1 Structure of Organizations for Production of Public and Private Goods Shyam Sunder, Yale University American Accounting Association’s International Visiting Lecturer Bogazici University, Istambul October 9, 2000

2 Compare Public and Private Good Organizations b Private good organizations produce and sell goods for a price to customers b Customers can impose discipline on them b Shareholders control manager by offering them net income based compensation

3 Public Good Organizations b Public good organizations have beneficieries, not customers b Weaker or no customer discipline b Efficient production of public goods is very difficult b Solution is bureaucracy

4 Outline b Organizations as a set of contracts b Accounting as a contract implemetation mechanism b Compare resource flows, management structure, decisions, and accounting in organizations b Examples and implications

5 Faculty Teaching by Subject Subject Area AuditingFinancialManageral/CostMAS/SystemsTaxationGovernmentResearch All current Teaching (In percent)

6 Calls for Reforms b Arthur Andersen: Sound Financial Reporting in Public Sector: A Prerequisite to Fiscal Responsibility b Coopers & Lybrand: Financial Reporting Practices of American Cities: A Public Report b Touche Ross: Public Financial Reporting by Local Governments b Robert N. Anthony: Tell It Like It is

7 Four Characteristics of Bureaucracy b Fixed wage b Impersonal rules b Tenure in job b Promotion from inside

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9 Cries in the Wilderness b Bolton: Don’t Put Government Financial Accounting in a Strait Jacket b Drebin: Is Accounting that is Good for General Motors Good for Detroit? b Mautz: Should Government Emulate Business?

10 Legitimate Reasons for Different Accounting b b Imposing business practices can cause considerable harm b b Bureaucracy is an efficient solution to a difficult problem b b Efficient production of public goods is a lot more difficult b b Example: Besselman, Arora and Larkey Study of Defense Department

11 Lack of Theory of Organizations to Produce Public Goods b Management curricula linked to economics. b Absence of economic theory of public good organizations b Economics and management courses emphasize private goods only. b Contract theory of organizations can help b An example of a lack of theory driving out teaching and practice

12 A Framework for Contract Theory of Organizations b Chester Barnard, President, Bell Telephone Company of New Jersey Functions of the Executive 1937Functions of the Executive 1937 b Herbert A. Simon, b Herbert A. Simon, Administrative Behavior, 1946

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15 Necessary Conditions b 1) Individual Condition: Each participants expects to receive at least the opportunity cost of contributions he/she makes to the organization b 2) Aggregate Condition: Contributions of all participants can produce enough output to meet the expectations of all

16 Functions of Accounting b b Measures resource contributions b b Determines inducements b b Compares contributions to inducements

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

18 What are public and private goods? b Pure public goods satisfy two conditions: b Zero marginal cost of serving an additional user b Nonexcludability: those who do not pay still benefit. b Examples: National defense for citizens of U.S. Public radio in city

19 Pure private goods do not satisfy either condition b Examples: a cup of coffee, car, suit b Most goods and services lie in between the two extremes of pure public and pure private goods

20 Comparing Private and Public Good Organizations b b Resource flows b b Residual Claims b b Product Market Discipline b b Decision Making Product Investment b b Accounting and Control

21 Resource Flows b b Unreciprocated outflow to beneficiaries b b No quid pro quo b b Need unreciprocated inflow (tax, gifts) b b Captial versus revenue account cash flows b b In Public good organizations, capital flows are “revenue” contributions

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24 Residual Claims b b An economizing device in private good organizations b b Reduce the number of contracting relationships b b Residual claimant given control (susceptible to others' non- performance) b b All agents can protect their interests directly

25 Stock Market Consequences of Residual Claims b b Trading in residual claims (stock market) b b Creates incentives to gather and produce information b b A large information industry exists b b Capitalizability of residual claims induces interest in longer term resource flows

26 Public Goods Organizations b b No tradeable residual claims b b Weaker incentives to search for information b b Weaker concern for the longer run (e.g., Social Security debates)

27 Defining Managers’ Contracts b b Private Good Organizations make it self-enforcing: link compensation to the residual (accounting and audit) b b No product market discipline  No link of managerial compensation to residual

28 Product Market Discipline b b Customers in PGOs negotiate terms b b No transaction if not satisfied b b Can withhold revenues b b Residual-based contract for managers possible

