Contract Theory of Organizations,
Accounting and Control
Shyam Sunder, Yale University
Third International Conference on Accounting and
Finance
University of Namibia, Windhoek, June 13-14, 2011
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Three Basic Ideas
• Organizations as a set of contracts
• Shared facts for conflict resolution
• Control in organizations as balance and
equilibrium among various interests
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Organization as a set of Contracts
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Economic agents
Contracts
Contributions
Resource Entitlements
Necessary Conditions
Satisfies each individual
Aggregate feasibility
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Shareholders
Employees
Creditors
Customers
Managers
Government
Vendors
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Shareholders
Sk
ills
Co
mp
ens
a
tio
n
Equity Capital
Residual
Rights
Employees
Creditors
t
res
e
t
In oan
l
L
ita
p
Ca
Skills
Cash
Good
s
Servi and
ces
Government
xe
s
Ta
Pu
bl
ic
G
oo
ds
Managers
Customers
and
s
d
Goo ices
Serv
h
Cas
Compensation
Vendors
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Contributions and Entitlements of Various Agents
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Assumptions
• Economic agents
• Preferences
• Consistency of actions
• Contract as mutual understanding or expectation
• Not necessarily explicit
• Role of social conventions
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Goals and Scope
• Goals of each individual
• Organization’s goals not considered
– Organization as an arena
– Organization as a tournament
• Applicable to all organizations
• Focus here on business firm
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Functions of Accounting
• To Help
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Assemble
Implement
Enforce
Modify
Maintain
• the contract set through five processes
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Five Processes of Accounting
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Measuring resource inflows
Measuring resource outflows
Determination of contract performance
Information for factor markets
Common knowledge for contract
renegotiation
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Measuring Resource Inflows
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Vendors: At the receiving dock
Customers: cashier, accounts receivables
Labor: clock, inspection
Managers: intangible
Shareholders: shareholder accounts
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Measuring Resource Outflows
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Employees: payroll
Customers: shipping
Vendors: account payables
Government: tax accounts
• Data organized by cause-effect in double-entry
bookkeeping
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Contract Performance
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Compare resource inflows and outflows
Determine who has fulfilled contracts, how much
Comparative reports
Examples:
Customer account statement
Managerial accounting
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Information for Factor Markets
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What resources are expected
What resources are available for disbursement
Find people who have/want them
Markets for labor, goods, and capital
Proforma financial statements, business plans and
budgets by the entrepreneur
• No permanent occupants, must find replacements
• Costs and benefits of occupying contractual slots
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Common Knowledge for Renegotiation
• All contracts have finite terms (except shareholders)
• Conditions Change
• Potential for Empty as well as Serious Threats and
Bluffs
• Public Disclosure and Common Knowledge
• Cut Deadweight Losses to Society
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Necessary Conditions
• 1) Individual Condition: Each participants
expects to receive at least the opportunity
cost of contributions he/she makes to the
organization
• 2) Aggregate Condition: Contributions of all
participants can produce enough output to
meet the expectations of all
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Income/Value of the Firm
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Extensive income as the sum of:
To the shareholders
To customers
To Vendors
To employees
To creditors
To government
To community, etc.
Inducement from the firm – O.C. of contributions
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Income/Value to Investors
• Residual income and corresponding
shareholder value created
• Focus of current financial reports
• Apply similar perspective to other
participants in the firm
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Income/Value to Customers
• Customer’s “investment” in the form in the form of search,
learning, negotiation, payments, settlement of disputes
• Expected PV of benefits from goods received should exceed
the PV of investments
• Includes immediate transaction as well as the
consequences of the transaction for resource flows
associated with any future transactions (reduction in time,
cost, search etc. for later transactions)
• In a perfect product market, consumer’s surplus from the
firm is zero (may be +ve from industry, and the economy)
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Value to Government
• Various levels of government provide mostly nonpriced services plus some priced goods
• Resources from taxation
• Value of the firm to the government from providing
priced services is the same as for vendors
• Value of the firm to the government from providing
non-priced services is taxes plus fees minus O.C. of
resources spent on providing services
• Major challenge to put this into practice
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Value of the Firm to Community
• Local, national and global
• Most exchanges in form of externalities
• Value of the firm to the community is
the sum of net externalities plus the net
payments
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Measurement of Income/Value
• J.M. Clark (1936): Three fundamental challenges
to determining the value of private enterprise
– Imperfect and incomplete markets
– Fundamental values not as exact as market values
– Fundamental concepts should be independent of
specific institutions of exchange (generality)
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Problems in Control of Managers
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At the procedural hub of the contracts
Control resources, have information
Monitor and negotiate with others
Difficult to measure their contributions
Can appropriate resources and information
Misappropriation difficult to detect
Devising a scheme to induce managers to contribute what
is expected of her
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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
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Classification by Markets
• Market for managers (Hatfield, 1924))
• Market for capital (Hatfield, 1924)
• Market for product (Sunder, 1999)
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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
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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 View of 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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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
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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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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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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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Finally …
• Accounting enables organizations to function, serve all
participants
• Broad perspective on functions of accounting; accounting
systems designed for organizations functioning in different
environments
• Bookkeeping, managerial accounting, and auditing serve small
proprietorship, large proprietorship, and public corporations
• Understanding accounting and control in public good-producing
organizations that do not have customers, only beneficiaries.
Thank You.
Shyam.sunder@yale.edu
www.som.yale.edu/faculty/sunder
Theory of Accounting and Control, 1997
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