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Management Controls, Expectations, Common Knowledge, and Culture

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Title: 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

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

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

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

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

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
    organizationsbusiness, government, society,
    academia

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

9
Firm as a Set of Contracts
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

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

12
Measuring Outflows
  • Payroll accounts
  • Tax accounts
  • Cashier
  • Shipping

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

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

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

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

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

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)

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

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

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

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

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

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

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

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

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 maximizationof 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)

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...

29
Emperor Has No Clothes
30
(No Transcript)
31
Stock Market
  • Stock Market is like a newspaper beauty contest
  • John Maynard Keynes, (1936)

32
Newspaper Beauty Contest
Which Face is the prettiest?
33
Which face will they judge to be the prettiest?
34
Which face will they judge to be the prettiest?
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 dont adopt LIFO
  • Apprehension about stock market reaction (no
    empirical support)

36
Beliefs About Others Beliefs
  • Common elements to the three stories about the
    emperors clothes, stock market and LIFO
  • Central role of what we believe about others, and
    about their beliefs

37
Emperors 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

38
Emperors 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

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

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

41
Stock Market (Contd.)
  • What if I now believe that the stock markets
    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

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?

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

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

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

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

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

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

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

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)

51
On E-Commerce Trading Platforms
  • Opacity of Internet cuts common knowledge
  • More difficult to attain expectational
    equilibrium among transaction partners
  • New external players come into direct contact
    with each other
  • E-commerce must establish expectational control
    among them all

52
Framework for Control
  • Duh, Jamal and Sunder (2001) two-dimensional
    framework for controls in online auctions like
    eBay
  • Three criteria privacy, security and integrity
  • Four points of view customers, sellers,
    employees, operators
  • Useful for
  • Identifying weaknesses in control
  • Developing market for assurance services
  • Regulation policy for trade, privacy and
    governance
  • Research on open, interesting questions

53
Competitive Development of Standards in E-Commerce
  • Competitive development of control standards by
    assurance service providers (Jamal, Maier and
    Sunder, 2001)
  • WebTrust industry standards, slow acceptance
  • TRUSTE seal verification of client claims
  • Competitive development of standards in
    e-commerce in sharp contrast to the monopoly
    approaches more popular in other aspects of
    accounting and auditing

54
Threats to Control
  • Environment of organizations changes continually
    (factor and product market conditions)
  • A contract set which is in control today, will
    not be in control tomorrow if conditions change
  • Left to itself, the organization will collapse
    because a fixed set of contracts cannot remain in
    expectational equilibrium except by sheer chance

55
Functions of Top Management
  • This function goes by many labels (long term
    planning, strategic management, etc.)
  • It always amounts to the same thing
  • Monitor your environment
  • Anticipate changes in factor and product markets
  • Redesign contracts to be in control under the new
    conditions
  • Renegotiate contracts
  • Implement new contracts
  • Perpetual revision of corporate plans to retain
    their desirability from the point of view of all
    participants

56
Let Me Summarize
  • Control a key concept in management
  • Need an appropriate model of organizations to
    study control
  • Help do accounting and control better
  • Find appropriate place for control in the
    intellectual structure of the discipline of
    management

57
Role of Accounting
  • Organizations as sets of contracts or alliances
    among people
  • Agents seeking their own goals contribute
    resources in exchange for inducements
  • Accounting helps define, implement, enforce and
    modify contracts, serving a critical function in
    organizations

58
Design of Organizations and Controls
  • Both designs depend on conditions prevailing in
    the appropriate markets
  • Market for managerial labor differentiated
    stewardship model from bookkeeping
  • Market for capital differentiated financial
    reporting model from stewardship
  • Market for products differentiates government and
    not-for-profit model from private good
    organizations

59
Expectations and Common Knowledge
  • Contrcts are based on expectations
  • Expectations not well-understood yet
  • First as well as higher orders of knowledge play
    important part in management
  • Not always reasonable to assume common knowledge
  • Breakdown of common knowledge has important
    consequences for behavior and outcomes in
    organizations and markets

60
Culture and Control
  • Culture of a group can be thought of as
    expectations its members hold about the behavior
    of others in the group
  • An organization is in control if the behavior of
    its members corresponds to the expectations of
    others
  • Control is a state of expectational equilibrium

61
Whats Management For
  • Changing environment threatens control
  • Top management must anticipate and deal with
    these threats to control
  • Set of feasible corporate plans is too large to
    contemplate and analyze
  • Due to time limitations, managers search in the
    neighborhood of existing plans and settle on
    satisficing solutions
  • Simons boundedly rational behavior

62
Thank You
  • The paper and the slide presentation will be
    available on my website
  • http//www.som.yale.edu/faculty/sunder
  • Please send your comments to
  • Shyam.sunder_at_yale.edu
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