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					Markets, Organizations and
        Shyam Sunder
        Yale University
  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

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               Organizations and Accounting
• Pick three broad themes
•    Classical
•    Stewardship
•    Market-based
• Differences in the Assumptions
• Differences in the Range of Phenomena
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               Organizations and Accounting
              Common Perspective
• Accounting as a solution
• Same Fundamental Problem in
•    kingdom
•          temple
•          medieval manor
•          farm
•          family-run grocery store
•          textile mill
•          bank
•          multinational corporation
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                         Organizations and Accounting
   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
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               Organizations and Accounting
             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
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                   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

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                  Organizations and Accounting
       Classification by Market for
• 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

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                Organizations and Accounting
 Bookkeeping for Proprietorships
• Bookkeeping serves proprietorships well
• Assists memory
• Establishes control
• Establishes cause and effect relationship
  between resource flows (Double Entry: Ijiri,
• Most organizations, and their accounting in
  this category
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                Organizations and Accounting
          Classical Perspective
• Economic activity by family groups, Yamey’s
• Counting sufficient initially
• Complex forms--repeat trades, credit, recording,
• Track resources and obligations
• Contracting parties are customers, suppliers, few
• No shareholders, auditors, or managerial hierarchy
• Paciolo as solution for traders
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                   Organizations and Accounting
           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
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                   Organizations and Accounting
    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
• Stewardship accounting addresses information
     asymmetry and diversity of interests
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                   Organizations and Accounting
     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

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                  Organizations and Accounting
     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
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                   Organizations and Accounting
             Ship Vs. Factory
• Owner cannot observe manager’s actions in either
• 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,
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                   Organizations and Accounting
               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
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                    Organizations and Accounting
       Classification by Market for
• Without market for capital, ownership is
  tightly held
• Liquid capital market causes diffuse
• Difficulty of directing/monitoring
  professional managers
• Gives rise to financial reporting form of
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                Organizations and Accounting
    Subdivision of ownership into small
• Supervision of operations by small shareholders not
• Modern financial reporting designed to operate such
• In United States, the model developed in mid-nineteenth
• 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
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                          Organizations and Accounting
  Differences from bookkeeping
   and managerial accounting
• Attention to market for capital
• Homogenous, undifferentiated (Ijiri)
• New Demands of Publicly-held corporation on
• 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 Markets,
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                  Organizations and Accounting
Financial Reporting for Publicly-
           Held Firms
• Investors pre-commit their capital, vulnerable to
  other’s nonperformance
• Rely on rules and standards to defend shareholder
• 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
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                  Organizations and Accounting
           Consequences of Market
• 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

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                   Organizations and Accounting
             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

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                      Organizations and Accounting
       Responsiveness to Prospects
• Managers can try to smooth reports to
  prevent overreaction
• But they can also smoothing in self-serving
• Elimination of discretion is a double-edged
• Managers reveal themselves by how they
  exercise discretion
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                Organizations and Accounting
           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
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                  Organizations and Accounting
        Effects of Market Based
•    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 Markets,
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                    Organizations and Accounting
 Other Consequences of Financial
• 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

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                Organizations and Accounting
           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
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                Organizations and Accounting
           Inclusiveness of Financial
• 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.
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                   Organizations and Accounting
      Classification by Markets for
• 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
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               Organizations and Accounting
           Public Vs. Private Good
• 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

7/7/2010           Shyam Sunder, Markets,       30
                 Organizations and Accounting
            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
7/7/2010          Shyam Sunder, Markets,       31
                Organizations and Accounting
  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
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                  Organizations and Accounting
           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

7/7/2010             Shyam Sunder, Markets,         33
                   Organizations and Accounting
                     Thank You
• The paper and the slides will be available at
  my web page:
• or email to

7/7/2010                Shyam Sunder, Markets,                34
                      Organizations and Accounting

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