Contract Theory of Organizations,
Accounting and Control
Shyam Sunder,
Yale University
University of Sao Paulo
Sao Paulo, Brazil, March 12, 2013
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Contract Theory
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Outline
• Organizations as alliances among people seeking their
goals
• Culture of a group is the set of common knowledge
expectations its members have from one another
• Control as equilibrium or balance: organization is in
control if expectations of its members from one another
match what its members find in their own best interests
• Control threatened by changes in environment; without
prompt repair, organization collapses
• Strategic management: anticipate threats, redesign and
renegotiate alliances to restore control with respect to the
changed environment.
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Organizational Design
• Perspective includes a review of
– Organizations,
– Expectations,
– Common knowledge, and
– Culture;
• Disruption and threats to control
• Strategic management: what top managers do to
maintain control
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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
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Contracts
• Participating agents promise to deliver resources
• In exchange for the 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 satisfies the condition is assembled
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Agent
• Has personal goals
• From his opportunity set, chooses preferred
actions
• Actions are consistent with his preferences,
information and opportunity set
• Difficult to model in social sciences without
a minimal level of behavioral consistency
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Examples of Contracts
• Contract is a mutual expectation or understanding
among agents
• Lunch date
• This class
• 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
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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
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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)
– Support (Community)
• Each party gets resources in exchange
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Firm as a Set of Contracts
Managers
nagerssss
Shareholder
s
Government
Creditors
Auditors
Employees
Vendors
Customers
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Accounting in Organizations
• Operating mechanism for contracts
• Necessary to assemble, implement, enforce,
modify and maintain the contract set
• Five functions
–
–
–
–
–
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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
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Measuring Contributions
• Receivables and cashier
• Receiving dock for supplies
• Punch clock and quality control
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Measuring Outflows
•
•
•
•
Payroll accounts
Tax accounts
Cashier
Shipping
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Contract Fulfillment
• Matching resource inflows and outflows to
contracts
• Performance evaluation
• Adjusting contracts to resource realizations
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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
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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
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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
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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
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Mutuality of Expectations
• Expectations are rarely fixed
• All actions create/influence expectations
• Firm must manage them (problem of participative
budgeting)
• With unfilled expectations, people turn away
• With overfilled expectations set up 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)
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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...
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Emperor Has No Clothes
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Stock Market
• Stock Market is
like a newspaper
beauty contest
• John Maynard
Keynes, (1936)
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Newspaper Beauty Contest
Which Face is the prettiest?
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Which Face is the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which face will they judge to be the prettiest?
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Which Face is the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which face will they judge to be the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which face will they judge to be the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which Face is the prettiest?
Which face will they judge to be the prettiest?
Which face will they judge to be the prettiest?
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LIFO Inventory Accounting
• If your inventory prices rise, and end-ofyear 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)
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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
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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
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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
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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
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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
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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
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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?
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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
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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
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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
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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
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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
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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
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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
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If Individual Condition Is Not
Met
• People who do not expect to get from the
organization at least the opportunity cost of
their contributions will go elsewhere
• This is the definition of opportunity cost
• Shareholders will not buy your stock if they
can higher risk-adjusted return elsewhere
• Customers will not buy your goods if they
can get better price or quality elsewhere
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If Aggregate Condition Is Not
Met
• Firms runs out of resources to meet its obligations
(expenses exceed revenue)
• Some agent(s) disappointed because the promises made to
them are not fulfilled
• These agents quit (and probably impose additional costs on
the organization—e.g., law suits)
• If these individuals were essential for the production
function of the firm, their departure makes things worse
• If they were not essential, the firm did not choose the
optimum production function
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No Coercion
• Matching of agent actions to what others expect of
them should not be achieved through coercion
• It has to be created through socially legitimate
incentives and motivational methods
• What is legitimate varies across societies
• Performance-based compensation may be
considered coercive in some societies but not in
others
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Not Based on Misunderstanding
• Participant actions and others’ expectations
of them may just happen to match due to
misunderstanding
• Such a match is not sustainable; it
disappears as soon as the participants get
better information
• A match based on misunderstanding does
not imply control
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Not Based on False Promises
• A match may sometimes be obtained
through false promises—e.g., Ponzi
schemes
• Again, these are not sustainable
• Disclosure of truth destroys the organization
• Such a house of cards is not “in control”
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Disintegration of Organizations
• When actions do not match the
expectations, people are disillusioned and
quit
• Organizations disintegrate
• Miscalculation, coercion, misunderstanding,
or misrepresentation by agents destroy
control
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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
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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
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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
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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
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Expectations and Common
Knowledge
• Contracts 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
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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
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What’s 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
• Simon’s boundedly rational behavior
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Thank You
• Please send your comments to
• [email protected]
• www.som.yale.edu/faculty/sunder/research
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