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Management Controls, Expectations, Common Knowledge, and Culture Shyam Sunder Yale University Plenary Address, American Accounting Association Management Accounting Conference, Austin TX, January 11-12, 2002 Control in Organizations Share some ideas on control in organizations

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Management Controls, Expectations, Common Knowledge, and Culture

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Management Controls, Expectations, Common Knowledge, and Culture

Shyam Sunder

Yale University

Plenary Address, American Accounting Association Management Accounting Conference, Austin TX, January 11-12, 2002


Control in Organizations

  • Share some ideas on control in organizations

  • Can think of control as expectational equilibrium

    • That it, correspondence between what people choose to do, and what others expect them to do

  • This perspective is useful accounting, and management

  • Perspective includes a review of perspectives on

    • Organizations,

    • Expectations,

    • Common knowledge, and

    • Culture;

  • Disruption and threats to control

  • Strategic management: what top managers do to maintain control

Management Controls


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

Management Controls


Contracts

  • Participating agents promise to deliver resources

  • In exchange for 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 satisfied the condition is assembled

Management Controls


Economic Agents

  • Has personal goals

  • Actions are consistent with his preferences

  • From his opportunity set, chooses preferred actions

  • Consistency of actions is the key characteristic

  • Difficult to model in social sciences without a minimal level of behavioral consistency

Management Controls


Examples of Contracts

  • Contract is a mutual expectation or understanding among agents

  • Lunch date

  • This conference

  • 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

Management Controls


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

Management Controls


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)

    • Community (support)

  • Each party gets resources in exchange

Management Controls


Firm as a Set of Contracts

Management Controls


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

Management Controls


Measuring Contributions

  • Receivables and cashier

  • Receiving dock for supplies

  • Punch clock and quality control

Management Controls


Measuring Outflows

  • Payroll accounts

  • Tax accounts

  • Cashier

  • Shipping

Management Controls


Contract Fulfillment

  • Matching resource inflows and outflows to contracts

  • Performance evaluation

  • Adjusting contracts to resource realizations

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


Classification by Markets

  • Market for managers (Hatfield, 1924))

  • Market for capital (Hatfield, 1924)

  • Market for product (Sunder, 1999)

Management Controls


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)

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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)

Management Controls


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...

Management Controls


Emperor Has No Clothes

Management Controls


Management Controls


Stock Market

  • Stock Market is like a newspaper beauty contest

  • John Maynard Keynes, (1936)

Management Controls


Newspaper Beauty Contest

Which Face is the prettiest?

Management Controls


Which face will they judge to be the prettiest?

Management Controls


Which face will they judge to be the prettiest?

Management Controls


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)

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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?

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


Three Simultaneous Consequences

  • Speeded up development of homogenized global norms for commercial transactions and culture (Nobody knows you are a dog!)

  • With shrinking cost of creating specialized platforms, new platforms for pre-existing social, linguistic, national and technological groups (What will be the language of Internet in 2015?)

  • Hybrid media (eBay gives your phone number to your transactions partner to enable an aural “eye contact” to clinch the deal)

Management Controls


On E-Commerce Trading Platforms

  • Opacity of Internet cuts common knowledge

  • More difficult to attain expectational equilibrium among transaction partners

  • New “external” players come into direct contact with each other

  • E-commerce must establish expectational control among them all

Management Controls


Framework for Control

  • Duh, Jamal and Sunder (2001) two-dimensional framework for controls in online auctions like eBay

  • Three criteria: privacy, security and integrity

  • Four points of view: customers, sellers, employees, operators

  • Useful for

    • Identifying weaknesses in control

    • Developing market for assurance services

    • Regulation policy for trade, privacy and governance

    • Research on open, interesting questions

Management Controls


Competitive Development of Standards in E-Commerce

  • Competitive development of control standards by assurance service providers (Jamal, Maier and Sunder, 2001)

  • WebTrust: industry standards, slow acceptance

  • TRUSTE seal: verification of client claims

  • Competitive development of standards in e-commerce in sharp contrast to the monopoly approaches more popular in other aspects of accounting and auditing

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


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

Management Controls


Expectations and Common Knowledge

  • Contrcts 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

Management Controls


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

Management Controls


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

Management Controls


Thank You

  • The paper and the slide presentation will be available on my website:

  • http://www.som.yale.edu/faculty/sunder

  • Please send your comments to

  • Shyam.sunder@yale.edu

Management Controls


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