoundrels made people believe that the clothes will be invisible only to the incompetent and the stupid People thought that others believed it Nobody wants to be seen as stupid or incompetent by others, lose his/her job Visibility of clothes was private, it was easy to fake seeing the clothes 9/21/2018 Management Controls

Emperor’s Clothes (Contd.) Scenario 1: Everyone was privately convinced of their incompetence, and cheered to deny it publicly Scenario 2: People did not believe they were incompetent just because they could see the naked emperor, but believed that others so believed, and cheered to avoid being seen as stupid 9/21/2018 Management Controls

What about the Child? The child did not know the link between visibility and competence Child was innocent, and said what he saw People know children to be innocent People knew that people knew this 9/21/2018 Management Controls

Keynes on Stock Market Price of Microsoft shares is $100 I expect the price to be $125 a year from now. Is it a good buy? Rule 1: Yes, if your opportunity cost of capital is less than $25 for the year 9/21/2018 Management Controls

Stock Market (Contd.) What if I now believe that the stock market’s assessment of the value of Microsoft shares a year from now will be $90? Can I change the beliefs of others in the market? If not, Rule 2: Sell at $100 Higher order rules 9/21/2018 Management Controls

Should I Pay Attention to Others When I Know I Am Right? What if everyone believes them (who are wrong), and not me (who is right) Fight them? or Join them? 9/21/2018 Management Controls

What About Accounting Agency problem: how to induce managers to maximize shareholder value (e.g., choose LIFO) Solution: Link managerial compensation to shareholder value Problem 2: Value manipulation Solution: Use market, not accounting, measures of value 9/21/2018 Management Controls

Value Maximizing Manager in an Efficient Market LIFO can increase NPV of cash flow But manager maximizes stock price What does manager believe about how stock prices are determined? Suppose manager believes that stock prices depend on income, not cash Then manager is rationally led to reject LIFO even if it saves cash for the firm After these examples of the consequences of common knowledge assumption, let us consider culture 9/21/2018 Management Controls

Culture In management, culture often treated as a counterpoint to economics Can think of culture of a group as the common knowledge expectation of behavior of the members of a group Starting meetings on time Wearing black on black Expectations lie at the heart of economic models 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

Comprehensive Perspective on 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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

Three Simultaneous Consequences Speeded up development of homogenized global norms for commercial transactions and culture (Nobody knows you are a dog!) With shrinking cost of creating specialized platforms, new platforms for pre-existing social, linguistic, national and technological groups (What will be the language of Internet in 2015?) Hybrid media (eBay gives your phone number to your transactions partner to enable an aural “eye contact” to clinch the deal) 9/21/2018 Management Controls

On E-Commerce Trading Platforms Opacity of Internet cuts common knowledge More difficult to attain expectational equilibrium among transaction partners New “external” players come into direct contact with each other E-commerce must establish expectational control among them all 9/21/2018 Management Controls

Framework for Control Duh, Jamal and Sunder (2001) two-dimensional framework for controls in online auctions like eBay Three criteria: privacy, security and integrity Four points of view: customers, sellers, employees, operators Useful for Identifying weaknesses in control Developing market for assurance services Regulation policy for trade, privacy and governance Research on open, interesting questions 9/21/2018 Management Controls

Competitive Development of Standards in E-Commerce Competitive development of control standards by assurance service providers (Jamal, Maier and Sunder, 2001) WebTrust: industry standards, slow acceptance TRUSTE seal: verification of client claims Competitive development of standards in e-commerce in sharp contrast to the monopoly approaches more popular in other aspects of accounting and auditing 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

Expectations and Common Knowledge Contrcts are based on expectations Expectations not well-understood yet First as well as higher orders of knowledge play important part in management Not always reasonable to assume common knowledge Breakdown of common knowledge has important consequences for behavior and outcomes in organizations and markets 9/21/2018 Management Controls

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 9/21/2018 Management Controls

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 9/21/2018 Management Controls

Thank You The paper and the slide presentation will be available on my website: http://www.som.yale.edu/faculty/sunder Please send your comments to Shyam.sunder@yale.edu 9/21/2018 Management Controls