Markets, Organizations and Accounting

1. Markets, Organizations and Accounting Shyam Sunder Yale University

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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