Management Controls, Expectations, Common Knowledge, and Culture

1. Management Controls, Expectations, Common Knowledge, and Culture Shyam Sunder Yale University Plenary Address, American Accounting Association Management Accounting Conference, Austin TX, January 11-12, 2002

2. Control in Organizations • Share some ideas on control in organizations • Can think of control as expectational equilibrium • That it, correspondence between what people choose to do, and what others expect them to do • This perspective is useful accounting, and management • Perspective includes a review of perspectives on • Organizations, • Expectations, • Common knowledge, and • Culture; • Disruption and threats to control • Strategic management: what top managers do to maintain control Management Controls

3. Contract View of Organizations • Work of Barnard, Simon, Cyert and March, Cooper, beginning in the 1930s (“Carnegie School”) • Useful to think about organizations as a set of contracts or alliance among people • Simple, powerful synthesis of economic and organization theories • Can sustain a robust theory of accounting and control (Sunder 1997) • If organization is a set of contracts, • Accounting is the operating mechanism to make the contracts work Management Controls

4. Contracts • Participating agents promise to deliver resources • In exchange for promise of inducements • Agents enter contracts if they expect to get more than the opportunity cost of their contributions • To succeed, an organization must have a production function to simultaneously satisfy all contracts • Otherwise dissatisfied agents abandon the alliance • Organization collapses unless an alternative set of contracts that satisfied the condition is assembled Management Controls

5. Economic Agents • Has personal goals • Actions are consistent with his preferences • From his opportunity set, chooses preferred actions • Consistency of actions is the key characteristic • Difficult to model in social sciences without a minimal level of behavioral consistency Management Controls

6. Examples of Contracts • Contract is a mutual expectation or understanding among agents • Lunch date • This conference • Promising a delivery schedule to customer • Explicit of implicit promise of relevant action • Legal enforceability or written form not necessary • Social conventions play an important role Management Controls

7. Players and the Game • Individuals have goals; they are the players • Organization is the game in which individuals play to seek their own goals • Perspective is applicable to a broad range of organizations—business, government, society, academia Management Controls

8. Business Organizations • For present discussion, consider business organizations • Consider them as an alliance among contributors of • Capital (shareholders, creditors) • Labor (employees, managers) • Factors (vendors) • Cash (customers) • Public services (government) • Community (support) • Each party gets resources in exchange Management Controls

9. Firm as a Set of Contracts Management Controls

10. Accounting in Organizations • Operating mechanism for contracts • Necessary to assemble, implement, enforce, modify and maintain the contract set • Five functions • Measure resource contributions from agents • Monitor resource outflows to agents • Relate inflow and outflow for each agent • Maintain liquidity of factor markets • Common knowledge to facilitate contract renegotiation Management Controls

11. Measuring Contributions • Receivables and cashier • Receiving dock for supplies • Punch clock and quality control Management Controls

12. Measuring Outflows • Payroll accounts • Tax accounts • Cashier • Shipping Management Controls

13. Contract Fulfillment • Matching resource inflows and outflows to contracts • Performance evaluation • Adjusting contracts to resource realizations Management Controls

14. Maintaining Liquidity of Factor Markets • Individuals agents come and go • Finding replacements for departing agents in appropriate factor markets • Convincing new people to participate • Advertising motive in all factor markets Management Controls

15. Facilitating Contract Renegotiation Through Common Knowledge • Most contracts are finite term contracts • Motive to bluff at the time of renegotiation • Ex ante agreement to share some information as common knowledge • Common knowledge cannot be used to bluff others • Reduces dead weight losses to society Management Controls

16. A Taxonomy of Organizations and Accounting By Markets • Organization operate in a variety of markets • Markets vary by the degree of development, frictions, information conditions, competition, and characteristics of resources • Organizations vary by the markets they operate in • Accounting, like electrical system of a building, varies by the nature of organization • We can classify organizations and their accounting on the basis of market characteristics Management Controls

17. Classification by Markets • Market for managers (Hatfield, 1924)) • Market for capital (Hatfield, 1924) • Market for product (Sunder, 1999) Management Controls

