Theory of Accounting and Control

1. Theory of Accounting and Control Shyam Sunder, Yale University Kozminski University, Warsaw, Poland May 16, 2009

2. ACCOUNTING AND CONTROL IN ORGANIZATIONS: A CONTRACT THEORY PART I: CONTRACT THEORY OF THE FIRM CHAPTER 1: INTRODUCTION CHAPTER 2: ACCOUNTING AND CONTRACT MODEL OF THE FIRM PART II: MICROTHEORY OF ACCOUNTING AND CONTROL CHAPTER 3: CONTRACTING FOR MANAGERIAL SKILLS CHAPTER 4: MANAGERS AND ACCOUNTING DECISIONS CHAPTER 5: INCOME AND ITS MANAGEMENT CHAPTER 6: INVESTORS AND ACCOUNTING CHAPTER 7: ACCOUNTING AND THE STOCK MARKET CHAPTER 8: AUDITORS AND THE FIRM PART III: MACROTHEORY OF ACCOUNTING AND CONTROL CHAPTER 9: CONVENTIONS AND CLASSIFICATION CHAPTER 10: DECISION CRITERIA AND MECHANISMS CHAPTER 11: STANDARDIZATION OF ACCOUNTING CHAPTER 12: GOVERNMENT, LAW AND ACCOUNTING CHAPTER 13: ACCOUNTING FOR PUBLIC GOOD ORGANIZATIONS

3. ACCOUNTING AND CONTROL IN ORGANIZATIONS: A CONTRACT THEORY Part I: CONTRACT THEORY OF THE FIRM Chapter 1: Introduction THREE BASIC IDEAS • Organizations as a Set of Contracts • Shared Facts for Conflict Resolution g • Control in Organizations as Balance and Equilibrium MICROTHEORY OF ACCOUNTING AND CONTROL • Functions of Accounting and Control • Managers and Income • Shareholders, Stock Markets, and Auditors MACROTHEORY OF ACCOUNTING AND CONTROL • Basic Features of Accounting • Social Choice Criteria, Mechanisms, and Standardization • Government and Public-Good Organizations Chapter 1 References

4. Chapter 2: Accounting and the Contract Model of the Firm • THE FIRM AS A SET OF CONTRACTS • ACCOUNTING AND THE FIRM • Measuring Contributions • Measuring Entitlements • Distribution of Information about Contract Fulfillment • Liquidity of Markets for Contractual Slots • Common Knowledge for Renegotiation of Contracts • CORRESPONDENCE BETWEEN ORGANIZATIONAL AND ACCOUNTING FORMS • Bookkeeping • Managerial Accounting • Financial Reporting • Chapter 2 References

5. Part II: MICROTHEORY OF ACCOUNTING AND CONTROL Chapter 3: Contracting for Managerial Skills CHARACTERISTICS OF MANAGERS • Human Capital • Measuring Managerial Contribution • Contact with Other Agents FORMS OF CONTRACTS FOR MANAGERS • Manager’s Preferences • Contracts of Top, Middle, and Lower Level Managers Chapter 3 References

6. Chapter 4: Managers and Accounting Decisions HIERARCHY OF ACCOUNTING DECISIONS • Discretionary Decisions on Expensing-Capitalization of Costs • Accounting Estimates • Accounting Principles • Disclosure Policy • Internal Controls • Accounting Standards CERTAIN FEATURES OF CONTROL SYSTEMS • Cost of Accounting • Transfer Pricing • Cost Allocations • Participative Budgeting • Standards and Variance Analysis MANAGERIAL CONSEQUENCES OF ACCOUNTING DECISIONS • The LIFO Puzzle • Accounting for Leases • The Restructuring of Troubled Loans • Cost of Exploration, Research and Development • Recognizing Option Value as Compensation Expense • Rationality of Apparently Irrational Decisions OBSERVABLE BEHAVIOR OF MANAGERS • Preference for Status Quo • Income Management • Prediction of Accounting Methods by Firm Characteristics Chapter 4 References

7. Chapter 5: Income and its Management INTRODUCTION TO INCOME FUNCTIONS OF INCOME IN A FIRM • Assessing Viability of the Firm • Managerial Evaluation and Contract Renegotiation ATTITUDES OF AGENTS TOWARD INCOME • Shareholders • Managers • Determination of Entitlements MANAGEMENT OF INCOME • Statistical Measures of Smoothness • Income Processes: Smoothness vs. Smoothing • Income-Smoothing vs. the “Big Bath” Hypotheses • Instruments of Income Management • Summary of Empirical Findings Chapter 5 References

