1. Shyam Sunder, Yale University
Accounting and Controls for Local Governments: Organizing for Public- Vs. Private- Goods
Shyam Sunder, Yale University
Inaugural Address
40th All-India Accounting Conference
Indian Accounting Association
Udaipur, India, November 18-19, 2017
IAA Udaipur, ©2017 Shyam Sunder

2. AAA, San Diego, Copyright C1999 Shyam Sunder

3. Elephants and fish
AAA, San Diego, Copyright C1999 Shyam Sunder

4. How Do Governments Differ from business?
Can you tell which fish is drinking water?
“Just as it is difficult to know if a swimming fish is drinking water, it is difficult to detect if officers appointed for carrying out works steal king’s wealth.”
Arthaśāstra (2.9.33)
AAA, San Diego, Copyright C1999 Shyam Sunder

5. But wait, you might say, employees in businesses can steal too
Yes, of course, they can, and they do.
But there is a big difference.
I am going to talk about that difference.
Why it is important
And how it changes good management and accounting between business and government organizations
AAA, San Diego, Copyright C1999 Shyam Sunder

6. But WE need to start from a few steps back: Private and Public Goods
Businesses produce mostly private goods
These goods are sold to willing customers for a price
If the customer does not like the good or the price, (s)he can walk away and buy from another merchant
Competition: buyers discipline firm managers
AAA, San Diego, Copyright C1999 Shyam Sunder

7. Governments produce mostly public goods
National defense
Clean air and water
Roads
Sanitation, drainage
Courts/justice
Police and public safety
Broadcast TV/Radio
AAA, San Diego, Copyright C1999 Shyam Sunder

8. Special characteristics of PURE public goods
Non-exclusion
Everyone can use them
Cannot exclude those who do not pay from the benefits of public goods
Non-rivalrous or shared consumption
One person’s consumption of a public good does not reduce its usefulness to others
In fact, most goods have some features of public as well as private goods, but we shall talk as if businesses produce mostly private goods and governments produce mostly public goods
AAA, San Diego, Copyright C1999 Shyam Sunder

9. Private Goods: competition makes customer the king
Private good organizations produce and sell goods for a price to their customers
Managers try to attract and satisfy customers
Customers impose discipline on managers by not buying; penalizing managers by denying them revenue
Shareholders control manager by offering them net income-based compensation
This simplifies the problem of control
AAA, San Diego, Copyright C1999 Shyam Sunder

10. Private-Good Organizations
Elephants = managers, employees
Easier for proprietors, shareholders, and customers to monitor if they are stealing (drinking their water)
AAA, San Diego, Copyright C1999 Shyam Sunder

11. But, public Good Organizations Have
Beneficiaries, not customers
Beneficiaries do not pay (directly, no quid pro quo)
Weaker or no customer discipline on managers
Efficient production of public goods is far more difficult challenge without help of customer monitoring/discipline
Solution is: surprise, surprise!
BUREAUCRACY
AAA, San Diego, Copyright C1999 Shyam Sunder

12. Don’t be surprised I am going to argue:
Businesses produce private goods, and governments produce public goods
Businesses get free help from customers in monitoring their managers
Governments do not have this benefit of free monitoring
Their governance problem is much more difficult
Bureaucracy and government accounting tries to solve this problem. How?
AAA, San Diego, Copyright C1999 Shyam Sunder

13. Outline Organizations as a set of contracts
Accounting as a contract implemetation mechanism
Compare resource flows, management structure, decisions, and accounting in private and public good organizations
Examples and implications
AAA, San Diego, Copyright C1999 Shyam Sunder

14. MANY Calls for Reforms since the 1970s
Most of them called for governments to adopt business accounting practices
Arthur Andersen: Sound Financial Reporting in Public Sector: A Prerequisite to Fiscal Responsibility
Coopers & Lybrand: Financial Reporting Practices of American Cities: A Public Report
Touche Ross: Public Financial Reporting by Local Governments
Robert N. Anthony: Tell It Like It is
I shall show why government cannot be improved by using accounting practices of business
AAA, San Diego, Copyright C1999 Shyam Sunder

15. Cries in the Wilderness
Bolton: Don’t Put Government Financial Accounting in a Strait Jacket Drebin: Is Accounting that is Good for General Motors Good for Detroit? Mautz: Should Government Emulate Business? I agree with their arguments, but for a different reason
AAA, San Diego, Copyright C1999 Shyam Sunder

16. Legitimate Reasons for Different Accounting
Imposing business practices can cause considerable harm
Bureaucracy is an efficient solution to a difficult problem
Efficient production of public goods is a lot more difficult
Example: Besselman, Arora and Larkey Study of Defense Department
AAA, San Diego, Copyright C1999 Shyam Sunder

17. Four Characteristics of Bureaucracy
Fixed wage
Impersonal rules
Tenure in job
Promotion from inside
AAA, San Diego, Copyright C1999 Shyam Sunder

