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Markets, Organizations and Accounting Shyam Sunder Yale University Contract View of Organizations Chester Barnard, Functions of the Executive , 1937 Organization as a set of contracts

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Markets organizations and accounting l.jpg
Markets, Organizations and Accounting

Shyam Sunder

Yale University


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Contract View of Organizations

  • Chester Barnard, Functions of the Executive, 1937

  • Organization as a set of contracts

  • Example: Business as a set of contracts among employees, shareholders, managers, customers, vendors, creditors, auditors, government, etc.

  • A synthesis of markets and organizations

Shyam Sunder, Markets, Organizations and Accounting


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Synthesis

  • Pick three broad themes

  • Classical

  • Stewardship

  • Market-based

  • Differences in the Assumptions

  • Differences in the Range of Phenomena Organized

Shyam Sunder, Markets, Organizations and Accounting


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Common Perspective

  • Accounting as a solution

  • Same Fundamental Problem in

  • kingdom

  • temple

  • medieval manor

  • farm

  • family-run grocery store

  • textile mill

  • bank

  • multinational corporation

Shyam Sunder, Markets, Organizations and Accounting


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Basic Identity of Organizations

  • Organizations collect, transform, and disburse resources in various markets

  • Some markets more developed now

  • Accounting depends on how developed the markets are

  • Organizations adapt to changing markets

  • Transnational corp. dominant today

Shyam Sunder, Markets, Organizations and Accounting


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Hatfield’s Insight

  • Substitution of small partnership for the individual trader changed bookkeeping

  • Then sub-division of ownership caused separation from control

  • Investment in fixed capital

  • Business as a continuum--Paciolo

  • Hatfield (1924) classified by managerial labor and capital markets

  • We add: classification by product markets

Shyam Sunder, Markets, Organizations and Accounting


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Classification of Organizations and Accounting

  • Organizations of various sizes and design coexist

  • Various forms of accounting to serve them coexist

  • Each accounting perspective uses an organizational form as a prototype

  • Use Hatfield’s key events as boundary lines

  • 1. Separation of ownership and control

  • 2. Dispersal of shareholdings

Shyam Sunder, Markets, Organizations and Accounting


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Classification by Market for Managers

  • Owner-managed organizations use bookkeeping form of accounting

  • Traditional double entry model

  • With development of managerial labor markets, ownership and control separate

  • Then they need stewardship accounting

Shyam Sunder, Markets, Organizations and Accounting


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Bookkeeping for Proprietorships

  • Bookkeeping serves proprietorships well

  • Assists memory

  • Establishes control

  • Establishes cause and effect relationship between resource flows (Double Entry: Ijiri, 1975)

  • Most organizations, and their accounting in this category

Shyam Sunder, Markets, Organizations and Accounting


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Classical Perspective

  • Economic activity by family groups, Yamey’s farmer

  • Counting sufficient initially

  • Complex forms--repeat trades, credit, recording, Communication

  • Track resources and obligations

  • Contracting parties are customers, suppliers, few employees

  • No shareholders, auditors, or managerial hierarchy

  • Paciolo as solution for traders

Shyam Sunder, Markets, Organizations and Accounting


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Stewardship Accounting for Professional Managers

  • Two or more levels of management hierarchy

  • Must solve the agency problem

  • Use managerial accounting techniques: budgeting, performance evaluation, compensation, cost analysis, transfer pricing, and decentralization

  • Includes bookkeeping, but goes beyond

  • Separation of ownership and control

  • Two or more levels of management must deal with independent interests

Shyam Sunder, Markets, Organizations and Accounting


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Dealing with Multiple Egos

  • Accountee and the accountor

  • Temples, king’s household, merchants or lords

  • Organizations differ from individuals

  • They must deal with the actions, thoughts, information and motives of more than one person

  • No single person has all the information

  • Everybody has a local monopoly on some information

  • Stewardship accounting addresses information asymmetry and diversity of interests