8. Chapter 6: Investors and Accounting DESCRIPTION OF THE INVESTOR CLASS • The Lack of Active Participation • Transferability of Contract • Heterogeneity of Preferences • Information and Speed of Price Adjustments • Information Intermediaries • Creditors INVESTOR ATTITUDES AND PREFERENCES • Reporting on Contract Performance • Incentives to Managers • Aggregation Adds Information ACCOUNTING CHOICE MECHANISMS FOR INVESTORS • Organization of the Firm • Trading in Capital Markets • Voting and Proxies • Sociopolitical Institutions CONSEQUENCES OF ACCOUNTING POLICY FOR INVESTORS • Accounting Information as Public Goods • Production of Information By Intermediaries Chapter 6 References

9. Chapter 7: Accounting and the Stock Market INTRODUCTION • Limited Role for Valuation Rules • Role of Information Intermediaries QUESTIONS ABOUT ACCOUNTING AND THE STOCK MARKET • Money from Accounting Numbers • Money from Advance Access to Accounting Numbers • Effect of Accounting Methods on the Stock Market • Effect of the Stock Market on Accounting • Accounting Without the Stock Market • The Stock Market Without Accounting PROBLEMS OF INFERENCE • The Needle in a Haystack Problem • The Expectations Problem • The Self‑Selection Problem Chapter 7 References

10. Chapter 8: Auditors and the Firm INTRODUCTION THE FUNCTION OF AUDIT IN THE FIRM AUDITOR DECISIONS • Allocation of Resources in an Audit Assignment • Audit Opinion • Pricing of Services and Bidding for Clients • Audit Policies, Training, Quality Control, and Self Regulation • Technology of Audit Institutional Structure of the Audit Profession • Development of Audit Standards • Development of Accounting Standards • Who Sets the Standards? • Auditors’ Responsibility for Detection of Fraud • Competition, Entry, Discipline Chapter 8 References

11. Part III: MACROTHEORY OF ACCOUNTING AND CONTROL Chapter 9: Conventions and Classification CONVENTIONS • ACCOUNTING CONVENTIONS ECONOMIC FEATURES OF ACCOUNTING • Entity • Going Concern or Continuity • Period • Valuation • Accrual TEMPORAL STABILITY OF ECONOMIC FEATURES • Double Entry • Economic Resources UNIFORMITY AND CLASSIFICATION Chapter 9 References

12. Chapter 10: Decision Criteria and Mechanisms CRITERIA FOR SOCIAL CHOICE • Technological Efficiency • Simple Economic Efficiency • Multi-Person Economic Efficiency • Multi-period Problem • Uncertainty Problem SOCIAL COST‑BENEFIT ANALYSIS • Which costs and which benefits? • Problems of partial analysis • Nonlinear utilities • Measures of Efficiency MECHANISMS FOR SOCIAL CHOICE • Limitations of Voting Mechanisms • Market Mechanisms in Accounting Standards • Legal Rights and Markets Chapter 10 References

13. RULES AND ECONOMIC DECISIONS Rules as Constraints Rules as Payoff Functions Voluntary and Mandatory Behavior ECONOMICS OF RULES AND STANDARDS Benefits Costs Distribution and Equity Adjustment to New Standards ECONOMIC THEORIES OF STANDARDS Monopoly and Limiting Competition Provision of Public Good ACCOUNTING STANDARDS Types of Standards Enforceability of Standards Market Argument Argument for Market Failure A Synthesis INSTITUTIONS FOR SETTING ACCOUNTING STANDARDS Models of Social Institutions Force of Standards Capture of Institutions EFFECTS OF STANDARDS On Accounting Systems On Accounting Education On the Auditing Profession Chapter 11 References Chapter 11: Standardization of Accounting

14. Chapter 12: Government, Law, and Accounting GOVERNMENT AS A CONTRACTING AGENT • Government as Tax Collector • Government as Customer GOVERNMENT AS A SUPER-FIRM • Charter of Firms • Sale of Securities • Certification, Licensing, and Discipline of Auditors Chapter 12 References

