Contract Theory of Accounting Shyam Sunder Yale University 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting Three Basic Ideas Organizations as a set of contracts Shared facts for conflict resolution Control in organizations as balance and equilibrium 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting Micro and Macro Theory Micro Functions of accounting Managers and Income Shareholders, stock markets, and auditors Macro Basic features of accounting Social choice criteria, mechanisms and standardization Government and public good organizations 7/18/2019 Contract Theory of Accounting

A Framework for Contract Theory of Organizations Chester Barnard, President, Bell Telephone Company of New Jersey Functions of the Executive 1937 Herbert A. Simon, Administrative Behavior, 1946 Foundation Idea: Organization as a set of contracts or an alliance 7/18/2019 Contract Theory of Accounting

Firm as a set of Contracts Economic agents Contracts Contributions Resource Entitlements Necessary Conditions Individual condition Aggregate Condition 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting 7/18/2019 Contract Theory of Accounting

Contributions and Entitlements of Various Agents 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting Assumptions Economic Agents Preferences Consistency of Actions Contracts as Mutual Understanding or Expectation Not Always Explicit Role of Social Conventions 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting 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 7/18/2019 Contract Theory of Accounting

Functions of Accounting To Help Assemble Implement Enforce Modify Maintain the contract set by five processes 7/18/2019 Contract Theory of Accounting

Processes of Accounting Measuring Resource Inflows Measuring Resource Outflows Determination of Contract Performance Information for Factor Markets Common Knowledge for Contract Renegotiation 7/18/2019 Contract Theory of Accounting

Measuring Resource Inflows Vendors: At the Receiving Dock Customers: Cashier, Acc. Rec. Labor: Clock, Inspection Managers: Intangible Shareholders: Shareholder Accounts 7/18/2019 Contract Theory of Accounting

Measuring Resource Outflows Employees: Payroll Customers: Shipping Vendors: Account Payables Government: Tax Accounts Data Organized by Cause-Effect 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting Contract Performance Compare resource inflows and outflows Determine Who Has Fulfilled contracts, How Much Comparative Reports Examples: Customer Account Statement Managerial Accounting 7/18/2019 Contract Theory of Accounting

Information for Factor Markets What resources are needed What resources to distribute Find people who have/want them Factor Markets for Labor, managers, customers, supplies, investors Proforma financial statements, business plans and budgets by the entrepreneur  No permanent occupants, find replacements Costs and Benefits 7/18/2019 Contract Theory of Accounting

Common Knowledge for Contract 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 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting 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 7/18/2019 Contract Theory of Accounting

Special 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 7/18/2019 Contract Theory of Accounting

Classification and Synthesis of Accounting Pick three broad themes Classical Stewardship Market-based Differences in the Assumptions Differences in the Range of Phenomena Organized Differences in the degree of development of markets 7/18/2019 Contract Theory of Accounting

Contract Theory of Accounting Thank You The paper, and slides will be available at http://www.som.yale.edu/faculty/sunder/research.html or email to shyam.sunder@yale.edu 7/18/2019 Contract Theory of Accounting