Markets, Organizations and Accounting - PowerPoint PPT Presentation

Markets, Organizations and Accounting

Shyam Sunder

Yale University

• 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

• 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

• 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

• 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

• 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

• 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

• 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 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

• 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

• 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

• 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

• 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

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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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

• 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 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

• 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

• 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