15. Chapter 13: Accounting for Public Good Organizations NOMENCLATURE AND CLASSIFICATION ECONOMIC CHARACTERISTICS OF NRIOs • Markets for Resources • Agents CHARACTERISTICS OF ACCOUNTING IN PUBLIC GOOD ORGANIZATIONS • Entities and Funds • Government Funds • Proprietary Funds • Fiduciary Funds • Consolidation and Detail • Recognition and Accrual • Fixed Assets, Depreciation and Long Term Liabilities • Budgets, Appropriations, and Encumbrances INTERACTION BETWEEN ACCOUNTING FOR NRIOs AND ARIOs Chapter 13 References

16. CHAPTER 1 SHARED FACTS FOR CONFLICT RESOLUTION Disputes, waste of resources Role of evidence (shared info) Common knowledge • Theoretical abstraction • Practical Approximation Games of imperfect, incomplete information Firm as a game of incomplete information Role of public disclosure CONTROL IN ORGANIZATION Conflict and cooperation Bargaining example Balance & Equilibrium Contrast from control OF organizations

17. CHAPTER 3 CHARACTERISTIC OF MANAGERS • Wealth as human capital • Contribution hard to measure • Procedural centrality HUMAN CAPITAL • Stock of human capital is inalienable • Long term contracts are on flow, which are not enforceable • Contracts must be self-enforcing • Human capital used at work but not used up (actually it is accumulated at work) • Compensation: current + accretion of human capital(Accounting is important for both) • Short run supply of managerial human capital is inelastic • Opportunity to extract rents • Vulnerable to expropriation • Managers cannot sell their job slots • Managerial market transactions rely on reputation • accounting permanence data • Managers have an un-diversified portfolio of personal wealth which is sensitive to small changes in current performance • Performance data extrapolated by investors/superiors • Performance smoothing by managers

18. MEASURING MANAGERIAL CONTRIBUTIONS • Not directly measurable • More difficult at higher levels • Difficulty in designing their contacts PROCEDURAL CENTRALITY: CONTACT WITH OTHER AGENTS • Procedural centrality of managers • Managing contracts • Surprises: nature, unanticipated behavior of others • Privileged access to info about other contracts • Info asymmetry in favor of managers • Problems of adverse selection • they know what others don’t Moral hazard • others do not know what they did Could sell info to competitors for personal gain Prohibition on sharing services of managers across competitors

19. Enforcement difficult because of Nature of work human capital involvement in contracts of others Legal system could help if shared information is available HOW DO WE MAKE IT SELF-ENFORCING? FLAT SALARY: IN PUBLIC GOOD ORGANIZATIONS EVEN OUTPUT IS DIFFICULT TO MEASURE POOR MOTIVATIONAL TOOL PERFORMANCE CONTINGENT CONTRACTS NO SINGLE MEASURE IS PERFECT FACTORS OUTSIDE MAN. CONTROL SUBJECT TO MAN. MANIPULATION CONDITIONS FOR JOB LOSS LEFT UNSPECIFIED RIGHT TO UNILATERAL TERMINATION WITHOUT CAUSE ROLE OF ACCOUNTING IN MANAGERIAL CONTRACTS MANAGERS’ PREFERENCES PECUNIARY VARIABLES NONPECUNIARY VARIABLES (FUTURE COMP.) SALARY IS ABOUT HALF OF TOTAL FOR CEOS BENEFITS DRIVEN BY TAX LAW, TRANS. COSTS, SIGNALING INTERACTION BETWEEN PECUNIARY AND OTHERS FORMS OF CONTRACTS FOR MANAGERS

20. Accounting and control includes Basic data collection Performance reports Financial reports Choice of organizational form includes the choice of accounting and control Managers directly in charge of accounting and control Other agents participate less directly Reacting and “voting with their feet” Managers must anticipate and consider such reactions Managers also participate in shaping accounting regimes Consider the range of managerial accounting decisions Review some features of accounting from contract perspective Consequences of accounting decisions for managers Consequences for observable managerial behavior Hierarchy of Accounting Decisions By frequency of decisions Expensing-Capitalization decisions Managerial unique access to causes and consequences Create facts by classification Discretion unavoidable, no perfectly mechanical solution for classification is possible Demarcation of capital improvements, repairs, overhauls, rebuilding, salvaging and maintenance Managers can choose timing of transactions Law of conservation of income Performance measures and contractual consequences Short-term contracts induce capitalization Countervailing factors: smoothing, longer term compensation plans, and auditing Accounting estimates Bad debt allowance, warranty costs, NRV of byproducts, salvage values and economic life Varying degrees of flexibility Same motivations as the expensing decisions Chapter 4Managers and Accounting Decisions