18. Without Market for Managers • Owners must manage themselves • Classical double entry bookkeeping model for was developed for proprietorships, traders • Accounting differentiated from counting through cause-effect links (Ijiri, 1975) • Powerful instrument of control over resource flows • Classical bookkeeping serves the simple organizations (largest number of firms in this class) Management Controls

19. With Markets for Managers • With liquid market for managerial services, professional managers enter organizations • Two or more levels of management (hierarchy), multiple decision makers, divergent interests • Stewardship accounting developed to handle these problems (budgeting, planning, divisional performance, compensation, decentralization, transfer pricing, etc., absent in Paciolo) • Hierarchical organizations, professional managers, managerial accounting, business school training Management Controls

20. Without Markets for Capital • Single owner, friends, family supply all capital • They can directly manage the firm, or give effective direction to hired managers • Privately owned firms Management Controls

21. With Markets for Capital • Number of sources of capital multiplies • Large number of shareholders cannot directly give effective direction to hired managers • Financial reporting model of accounting developed in response to markets for capital • Publicly held corporations place new demands on accounting • Investors are far-removed from operations • Use rigid rules to protect their interests from managers they hardly know • Want more informative reports but get less as they eliminate managerial discretion Management Controls

22. In Active Capital Markets • Multiple competing sources of information • Markets can react very fast to information • Use of reserves to smooth out reported performance becomes more difficult • Shift from stock to flow variables in reports • Development of “pro forma” or “good” earnings • Accountants have become more aware of the economics of competing sources of information • Trade-offs between information (e.g. inflation accounting) and contract enforcement Management Controls

23. Classification by Product Markets • Private good producing organizations (cars, furniture) can be denied revenue by their customers • Shareholders delegate production decisions to hired managers motivated by residual based contracts • Driven by developed product markets Management Controls

24. Without Product Markets • Public good producing organizations have beneficiaries, not customers, who cannot discipline managers by denying them revenue • Managers cannot be delegated production/output decisions, cannot be motivated by residual-based contracts • Bureaucratic organizations, accounting • Generally, extend of development of various markets determines the design of organization and their accounting Management Controls

25. Expectations • Thinking, anticipating a future event or object (e.g., salary at the end of the month) • Tinged with hope toward our preferences • First moment of a probability distribution which is • Objective (e.g., value of a lottery ticket) • Subjective (e.g., value of a lottery ticket) • Two of these three meanings are subjective • Will coincide only by chance Management Controls

26. Human Expectation Formation • Complex • Not well understood • Risk of flying versus driving! • Contracts defined as expectations of resource flows • Customer expectations from cars • Employee expectations from job • Investor expectations of returns Management Controls

27. Mutuality of Expectations • Expectations are rarely taken as a given • Every action creates/influences expectations • Firm must manage them (problem of participative budgeting) • With unfilled expectations, people turn away • With overfilled expectations, set up for disappointment later • Management gurus preach maximization—of profits, growth, quality, EPS, stock prices, etc., instead of setting a target and sticking to it • Pursuit of moving targets (Enron expected 91 percent growth rate in free cash flows for next 6 years) Management Controls

28. Common Knowledge • Technical term in philosophy, statistics, game theory and economics • Denotes knowledge that includes knowledge about what others know • Aumann (1976): Two people 1 and 2 are said to have common knowledge of an event E if • both know it, • 1 knows that 2 knows it, • 2 knows that 1 knows it, • 1 knows that 2 knows that 1 knows it, • and so on... Management Controls

29. Emperor Has No Clothes Management Controls

30. Management Controls

31. Stock Market • Stock Market is like a newspaper beauty contest • John Maynard Keynes, (1936) Management Controls

32. Newspaper Beauty Contest Which Face is the prettiest? Management Controls

33. Which face will they judge to be the prettiest? Management Controls

34. Which face will they judge to be the prettiest? Management Controls

35. LIFO Inventory Accounting • If your inventory prices rise, and end-of-year inventory volume is stable or rising • You can delay paying taxes (higher net present value of cash flows) • But have to report lower income also • Many firms don’t adopt LIFO • Apprehension about stock market reaction (no empirical support) Management Controls