29 Public Good Organizations’ Beneficiaries b b Cannot withhold resources directly b b Would continue to consume resources of poorer quality

30 Private Good Contract in Public Good Organization b b Dysfunctional b b Simple for managers to maximize the residual by cutting the quality or quantity b b This makes the organization becomes redundant b b Efficient structure for private goods is not efficient for public goods

31 Redistribution of Decision Rights b b This Problem in public good organizations is addressed by Redistribution of decision making responsibilities b b Managerial contract delinked from residual

32 Product Decision Rights b b Managers have information, expertise, and decision rights in private good b b In public goods, the governing body specifies what is produced, quantity, quality, and who gets them, because it pays for them b b Residual generation is irrelevant because the net residual is negative

33 Product Decision Rights in Public Good Organizations b b The informational advantage managers in private goods is left unused in public goods b b Managers not offered incentives to look for newer types of public goods   They may do so to seek promotion and power, retain jobs

34 Investment/Production Decision Rights b b Managers choose residual maximizing quantity, quality using their information b b Delegation of quantity decisions possible through linkage between residual and remuneration b b Investment decisions are derived decisions from the quantity decisions

35 Investment/Production Decision Rights in Public Goods Orgs. b b In public goods, governing bodies make quantity and quality decisions, b b And therefore, the capital investment decisions

36 Accounting and Controls b b Differences between internal control and financial reporting b b Differences often misinterpreted as prima facie evidence of poorly designed or poorly run public-good organizations

37 Accounting and Control Differences b Entities b Funds b Consolidation b Assets/Depreciation b Revenue (cash versus accrual) b Budgets

38 Entities, Funds and Consolidation b b Restrictions on use of funds to make each fund a separate entity b b Governing bodies direct funds to implement their production decisions b b Beneficiaries cannot discipline the managers b b Segregation of funds is a device to implement the contract

39 Detail in Public Good Financial Reports b b Even small public good organizaations have fat financial reports b b Why do they not aggregate?

40 Reports Reflect the Decision Structure b b Governing boards make product/investment decisions b b Public good org. reports comparable to middle management reports b b Each fund serves a different constituency b b If funds cannot be commingled, why consolidate?

41 Fixed Assets and Depreciation b b Private ‑ good: Record and value of long ‑ term assets at acquisition cost b b Expense as cost of production over life b b Use of standard formulas b b Statistical inaccuracy vs. objectivity b b Valuation of individual assets and the residual rights for transactions b b Useful for traders

42 Public Good Organizations b b Residual rights not traded b b Sale of fixed assets infrequent b b Uniqueness of many assets (Mount Rushmore) b b Dominant market position b b Nonmonetary disclosure of assets   Not sure if some assets are liabilities

43 Depreciation in Private Good Organizations b b Three functions: b b Estimating the residual surplus Information value of residual surplus Important statistic for all (viability, renegotiation) b b Charging depreciation to the cost of production for pricing decisions   Induce managers to goal congruence

44 In Public Good Organizations b b none of the above three reasons applicable b b No residual claimant b b Public goods are not sold b b Production investment decisions made by governing bodies

45 Accruals and Revenue/Expense Recognition b b In Private good organizations, realization principle represents the quid pro quo with the customers b b No quid pro quo for transactions in public-good organizations b b In absence of quid pro quo, applying accrual principle is chasing form, not substance

46 Budgets, Appropriations and Encumbrances b b Governing bodies of public-good organizations appropriate funds for specific items   The budget is an authorization to spend

47 Which one is the Independent Variable? b Legal charter b Interal Revenue Service Rules on tax status b Economic characteristics of organization’s output

48 Considered Polar Cases Only b Pure public and pure private goods are two polar cases b Most goods, and organizations that produce them lie in between b Rich spectrum of opportunities for study of organizations, economics and accounting controls

49 Bureaucracy As A Dirty Word b Bureaucracy is the oldest form of management b Does not receive a fair shake in press b Perhaps overused in welfare state b But it is necessary for many functions b Lack of understanding leads to misguided attempts at reform that can backfire

50 Unequal Race b Efficient production of public goods is more difficult than private goods (lack of customer discipline on managers) b Always room for improvement in current practices

51 Thank You b The working paper, talk, and slides are available at b esearch.html b or to