21. Accounting Principles Short term consequences for compensation Longer term consequences and constraints Image and signal Auditing Disclosure Policy Compliance with the law and disclosure beyond the required level Better information for participating/other agents Temptation to disclose selectively Trade off between credibility and cost of verification Effect on liquidity of factor markets Consequences of performance forecasts by managers Competitors and investor diversification (Competing against privately held firms) Disclosure to limit opportunism of managers Is less disclosure necessarily good for managers? Is more disclosure necessarily good for shareholders? Internal Controls Broad managerial discretion Foreign Corrupt Practices Act 1977 requirements Sarbanes-Oxley 2002 requirements Cost Accounting Standards Board for government vendors Manager is a principal as well as an agent in different contractual relationships within the firm Consistency of internal controls helps balance motives Ideal: self-enforcing contract for control Accounting Standards SEC, FASB, IASB make rules Managers often participate on behalf of the firm Can we distinguish managerial and firm interests? Bank loan restructuring example Reflexivity of accounting: does it only represent reality or does it also create reality? What should be role of firms/managers in setting standards?

22. Transfer Pricing Standard textbook solution discards the problem Essence of decentralization: trade-off between benefits and costs Benefits of central coordination Informational disadvantage of the center Heart of organizational design problem Cost Allocation Declared a dead issue many times, but not dead yet Does allocation of sunk costs to divisions make sense Ex post efficiency of resource utilization versus ex ante efficiency of resource acquisition decisions Participating Budgeting Empowerment vs. dispersed information argument Hayek: Information is dispersed in the economy Trade-off: better decisions based on more information Worse decisions shaded by information agents choose to share Management consulting fads wax and wane People bring their own expectations, no blank slate Standards and Variance Analysis Budgets and standards imply a discontinuity in managerial reward functions Anticipation by agents Complex non-linear dynamics Managerial Consequences of Accounting Decisions The LIFO Puzzle Accounting for Leases Restructuring of Troubled Loans Cost of Exploration, Research and Development Recognizing Option Value as a Compensation Expense Rationality of apparently irrational decisions? Observable Behavior of Managers Preference for status quo Income management Prediction of accounting methods by firm characteristics Certain Features of Control Systems Cost-benefit analysis of accounting and control systems

23. Firm as a source of “income” for all participants Wage income Personal service income Interest income Land rent Sales income, etc. Each agent looks at own return from the contributions Shareholder income—a narrower perspective What is special about shareholder income Residual nature Defined independently of others’ income The Degree of freedom problem—n pieces of a pie Timing of transfer of income to claimants: delay for shareholders’ Other agents get their share on predefined schedule Dividend is discretionary Diffuse of body of shareholders cannot enforce contracts on timing of transfer of income Taxation makes it difficult to automatically transfer income Income to equity cannot be measured precisely and in a timely manner No “ship accounting,” no periodic liquidation of assets, continued long term asset investments with imperfect and incomplete markets Indeterminacy of valuation, combined with the control of management over valuationopportunity for income management Difficulty of measuring managerial inputlinking compensation to output/income  use of managerial discretion for self-serving purposes Shareholders rely on information in possession of the mangers but cannot be sure that management will use this information only for shareholders’ benefit Independent audits to put constraints Imperfections of monetary representation of income vs. real income Chapter 5Income and Its Management

24. Functions of Income in the Firm Assessing viability Everybody makes projections to the future Managerial evaluation and contract renegotiation Law of Conservation of IncomeLaw of Conservation of Discounted Residual Income • Determination of Entitlements • Management of Income • Statistical measures of smoothness • Smoothing = smoothness? • Income smoothing and big baths • Instruments of income smoothing • Incentives for covering the tracks • Attitudes of Agents towards Income • Shareholders: money income as an estimate of real income • Would like to get the first best estimate • Fundamental model of valuation—relevance? • Managers: Use of accounting to advance their own welfare (job security, level, compensation, firm size all linked to corporate income), risk: dislike abrupt changes in income • Employment horizons shorter than firm horizon • Look at income management from the point of view of managers (bonus, options, could be terminated before the fruits of labor appear in the financial statements) • Managers’ expectations of what the shareholders would do • Manager cannot iron out the kinks in the income streams (no retrospective adjustments) • Limits on choice of accounting methods • Not certain about the consequences of choices they make • How do you “smooth” a random walk series?