36. Beliefs About Others’ Beliefs • Common elements to the three stories about the emperor‘s clothes, stock market and LIFO • Central role of what we believe about others, and about their beliefs Management Controls

37. Emperor’s Clothes • The scoundrels made people believe that the clothes will be invisible only to the incompetent and the stupid • People thought that others believed it • Nobody wants to be seen as stupid or incompetent by others, lose his/her job • Visibility of clothes was private, it was easy to fake seeing the clothes Management Controls

38. Emperor’s Clothes (Contd.) • Scenario 1: Everyone was privately convinced of their incompetence, and cheered to deny it publicly • Scenario 2: People did not believe they were incompetent just because they could see the naked emperor, but believed that others so believed, and cheered to avoid being seen as stupid Management Controls

39. What about the Child? • The child did not know the link between visibility and competence • Child was innocent, and said what he saw • People know children to be innocent • People knew that people knew this Management Controls

40. Keynes on Stock Market • Price of Microsoft shares is $100 • I expect the price to be $125 a year from now. • Is it a good buy? • Rule 1: Yes, if your opportunity cost of capital is less than $25 for the year Management Controls

41. Stock Market (Contd.) • What if I now believe that the stock market’s assessment of the value of Microsoft shares a year from now will be $90? • Can I change the beliefs of others in the market? • If not, Rule 2: Sell at $100 • Higher order rules Management Controls

42. Should I Pay Attention to Others When I Know I Am Right? • What if everyone believes them (who are wrong), and not me (who is right) • Fight them? or • Join them? Management Controls

43. What About Accounting • Agency problem: how to induce managers to maximize shareholder value (e.g., choose LIFO) • Solution: Link managerial compensation to shareholder value • Problem 2: Value manipulation • Solution: Use market, not accounting, measures of value Management Controls

44. Value Maximizing Manager in an Efficient Market • LIFO can increase NPV of cash flow • But manager maximizes stock price • What does manager believe about how stock prices are determined? • Suppose manager believes that stock prices depend on income, not cash • Then manager is rationally led to reject LIFO even if it saves cash for the firm • After these examples of the consequences of common knowledge assumption, let us consider culture Management Controls

45. Culture • In management, culture often treated as a counterpoint to economics • Can think of culture of a group as the common knowledge expectation of behavior of the members of a group • Starting meetings on time • Wearing black on black • Expectations lie at the heart of economic models Management Controls

46. Management Controls Again • A viable concept of control from organizations as sets of contracts, expectations, common knowledge and culture • An organization or group is in control when its members find it in their own best interests to behave in a manner that is expected of them by the other members of the group Management Controls

47. Control In Versus Control of • Control in organizations distinct from control of organizations • Control in emphasizes • Balance and equilibrium • Symmetry of points of view of agents • Control of emphasizes • Manipulation, even exploitation • Disparity in bargaining powers of agents Management Controls

48. Comprehensive Perspective on Control • Rules, incentives, monitoring, enforcement to align behavior and expectations • Consider two traders on eBay • Buyer expects to have the appropriate goods delivered • Seller expects to be paid • When expectations of both are met, the system is in control • The concept extends well beyond the traditional scope to employees and managers to include shareholders, customers, vendors, and others Management Controls

49. Traditional Locus of Control • Processes internal to the firm • Involving people who often have social relationships • In transactions governed by social relationships, shared norms of social exchange play an important role • E-Commerce transactions strip the social context • Scope of e-commerce has expanded well-beyond the traditional boundaries of transactional relationships Management Controls

50. Three Simultaneous Consequences • Speeded up development of homogenized global norms for commercial transactions and culture (Nobody knows you are a dog!) • With shrinking cost of creating specialized platforms, new platforms for pre-existing social, linguistic, national and technological groups (What will be the language of Internet in 2015?) • Hybrid media (eBay gives your phone number to your transactions partner to enable an aural “eye contact” to clinch the deal) Management Controls