9/7/2015Contract Theory1 Contract Theory of Organizations, Accounting and Control Shyam Sunder, Yale University University of Sao Paulo Sao Paulo, Brazil, March 12, 2013

9/7/2015Organizanal Design2 Outline Organizations as alliances among people seeking their goals Culture of a group is the set of common knowledge expectations its members have from one another Control as equilibrium or balance: organization is in control if expectations of its members from one another match what its members find in their own best interests Control threatened by changes in environment; without prompt repair, organization collapses Strategic management: anticipate threats, redesign and renegotiate alliances to restore control with respect to the changed environment.

9/7/2015Organizanal Design3 Organizational Design Perspective includes a review of –Organizations, –Expectations, –Common knowledge, and –Culture; Disruption and threats to control Strategic management: what top managers do to maintain control

9/7/2015Organizanal Design4 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

9/7/2015Organizanal Design5 Contracts Participating agents promise to deliver resources In exchange for the 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 satisfies the condition is assembled

9/7/2015Organizanal Design6 Agent Has personal goals From his opportunity set, chooses preferred actions Actions are consistent with his preferences, information and opportunity set Difficult to model in social sciences without a minimal level of behavioral consistency

9/7/2015Organizanal Design7 Examples of Contracts Contract is a mutual expectation or understanding among agents Lunch date This class 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

9/7/2015Organizanal Design8 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

9/7/2015Organizanal Design9 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) –Support (Community) Each party gets resources in exchange

9/7/2015Organizanal Design10 Firm as a Set of Contracts

9/7/2015Organizanal Design11 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

9/7/2015Organizanal Design12 Measuring Contributions Receivables and cashier Receiving dock for supplies Punch clock and quality control

9/7/2015Organizanal Design13 Measuring Outflows Payroll accounts Tax accounts Cashier Shipping

9/7/2015Organizanal Design14 Contract Fulfillment Matching resource inflows and outflows to contracts Performance evaluation Adjusting contracts to resource realizations

9/7/2015Organizanal Design15 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

9/7/2015Organizanal Design16 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

9/7/2015Organizanal Design17 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

9/7/2015Organizanal Design18 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

9/7/2015Organizanal Design19 Mutuality of Expectations Expectations are rarely fixed All actions create/influence expectations Firm must manage them (problem of participative budgeting) With unfilled expectations, people turn away With overfilled expectations set up 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)

9/7/2015Organizanal Design20 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...

9/7/2015Organizanal Design21 Emperor Has No Clothes

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9/7/2015Organizanal Design23 Stock Market Stock Market is like a newspaper beauty contest John Maynard Keynes, (1936)

9/7/2015Organizanal Design24 Newspaper Beauty Contest Which Face is the prettiest?

9/7/2015Organizanal Design25 Which face will they judge to be the prettiest?

9/7/2015Organizanal Design26 Which face will they judge to be the prettiest?

9/7/2015Organizanal Design27 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)

9/7/2015Organizanal Design28 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

9/7/2015Organizanal Design29 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

9/7/2015Organizanal Design30 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

9/7/2015Organizanal Design31 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

9/7/2015Organizanal Design32 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

9/7/2015Organizanal Design33 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

9/7/2015Organizanal Design34 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?

9/7/2015Organizanal Design35 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

9/7/2015Organizanal Design36 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

9/7/2015Organizanal Design37 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

9/7/2015Organizanal Design38 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

9/7/2015Organizanal Design39 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

9/7/2015Organizanal Design40 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

9/7/2015Organizanal Design41 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

9/7/2015Organizanal Design42 If Individual Condition Is Not Met People who do not expect to get from the organization at least the opportunity cost of their contributions will go elsewhere This is the definition of opportunity cost Shareholders will not buy your stock if they can higher risk-adjusted return elsewhere Customers will not buy your goods if they can get better price or quality elsewhere

9/7/2015Organizanal Design43 If Aggregate Condition Is Not Met Firms runs out of resources to meet its obligations (expenses exceed revenue) Some agent(s) disappointed because the promises made to them are not fulfilled These agents quit (and probably impose additional costs on the organization—e.g., law suits) If these individuals were essential for the production function of the firm, their departure makes things worse If they were not essential, the firm did not choose the optimum production function

9/7/2015Organizanal Design44 No Coercion Matching of agent actions to what others expect of them should not be achieved through coercion It has to be created through socially legitimate incentives and motivational methods What is legitimate varies across societies Performance-based compensation may be considered coercive in some societies but not in others

9/7/2015Organizanal Design45 Not Based on Misunderstanding Participant actions and others’ expectations of them may just happen to match due to misunderstanding Such a match is not sustainable; it disappears as soon as the participants get better information A match based on misunderstanding does not imply control

9/7/2015Organizanal Design46 Not Based on False Promises A match may sometimes be obtained through false promises—e.g., Ponzi schemes Again, these are not sustainable Disclosure of truth destroys the organization Such a house of cards is not “in control”

9/7/2015Organizanal Design47 Disintegration of Organizations When actions do not match the expectations, people are disillusioned and quit Organizations disintegrate Miscalculation, coercion, misunderstanding, or misrepresentation by agents destroy control

9/7/2015Organizanal Design48 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

9/7/2015Organizanal Design49 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

9/7/2015Organizanal Design50 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

9/7/2015Organizanal Design51 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

9/7/2015Organizanal Design52 Expectations and Common Knowledge Contracts 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

9/7/2015Organizanal Design53 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

9/7/2015Organizanal Design54 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

9/7/2015Organizanal Design55 Thank You Please send your comments to