Shyam Sunder, Markets, Organizations and Accounting


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Managerial Accounting Tools

  • Planning, budgeting, Divisional performance evaluation, Managerial Performance evaluation, Compensation, Decentralization, Transfer pricing, Capital budgeting, Activity-based costing

  • Builds on bookkeeping

  • Aide-memoir function needed even with single layer of management

  • Hierarchies need additional features

  • Undeveloped in Pacioli

Shyam Sunder, Markets, Organizations and Accounting


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Bookkeeping, Managerial Accounting in Contract theory

Managers’ work unobservable

  • No visible substance

  • Continuous operations

  • Complex environment

  • Manager’s contribution difficult to isolate, even after the passage of time

  • Compare the evaluation of

  • Captain of medieval trading ship

  • Manager of an auto factory

Shyam Sunder, Markets, Organizations and Accounting


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Ship Vs. Factory

  • Owner cannot observe manager’s actions in either case

  • Ship returns, goods sold, profit is known precisely

  • Captain’s contract function of profit

  • Auto plant is rarely liquidated

  • Difficult to know manager’s performance, even after years

  • How much wait for compensation

  • Managerial accounting uses budget to address this difficult problem

Shyam Sunder, Markets, Organizations and Accounting


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Role of Budgets

  • Budget is manager’s contract

  • Resources the manager is authorized to spend

  • Resources manager is expected to generate

  • Specified in terms of mutual observables

  • Financial as well as nonfinancial measures

  • Unobservable managerial effort not included

  • Stewardship accounting is the “engineering” of modern organizations

Shyam Sunder, Markets, Organizations and Accounting


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Classification by Market for Capital

  • Without market for capital, ownership is tightly held

  • Liquid capital market causes diffuse ownership

  • Difficulty of directing/monitoring professional managers

  • Gives rise to financial reporting form of accounting

Shyam Sunder, Markets, Organizations and Accounting


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Subdivision of ownership into small parts

  • Supervision of operations by small shareholders not feasible

  • Modern financial reporting designed to operate such organizations

  • In United States, the model developed in mid-nineteenth century

  • Railroads and public utilities needed large amounts of equity capital (Yamaji, 1992)

  • Publicly-held corporations,

  • A liquid stock market for trading their shares,

  • Accounting to sustain such organizations

Shyam Sunder, Markets, Organizations and Accounting


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Differences from bookkeeping and managerial accounting

  • Attention to market for capital

  • Homogenous, undifferentiated (Ijiri)

  • New Demands of Publicly-held corporation on Accounting

  • Investors are distant from operations

  • How to protect their interests

  • They put up resources up front

  • Vulnerable to nonperformance by other parties

  • Need assurance that others will make their promised contributions

Shyam Sunder, Markets, Organizations and Accounting


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Financial Reporting for Publicly-Held Firms

  • Investors pre-commit their capital, vulnerable to other’s nonperformance

  • Rely on rules and standards to defend shareholder interests

  • Rules limit managerial judgment, informativeness

  • Elimination of managerial discretion has both costs and benefits

  • Financial reporting implements contracts among strangers; bookkeeping, managerial accounting, handle acquaintances

Shyam Sunder, Markets, Organizations and Accounting


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Consequences of Market Mediation

  • Market-Mediated contracts push accounting towards rules and standards

  • Investors and analysts invest in alternative sources of information, reliance on financial reports reduced, not eliminated

  • Market price responsive to future prospect

  • Shift in emphasis from stock to flow variables

  • Market-based research made accountants sensitive to the alternative sources of information

