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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

Markets, Organizations and Accounting

Shyam Sunder

Yale University

contract view of organizations
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

synthesis
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

common perspective
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

basic identity of organizations
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

hatfield s insight
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

classification of organizations and accounting
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

classification by market for managers
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

bookkeeping for proprietorships
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

classical perspective
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

stewardship accounting for professional managers
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

dealing with multiple egos
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

managerial accounting tools
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

bookkeeping managerial accounting in contract theory
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

ship vs factory
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

role of budgets
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

classification by market for capital
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

subdivision of ownership into small parts
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

differences from bookkeeping and managerial accounting
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

financial reporting for publicly held firms
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

consequences of market mediation
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

rules and standards
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

responsiveness to prospects
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

stock to flow variables
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

effects of market based research
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

other consequences of financial reporting
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

financial reporting
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

inclusiveness of financial accounting
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

classification by markets for products
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

public vs private good organizations
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

to summarize
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

three criteria for classification
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

financial reporting33
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

thank you
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