18. Lack of Theory of Organizations to Produce Public Goods
Management curricula linked to economics.
Absence of economic theory of public good organizations
Economics and management courses emphasize private goods only.
Contract theory of organizations can help
An example of a lack of theory driving out teaching and practice
University Teaching in Accounting
Audit 11
Financial 44
Managerial/Cost 21
MAS/Systems 5
Taxation 10
Government 1
Research 3
AAA, San Diego, Copyright C1999 Shyam Sunder

19. A Framework for Contract Theory of BUSINESS organizations
AAA, San Diego, Copyright C1999 Shyam Sunder

20. Shareholders Employees Creditors Customers Managers Government Vendors
Figure 1
Resource Flows in Private-Good Organization
Employees
Shareholders
Creditors
Customers
Vendors
Government
Managers
Public Goods
Taxes
Goods and
Services
Cash
Compensation
Skills
Residual
Rights
Equity Capital
Interest
Loan
Capital
AAA, San Diego, Copyright C1999 Shyam Sunder

21. Functions of Accounting
Measures resource contributions of each participant
Determines their inducements
Compares their contributions to inducements
AAA, San Diego, Copyright C1999 Shyam Sunder

22. 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
Their misappropriation is difficult to detect
Devising a scheme to induce managers to contribute what is expected of her/him
AAA, San Diego, Copyright C1999 Shyam Sunder

23. Comparing Private and Public Good Organizations
Resource flows
Residual Claims
Product Market Discipline
Decision Making
Product
Investment
Accounting and Control
AAA, San Diego, Copyright C1999 Shyam Sunder

24. Resource Flows Unreciprocated outflow to beneficiaries No quid pro quo
Need unreciprocated inflow (tax, gifts)
Captial versus revenue account cash flows
In Public good organizations, capital flows are “revenue” contributions
AAA, San Diego, Copyright C1999 Shyam Sunder

25. Shareholders Employees Creditors Customers Managers Government Vendors
Figure 1
Resource Flows in Private-Good Organization
Employees
Shareholders
Creditors
Customers
Vendors
Government
Managers
Public Goods
Taxes
Goods and
Services
Cash
Compensation
Skills
Residual
Rights
Equity Capital
Interest
Loan
Capital
AAA, San Diego, Copyright C1999 Shyam Sunder

26. Residual Claims An economizing device in private good organizations
Reduce the number of contracting relationships
Residual claimant given control (susceptible to others' non- performance)
All agents can protect their interests directly
AAA, San Diego, Copyright C1999 Shyam Sunder

27. Stock Market Consequences of Residual Claims
Trading in residual claims (stock market)
Creates incentives to gather and produce information
A large information industry exists
Capitalizability of residual claims induces interest in longer term resource flows
AAA, San Diego, Copyright C1999 Shyam Sunder

28. Public Goods Organizations
No tradable residual claims
Weaker incentives to search for information
Weaker concern for the longer run (e.g., Social Security debates)
AAA, San Diego, Copyright C1999 Shyam Sunder

29. Resource Flows in Public-Good Organizations
Figure 1
Resource Flows in Public-Good Organizations
Employees
Governing Body
Creditors
Beneficiaries
Vendors
Government
Managers
Public Goods
Taxes
Goods and
Services
Cash
Compensation
Skills
Financial
Resources
Interest
Loan
Capital
AAA, San Diego, Copyright C1999 Shyam Sunder

30. Defining Managers’ Contracts
Private Good Organizations make it self-enforcing: link compensation to the residual (accounting and audit)
No product market discipline  No link of managerial compensation to residual
AAA, San Diego, Copyright C1999 Shyam Sunder

31. Product Market Discipline
Customers in private good organizations negotiate terms
No transaction if not satisfied
Can withhold revenues
Residual-based contract for managers possible (asked to maximize profits)
AAA, San Diego, Copyright C1999 Shyam Sunder

32. Public Good Organizations’ Beneficiaries
Cannot withhold resources directly
Would continue to consume resources of poorer quality
Have no alternatives
AAA, San Diego, Copyright C1999 Shyam Sunder

33. Private Good Contract in Public Good Organization
Dysfunctional
Simple for managers to maximize the residual by cutting the quality or quantity
This makes the organization redundant
Efficient structure for private goods is not efficient for public goods
AAA, San Diego, Copyright C1999 Shyam Sunder

34. Kautilya in Arthasastra: WHY No Residual Based Contract in Govt.
He who causes loss of revenue consumes the property of the king (2.9.13).
He who procures more than the normal revenue, consumes the countryside (2.9.15).
He who spends all the revenue without bringing in any profit swallows the labor of workers (2.9.17).
In other words, government should collect all its revenue, not exploit the tax payer, and control its expenses. Unlike business, don’t maximize the bottom line.
AAA, San Diego, Copyright C1999 Shyam Sunder

35. Redistribution of Decision Rights
This Problem in public good organizations is addressed by redistribution of decision making responsibilities
Managerial contract delinked from residual
AAA, San Diego, Copyright C1999 Shyam Sunder