Shyam Sunder, Markets, Organizations and Accounting


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Rules and Standards

  • U.S.:Interstate Commerce Commission

  • Federal Reserve Bank

  • New York Stock Exchange

  • Securities & Exchange Commission

  • American Institute of Certified Public Accountants

  • Financial Accounting Standards Board

  • Rules and standards limit exercise of judgment

  • Rigidity

  • Limits information managers can provide capital markets

Shyam Sunder, Markets, Organizations and Accounting


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Responsiveness to Prospects

  • Managers can try to smooth reports to prevent overreaction

  • But they can also smoothing in self-serving ways

  • Elimination of discretion is a double-edged sword

  • Managers reveal themselves by how they exercise discretion

Shyam Sunder, Markets, Organizations and Accounting


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Stock to Flow Variables

  • Shift in emphasis balance sheet income and cash flow statements

  • Markets for assets are imperfect

  • Historical book values can be poor indicators of the future earning power

  • But Projection of current earnings and cash flows into future also risky

  • Investors want to project sustainable earnings

  • Lengthy debates on isolation of non-recurring elements of income from the rest

Shyam Sunder, Markets, Organizations and Accounting


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Effects of Market Based Research

  • Sensitive to the alternative sources of information

  • With complex interaction among sources

  • Shares of most U.S. firms not traded, too small

  • Findings about large firms not generalizable

  • During for replacement of historical cost accounting during inflation

  • Market imperfections: historical cost yields more accurate estimates except under high inflation

  • Trade off: Precise values for trading vs. effectiveness of contracts

Shyam Sunder, Markets, Organizations and Accounting


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Other Consequences of Financial Reporting

  • Because of stock market, investors search for information

  • Many alternative sources of information

  • Shift in emphasis from balancesheet to income statement

  • Capital market places new demands and constraints on accounting

Shyam Sunder, Markets, Organizations and Accounting


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Financial Reporting

  • Suggestions for inflation adjustments to accounts during high inflation

  • Balancing benefits against the costs of errors in inflation accounting

  • Balancing value of accounting for security valuation versus contract enforcement

  • Most firms not publicly traded; do not use financial reporting model

Shyam Sunder, Markets, Organizations and Accounting


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Inclusiveness of Financial Accounting

  • All five functions of accounting

  • Measurement of resource inflows

  • Measurement of resource outflows

  • Reporting on contract fulfillment

  • Providing information to factor market

  • Providing common knowledge for contract renegotiation as public disclosure

  • Public disclosure is absent in bookkeeping and stewardship forms.

Shyam Sunder, Markets, Organizations and Accounting


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Classification by Markets for Products

  • Business organizations produce private goods (cars, clothes, furniture)

  • Have customers who can impose discipline on managers by withholding revenue

  • Many organizations produce public goods (security, clean air)

  • They have beneficiaries, not customers, who cannot impose discipline

Shyam Sunder, Markets, Organizations and Accounting


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Public Vs. Private Good Organizations

  • Different accounting and control systems needed for the two types of organizations

  • More power in product market causes managerial discipline to become weaker

  • Bureaucracy is a solution for such organizations

Shyam Sunder, Markets, Organizations and Accounting


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To Summarize

  • Organization as a set of contracts

  • People join alliances for gain

  • Accounting as a mechanism to help implement contracts

  • Various types of organizations depending on managerial, capital and product markets

  • Forms of accounting suited to each type of organization

Shyam Sunder, Markets, Organizations and Accounting


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Three Criteria for Classification

  • Three types of businesses:

  • Owner managed small businesses (bookkeeping)

  • Professionally managed businesses with closely-held ownership (stewardship)

  • Professionally managed businesses with diffused shareholdings (financial)

  • There are three basic accounting models

  • Stewardship model includes bookkeeping and financial reporting includes stewardship

Shyam Sunder, Markets, Organizations and Accounting


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Financial Reporting

  • The last category of organization, and the financial reporting model are a modern invention

  • All three forms of organizations, and their corresponding accounting model coexist today

  • Economic theory of organizations helps synthesize classical, stewardship, and market perspectives on accounting in a harmonious relationship with one another

Shyam Sunder, Markets, Organizations and Accounting


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Thank You

  • The paper and the slides will be available at my web page:

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

  • or email to shyam.sunder@yale.edu

Shyam Sunder, Markets, Organizations and Accounting


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