25. WHAT IS SPECIAL PRECOMMITMENT TIME DELAY RESIDUAL CLAIM ONLY MEASUREMENT AND CONT. FULFILLMENT CRUCIAL DESCRIPTION LITTLE PARTICIPATION ON PURPOSE, DESIRABLE, DIVERSIFICATION ROE ON OWNER MANAGED FIRMS SAME TRANSFERABILITY MINIMAL COST, RAPID PRICE ADJUSTMENT SYMMETRY OF INFO (PUBLIC DISCL.) CONTRAST PRIVATELY HELD FIRMS COST OF TAKING THEM PRIVATE PREFERENCE HETEROGENEITY LIQUID MARKET GIVES A UNIQUE MEASURE PRICE ADJUSTMENTS TO INFORMATION DETERMINE DISTRIBUTION OF WEALTH EQUITABLE RELEASE OF INFORMATION INFORMATION INTERMEDIARIES DEMAND FOR INFORMATION COST OF INFORMATION DIVERSIFICATION BY INDIVIDUAL INFORMATION INTERMEDIARIES PROBLEM OF EVAL. PORTFOLIO MAN. DO NOT ASK FOR DISCL. ANALYSTS DEMAND DISCLOSURE, DETAIL CREDITORS NONPERMANENT COMMITMENT SHORT TERM CREDITORS SECURED CREDITORS UNSECURED LONG TERM CREDITORS LARGE CREDITORS-LITTLE INTEREST DESIGN OF DEBT COVENANTS--GAAP WHY RELIANCE ON GAAP AUDIT COST INTERDEPENDENCE OF FIRM CONTRACTS SPECIAL GAAP FOR EVERY AGENT CHAPTER 6INVESTORS AND ACCOUNTING

26. INVESTOR ATTITUDES AND PREFERENCES REPORTING ON CONTRACT PERFORMANCE IMPORTANCE OF CONTRACT FULFILLMENT CONTROLS AND REDUNDANCY SYMMETRY OF INFO DISTRIBUTION INCENTIVES TO MANAGERS TOP MANAGER CONTRACTS LIMITS ON RELEVANCE AND RELIABILITY RRA IN OIL INDUSTRY AGGREGATION ADDS INFO INFORMATION IN AGGR. FUNCTION ACCOUNTING CHOICE MECHANISM ORGANIZATION OF THE FIRM NATURE OF CHARTER GOING PUBLIC TRADING IN CAPITAL MARKETS DIVIDENDS AND VALUATION ANALOGY OF BUYERS AND CARS REACTIONARY MODE MANAGERS ANTICIPATE INVESTOR PREF. VOTING AND PROXIES NOT AN EFFECTIVE INSTRUMENT FOR INV. SOCIO-POLITICAL INSTITUTIONS LEGISLATURE, REGULATORY BODIES CHANGES IN REGIME CONSEQUENCES OF ACCOUNTING POLICY FOR INV. ACCG. INFORMATION AS PUBLIC GOOD UNDER PRODUCTION? COMMON COST OF CONTRACTS SPECIAL VULNERABILITY OF INVESTORS NOT IN DIRECT TOUCH WITH OPERATIONS FREE DIST. OF INFO--DYNAMIC STABILITY ADVERTISING ANALOGY PRODUCTION BY INTERMEDIARIES WHO PAYS, WHO BENEFITS EARLY EFFICIENT MARKET EUPHORIA ECONOMICS OF INFORMATION MARKET CRITICISM OF DETAILS FOR ANALYSTS OPEN ENTRY TO ANALYST MARKET

