Summary by Rosalyn Mansour
Ph.D. Program in Accounting
University of South Florida, Spring 2004
Purpose: The purpose of this article is to use the theory of contracts, expectations, common knowledge, and culture to build a "Theory of Control" in organizations. A Theory of Control explains how control helps keep organizations intact by facilitating equilibrium between the expectations and behavior of agents.
A Contract View of Organizations
The foundation for Sunder's theory of control is based on the assumption that organizations are "a set of contracts or an alliance among economic agents" and that accounting is what makes organizations work (p. 173). Contracts are agreements between two or more economic agents (only people who act in their own best interests) and are formed for the purpose of mutual benefit. Contracts in this sense do not have to be legally enforceable, although they sometimes are.
This definition highlights the give-take relationship between both parties to the contracts. A contract will last as long as the resource being given/taken is agreeable to the parties to the contract. Such resources exchanged include both tangibles and intangibles like: labor, skills, satisfaction, hope, capital, cash, service, lower crime rates, and so forth. The contract view of organizations says that organizations are a "set of contracts" between stakeholders. This view does not limit itself to corporations, but also includes proprietorships, partnerships, public entities, and not-for-profits. For example, a college alumni association receives money from alumni and, in return, the alumni receive good feelings about their generosity as well as the tax write-off.
The author further states, "accounting helps define, implement, enforce, modify, and maintain the contract set of an organization (p. 174)" in five ways:
1. It is the tool used to define and measure the substance of what each economic agent gives and receives in performing its contracts. In other words, it's like a measuring stick.
2. It also "defines measures, records, and controls the outflow of resources from the organization (p. 175).
3. It "compares the data on resource inflows and outflows with the contract set to determine who has fulfilled his contract and to what degree (p. 175).
4. It "helps maintain liquidity in the firm's factor markets for labor, goods, and capital (p. 175)." For example, financial statements help convince investors to invest.
5. It helps prevent a breakdown in contracts by making knowledge available to all parties.
In sum, organizations are comprised of contracts between stakeholders and accounting is the "glue" that holds those contracts and organizations together so that all interested parties mutually benefit. This "glue" is specifically referred to as the organization’s control system. As organizations grow and change, control systems also adapt. Therefore, control systems can be classified along the same lines as the organizations they support. The author categorizes organizations using a taxonomy based on how developed its markets are in order to illustrate the organization's control systems.
Market for Managers - Like a proprietorship differs from a multinational corporation, organizations' markets for managers and control systems differ. A sole proprietorship run by its owner has no market for managers and information provided by double-entry bookkeeping is sufficient for control. Conversely, a large corporation has a huge market for managers, as seen in their multi-level hierarchies, which necessitates more complex control via the use of "planning and budgeting, divisional and managerial performance evaluation and compensation, decentralization, transfer pricing, capital budgeting, and various forms of variable and absorption costing including activity-based costing (p. 176)." The author calls the production of these complex tools "stewardship accounting."
Market for Capital - A sole practitioner has no market for capital; whereas the public company lies on the other side of the continuum. The more owners there are, the less able the owners are to directly control the actions of the firm or its managers. In case management does not carry out its contracts as agreed, the financial reporting model provides a way that owners can identify such a problem. It also discourages management malfeasance by financial reporting standards that management must follow. However, the stricter the rules are, the less informative the information. There is also a lot of non-financial information competing with financial reports and, as a result, investors (owners) are becoming less reliant upon financial statements. Furthermore, financial accounting standards can have the opposite effect of that intended in that it provides a means for earnings management, which is becoming a less accepted practice for sophisticated investors and causes less informative financial reports. Lastly, when considering the financial reports, investors have become more likely to put more emphasis on the income statement than in the balance sheet because assets and liabilities are carried at historical cost and are inadequate for predicting future earnings. Whether stakeholders would be better served by valuing assets and liabilities at market value is a debate that has not yet been resolved.
Classification by Markets for Products - Private goods are produced by business organizations whereas public goods would be produced by governmental-like organizations. In the case of private goods, individual customers have the power to choose what goods they will consume. As such, management control is achieved by such things as bonuses based on net income. If customers buy goods, net income increases and managers are rewarded. Likewise, as net income increases, owners are also positively affected. Consumers of public goods do not have the same ability to reward an organization by purchasing its products. For example, people have no individual choice in products/services like electricity, water, police force, and the like. Since management of companies producing public goods are not motivated by net income, alternative control systems have been developed, such as fixed compensation and detailed budgets. Differences between companies that provide private versus public goods can be seen when comparing government or not-for-profit financials to those produced by a corporation. For example, fund accounting versus accrual accounting.
Building Blocks of Control
Expectations - Agents and organizations both have to manage the expectations of their contracts. If one agent expects something that the other agent is unable to deliver, then there is disappointment. Conversely, if Agent A outperforms Agent B's expectations, the bar is raised and Agent A's expected normal performance is at the higher level. If an organization continually fails to meet stakeholders' expectations, it will eventually cease to exist. Such expectations are operationalized into things like budgets, performance measurements, and compensation plans. Expectations upon management need to be realistic. Goals such as increasing shareholder wealth by some percentage are often unrealistic; therefore, management either runs itself or workers ragged in trying to meet such expectations or in extreme cases it resorts to fraud. As Sunder points out, not everyone can consistently perform above average. Therefore, "management and control face the challenge of creating expectations and contracts that are sustainable in steady state (p. 180)."
Common Knowledge - Common knowledge, an assumption, is a piece of information known by both parties (agents) to a contract. It is important what agents believe about the other agents who are party to a contract. Also significant is what each agent believes about the others' belief(s). Sunder illustrates this point by explaining that in prior times of high inflation, few companies used the LIFO method for inventory. Had they switched to LIFO, income tax payments would have decreased. This trend was due to managers' fear that, because LIFO would decrease net income below prior years, the company's stock price would decrease and they would be penalized. It is the assumption that investors use income to value stock in the stock market that caused management, who is self interested, to base its actions on net income. Since future cash flows cannot be directly observed, stock prices are a proxy because it is assumed that the stock market performs efficiently and stock prices provide a just estimate of future earnings. In reality, management’s fear of switching to LIFO was unfounded because empirical research has shown that the stock prices for companies that switch to LIFO actually increase. It appears Sunder is saying that such assumptions about what investors value need to be relaxed so that management will be compelled to take actions that benefit the long-run welfare of the organization rather than the short-term stock price.
Sunder defines the culture of a group as "the common knowledge expectation of behavior of its members" and is "both a necessary as well as sufficient condition for any component of culture (p. 182)." For example, if everyone in the organization expects to be at his or her desk and working at 8:00 AM, then that is part of the organization's culture. Conversely, another organization where workers drag in anywhere from 8:00 am to 8:30 does not have a culture in regard to tardiness. As such, the former organization's culture controls the time that employees begin working and the organization is assured of adequate staffing during hours of operation. Another example of where culture relates to control is the expectation that budgeted targets will be met.
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