Accounting and Contract Theory of the Firm

Accounting and Contract Theory of the Firm
Shyam Sunder, Yale University Middle-Eastern Technical University Department of Business Administration Ankara, Turkey, November 24, 2008 12/3/2018 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 12/3/2018 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 12/3/2018 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 12/3/2018 Contract Theory of Accounting

Firm as a set of Contracts
Economic agents Contracts Contributions Resource Entitlements Necessary Conditions Individual condition Aggregate Condition 12/3/2018 Contract Theory of Accounting

12/3/2018 Contract Theory of Accounting

Contributions and Entitlements of Various Agents

Assumptions Economic Agents Preferences Consistency of Actions Contracts as Mutual Understanding or Expectation Not Always Explicit Role of Social Conventions 12/3/2018 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 12/3/2018 Contract Theory of Accounting

Functions of Accounting
To Help Assemble Implement Enforce Modify Maintain the contract set by five processes 12/3/2018 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 12/3/2018 Contract Theory of Accounting

Measuring Resource Inflows
Vendors: At the Receiving Dock Customers: Cashier, Acc. Rec. Labor: Clock, Inspection Managers: Intangible Shareholders: Shareholder Accounts 12/3/2018 Contract Theory of Accounting

Measuring Resource Outflows
Employees: Payroll Customers: Shipping Vendors: Account Payables Government: Tax Accounts Data Organized by Cause-Effect 12/3/2018 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 12/3/2018 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 12/3/2018 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 12/3/2018 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 12/3/2018 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 12/3/2018 Contract Theory of Accounting

Contracting for Managerial Skills
Managerial characteristics Human capital Stock inalienable Any long term contracts must be self-enforcing Used, but not used up, actually accumulates on the job Compensation = current + accretion of human capital (Accounting used for both components) Supply is inelastic in the short run (opportunity to extract rents, and vulnerable to expropriation) No right to transfer the job slot Large part of wealth tied up in human capital (not diversified) Performance data extrapolated by investors/superiors Performance smoothing by managers 12/3/2018 Contract Theory of Accounting

Managerial characteristics Measuring managerial contributions Not directly measurable More difficult at higher levels Difficulty in designing their contacts Procedural centrality--contact with other agents Managing contracts Surprises: nature, unanticipated behavior of others Privileged access to info about other contracts Info asymmetry in favor of managers Problems of adverse selection they know what others don’t Moral hazard others do not know what they did Could sell info to competitors for personal gain Prohibition on sharing services of managers across competitors 12/3/2018 Contract Theory of Accounting

Forms of Contracts for Managers Managerial Preferences Enforcement difficult because of Nature of work human capital involvement in contracts of others Legal system could help if shared information is available How do we make it self-enforcing? Flat salary contracts used in public good organizations Even output is difficult to measure Poor motivational tool Performance contingent contracts No single measure is perfect factors outside management control subject to management manipulation Conditions for job loss left unspecified Right to unilateral termination without cause 12/3/2018 Contract Theory of Accounting

Role of accounting in managerial Contracts
Managers’ preferences Pecuniary variables Non-pecuniary variables (future compensation) Salary is about half of total for senior managers In U.S. Benefits driven by tax law Interaction between pecuniary and others Bonus components--about one half Truncation of bonus Independence from accounting rules Use of controlled variables Use of environmental variables Salary itself is contingent continuation in job The difference is in the degree of explicitness Manager’s share of risk Termination Bonus Advancement uncertainty Reputation Incentives versus tax law driven benefits 12/3/2018 Contract Theory of Accounting

Top, middle and lower level managers
Nested hierarchy of firms and sub-firms CEO as shareholder of the subsidiaries Use of non-financial measures for transfers among subfirms Why are two subs part of the same firm Transfer pricing problem System of creating pseudo Top, middle and lower level managers prices Imperfect and incomplete prices Separation of top from other managers’ contribution is difficult Auditors control discretion at top Difficulty of evaluating middle managers 12/3/2018 Contract Theory of Accounting

Investors and Accounting
What is special about investors? Pre-commitment Time delay Residual claim only Measurement and cont. fulfillment crucial Description Little participation On purpose, desirable, diversification ROE on owner managed firms same Transferability Minimal cost, rapid price adjustment Symmetry of info (public discl.) Contrast privately held firms Cost of taking them private Preference heterogeneity Liquid market gives a unique measure 12/3/2018 Contract Theory of Accounting

Investors and Accounting
Description Price adjustments to information Determine distribution of wealth Equitable release of information Information intermediaries Demand for information Cost of information Diversification by individual information intermediaries Problem of evaluating portfolio managers Do not ask for disclosure Analysts demand disclosure 12/3/2018 Contract Theory of Accounting

Investor Attitudes and Preferences
Reporting on contract performance Importance of contract fulfillment Controls and redundancy Symmetry of information distribution Incentives to managers Top manager contracts Limits on relevance and reliability Reserve Recognition Accounting in oil industry Aggregation adds information Information in aggregation function 12/3/2018 Contract Theory of Accounting

Accounting Choice Mechanisms for Investors
Organization of the firm Nature of charter Going public Trading in capital markets Dividends and valuation Analogy of buyers and cars Reactionary mode Managers anticipate investor preferences Voting and proxies Not an effective instrument for investors Socio-political institutions Legislature, regulatory bodies Changes in regime 12/3/2018 Contract Theory of Accounting

Consequences of Accounting Policy for Investors
Accounting information as public good Too little production? Common cost of contracts Special vulnerability of investors Not in direct touch with operations Free distribution of information--dynamic stability Advertising analogy Production By Intermediaries Who pays, who benefits Early efficient market euphoria Economics of information market Criticism of details for analysts Open entry to analyst market, Regulation FD 12/3/2018 Contract Theory of Accounting

Accounting and the Stock Market
Possibility of making money in the stock market using publicly available accounting data Possibility of making money in the stock market using accounting data before it is publicly available Accounting principles and disclosure effect on the behavior of stock markets? Stock market effect on accounting and control? How would stock market be different without accounting? How would accounting be different without stock markets? 12/3/2018 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 Sunder, Shyam. “Classical, Stewardship and Market Perspectives on Accounting: A Synthesis.” In The Japanese Style of Business Accounting edited by Shyam Sunder and Hidetoshi Yamaji, Westport, CT: Quorum Books, 1999. 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

Classification by Markets
Market for managers (Hatfield, 1924)) Market for capital (Hatfield, 1924) Market for product (Sunder, 1999) 12/3/2018 Contract Theory of Accounting

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) 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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) 12/3/2018 Contract Theory of Accounting

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... 12/3/2018 Contract Theory of Accounting

Emperor Has No Clothes 12/3/2018 Contract Theory of Accounting

Stock Market Stock Market is like a newspaper beauty contest John Maynard Keynes, (1936) 12/3/2018 Contract Theory of Accounting

Newspaper Beauty Contest
Which Face is the prettiest? 12/3/2018 Contract Theory of Accounting

Which face will they judge to be the prettiest? 12/3/2018 Contract Theory of Accounting

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) 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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? 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

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 12/3/2018 Contract Theory of Accounting

Thank You 12/3/2018 Contract Theory of Accounting

Accounting and Contract Theory of the Firm

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Accounting and Contract Theory of the Firm

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