27. Accounting interface with shareholders Contributions: cash or real, made in advance Entitlements: real capital on basis of accounting records, converted to money in financial reports through valuation rules Reports of contract fulfillment: unnecessary Liquidity: verified reports to potential investors Public disclosure: to reduce information asymmetry Limited role for valuation rules Entitles to real capital, not money Imperfection of valuation rules, vulnerability to manipulation Only function (4) affected by valuation rules Role of information intermediaries Primary, secondary and tertiary markets: firm involved in P Derived demand in P market, bankers’ compensation Reputation of banker as protection against collusion (effectiveness??) Change of auditors, insurance Money from Public Accounting Numbers Discovery and use of information Competition in the market for information Trade off between the speed of dissemination and depth of markets Prospecting for gold Academic studies vs. practical implementation of money making Impossibility of informationally efficient markets Chapter 7: Accounting and the Stock Market

28. Money from Advance Access to Accounting Numbers We would like to have direct evidence about the money that can be made from advance access Insider trading studies Ball & Brown (event studies) don’t quite do it Effect of Accounting Numbers on Stock Market Investor expectations  stock prices Accounting data  investor expectations Difficulty of doing studies on formation of investor expectations (not from field data) Role of accounting in preserving the resources of the firm (control) Role of accounting in managerial/employee motivation Linking investor and employee behavior into an equilibrium Managerial selection Effect of the Stock Market on Accounting Not much research on the topic Beginning of efforts to standardize accounting after creation of the SEC Reynolds example Managerial concerns about stock market reaction (LIFO) Accounting without Stock Market Choice of going public Stock Market without Accounting Think about the question before the next value relevance study Accounting a must for mutual observables to contract on Stock market would be impossible without accounting Problems of Inference Needle in the Haystack Problem The Expectations Problem The Self-selection Problem

29. Chapter 8: Auditors and the Firm Functions of the Audit in the Firm Auditor Decisions • Allocation of resources in an audit assignment • Audit Opinions • Pricing audit services and bidding for clients • Audit policies, training, quality control, and self-regulation Institutional Structure of the Audit Profession • Development of Audit Standards • Development of Accounting Standards • Who Sets the Standards? • Auditors’ Responsibility for Detection of Fraud • Competition, Entry and Discipline

30. Examination of the traditional terms of accounting in terms of contract theory of the firm Link them to familiar social science concepts Features of accounting as economic choice of convention Temporal stability does not mean convention Distinction is important for setting accounting standards Rules as systems of classification Importance of the nature of classification for standard setting Conventions A coordinating device in a game Games in which coordination can yield Pareto superior outcomes but communication is difficult or impossible Applied to recurrent situations Must be common knowledge It is in the interest of everyone that one more person will conform to the convention Existence of an alternative which is just as good Driving on the right or left Debits on the right or left Balance sheet in order of decreasing or increasing liquidity In accounting literature a lot of confusion and confusing definitions of conventions (Gilman, Kohler’s Dictionary) Stake in maintaining the status quo Differentiated from economic choices Economic Features of Accounting Features which are not conventions Will changing the feature affect any agent? Conservatism Entity Going concern: use and disposal values Period Valuation Accrual Accrual Temporal Stability Double Entry Causal and classificational interpretations Economic resources Uniformity and classification Chapter 9: Conventions and Classification

31. Chapter 10. Decision Criteria and Mechanisms Criteria for social choice • Technical efficiency • Simple economic efficiency • Multiperson economic efficiency • Multiperiod problem • Uncertainty problem Social cost benefit analysis • Which costs, which benefits? • Problem of partial analysis • Nonlinear utilities • Measures of efficiency Mechanisms for Social Choice • Market or Political/Administrative • Limitations of voting mechanisms • Market mechanisms for accounting standards • Legal rights and markets

32. Outline of Current Research In Accounting Contract Model of the Firm • A Useful Framework for Organizing Accounting Research Micro-Level Research • Research on Decisions of Various Participants • Research on Effects on Various Participants Macro-Level Research • Research on characteristics of the system • Research on alternative designs of the system Survey the research work being carried out in each category • What are interesting questions in each category? • What have we learned so far? • What questions remain open? • (Use of Table of Contents of the Sunder book manuscript)

33. Functions of accounting and control Chapter 5: Managers and income • Difficulty of measurement • Link compensation to output • Choice of accounting methods • Income: role in organization multiple management Share holders, stock market & auditors • Basic features: conventions, economic features • Social choice mechanism &criteria • Standards • Government & law • Accounting for public good organization