36. Product Decision Rights
Managers have information, expertise, and decision rights in private good
In public goods, the governing body specifies what is produced, quantity, quality, and who gets them, because it pays for them
Residual generation is irrelevant because the net residual in government organizations is negative
AAA, San Diego, Copyright C1999 Shyam Sunder

37. Product Decision Rights in Public Good Organizations
The informational advantage managers in private goods is left unused in public goods
Managers not offered incentives to look for newer types of public goods
They may do so to seek promotion and power, retain jobs
AAA, San Diego, Copyright C1999 Shyam Sunder

38. Investment/Production Decision Rights in Private Good Organizations
Managers choose residual maximizing quantity, quality using their information
Delegation of quantity decisions possible through linkage between residual and remuneration
Investment decisions are derived decisions from the quantity decisions
AAA, San Diego, Copyright C1999 Shyam Sunder

39. Investment/Production Decision Rights in Public Goods Orgs.
In public goods, governing bodies make quantity and quality decisions,
And therefore, they also make the capital investment decisions
AAA, San Diego, Copyright C1999 Shyam Sunder

40. Accounting and Controls
Differences between internal control and financial reporting
Differences often misinterpreted as prima facie evidence of poorly designed or poorly run public-good organizations
AAA, San Diego, Copyright C1999 Shyam Sunder

41. Accounting and Control in Govt. organizations
Entities
Funds
Consolidation
Assets/Depreciation
Revenue (cash versus accrual)
Budgets
AAA, San Diego, Copyright C1999 Shyam Sunder

42. Entities, Funds and Consolidation
Restrictions on use of funds to make each fund a separate entity
Governing bodies direct funds to implement their production decisions
Beneficiaries cannot discipline the managers
Segregation of funds is a device to implement the contract
AAA, San Diego, Copyright C1999 Shyam Sunder

43. Detail in Public Good Financial Reports
Even small public good organizations have fat financial reports
Why do they not aggregate?
AAA, San Diego, Copyright C1999 Shyam Sunder

44. Reports Reflect the Decision Structure
Governing boards make product/investment decisions
Public good org. reports comparable to middle management reports
Each fund serves a different constituency
If funds cannot be commingled, why consolidate?
AAA, San Diego, Copyright C1999 Shyam Sunder

45. Fixed Assets and Depreciation
Private‑good: Record and value of long‑term assets at acquisition cost
Expense as cost of production over life
Use of standard formulas
Statistical inaccuracy vs. objectivity
Valuation of individual assets and the residual rights for transactions
Useful for traders
AAA, San Diego, Copyright C1999 Shyam Sunder

46. Public Good Organizations
Residual rights not traded
Sale of fixed assets infrequent
Uniqueness of many assets (Mount Rushmore)
Dominant market position
Nonmonetary disclosure of assets
Not sure if some assets are liabilities
AAA, San Diego, Copyright C1999 Shyam Sunder

47. Depreciation in Private Good Organizations
Three functions:
Estimating the residual surplus
Information value of residual surplus
Important statistic for all (viability, renegotiation)
Charging depreciation to the cost of production for pricing decisions
Induce managers to goal congruence
AAA, San Diego, Copyright C1999 Shyam Sunder

48. In Public Good Organizations
None of the above three reasons are applicable
No residual claimant
Public goods are not sold
Production investment decisions made by governing bodies
AAA, San Diego, Copyright C1999 Shyam Sunder

49. Accruals and Revenue/Expense Recognition
In Private good organizations, realization principle represents the quid pro quo with the customers
No quid pro quo for transactions in public-good organizations
In absence of quid pro quo, applying accrual principle is chasing form, not substance
AAA, San Diego, Copyright C1999 Shyam Sunder

50. Budgets, Appropriations and Encumbrances
Governing bodies of public-good organizations appropriate funds for specific items
The budget is an authorization to spend for a specific purpose
Each purpose has its own beneficiaries
Intermingling of funds not permitted
AAA, San Diego, Copyright C1999 Shyam Sunder

51. Which one is the Independent Variable?
Legal charter
Revenue Service Rules on tax status
Economic characteristics of organization’s output
AAA, San Diego, Copyright C1999 Shyam Sunder

52. Considered Polar Cases Only
Pure public and pure private goods are two polar cases
Most goods, and organizations that produce them lie in between
Rich spectrum of opportunities for study of organizations, economics and accounting controls
AAA, San Diego, Copyright C1999 Shyam Sunder

53. Bureaucracy As A Dirty Word
Bureaucracy is the oldest form of management
Does not receive a fair shake in press
Perhaps overused in welfare state
But it is necessary for many functions
Lack of understanding leads to misguided attempts at reform that can backfire
AAA, San Diego, Copyright C1999 Shyam Sunder

54. Unequal COMPARISON
Efficient production of public goods is a far more difficult task than private goods (lack of customer discipline on managers)
It is easier to tell if elephants are drinking water than fish
But there is always room for improvements in current practices
AAA, San Diego, Copyright C1999 Shyam Sunder

55. Thank You Shyam.sunder@yale.edu
r/research.html
AAA, San Diego, Copyright C1999 Shyam Sunder