1. 1 Accounting: Labor, Capital and Product Markets Shyam Sunder Yale University Zhytomyr State Technological University, Zhytomyr, May 18, 2006

2. 2 Dominant Theme: Harmonization and Convergence n Harmonization and convergence of accounting practice is a dominant theme in today’s accounting n Descriptive validity: probably, with IAS n Normative validity: doubtful, considering the links between accounting and markets n Build on this theme in this talk n Perhaps you would not mind a discordant note in the chorus of support for international harmonization of accounting standards

3. 3 Accounting Convergence or Differentiation by Economy and Sector n Accounting practices vary in different economies n Accounting practices also vary in different sectors of the same economy (e.g., private and public sectors, and in different industries) n Convergent development of markets generates convergent pressures on accounting n Globalization is development of cross-economy markets n We examine the sources, consequences and limits of these convergent forces

4. 4 Cross-Economy Overview n Contract model of organizations and accounting n Markets shape the organization n Differences in markets n Differences in accounting n Market development and cross-economy convergence of accounting n Limits to convergence

5. 5 Contract Theory of Organizations n Organizations can be seen as sets of contracts among people n Chester Barnard, President, Bell Telephone Company of New Jersey –Functions of the Executive 1937 n Herbert A. Simon, Administrative Behavior, 1946 n Terms of contract depend on the conditions prevailing in the respective markets

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7. 7 Markets Shape Organizations and Their Accounting n Market for capital n Market for labor n Market for products n Will consider two markets of special interest to accountants today –Markets for audit services –Markets for systems of governance (Tiebout) n All these markets are not equally developed in the same or in different societies

8. 8 Functions of Accounting n Accounting to help define, implement, renegotiate and enforce contracts –Measures resource contributions –Determines inducements –Compares contributions to inducements to determine fulfillment of contracts –Distribution of information to factor markets –Public disclosure to reduce conflict (American Airlines)

9. 9 Markets for Labor (Managerial) n Classical double entry: –For traders, –Causal links in transactions (ijiri) –Aid to memory, no hired managers n Managerial Accounting –For hired managers –Hierarchy or organization –Stewardship or agency problem –Rise of business schools to supply this market

10. 10 Contracting Problems in Markets for Labor n Problem of differential expectations of various parties –Importance of public disclosure to reduce conflict n Recent problems in US Corp. governance: asymmetric information –Managers defining their own contracts –Stealing from the firm n Very old issues (East India Company) n As labor markets developed in societies, so did organizations and their control systems

11. 11 Informal Evidence: U.S. and Japan n Differ in their industrial organization => definition of entity and consolidation n Importance of debt markets and control n Managerial and labor markets=> differences in employment contracts n Weak equity markets and financial reports n Non-existent market for corporate control n Changes in markets=>changes in accounting n With time, we could develop better field evidence on this correspondence

12. 12 Markets for Capital n Closely-held firms: equity supplied by one person or tight group who can control management n Publicly-held firms: equity supplied by a large, diverse group of investors who cannot directly control the managers n Gave rise to financial reporting form of accounting

13. 13 Consequences of Capital Markets n Robust accounting (less judgment) n Introduction of rules and auditors n Management of income less acceptable n Competition among source of information n Shift from stock to flow variables n Most firms’ shares not traded n Firms choose their organizational forms and their accounting regimes n US-Japan comparison of equity-bond markets and their financial reporting systems

14. 14 Markets for Products n Private good organizations produce and sell goods for a price to customers n Customers can impose discipline on them n Shareholders control managers by offering them net income based compensation

15. 15 Public Good Organizations n Public good organizations have beneficiaries, not customers n Weaker or no customer discipline n Efficient production of public goods is very difficult n Solution to the control problem is bureaucracy and a different accounting system

16. 16 Comparing Private and Public Good Organizations n Resource flows n Residual Claims n Product Market Discipline n Decision Making –Product –Investment n Accounting and Control

17. 17 Accounting and Controls n Differences between internal control and financial reporting n Differences often misinterpreted as prima facie evidence of poorly designed or poorly run public good organizations

18. 18 Accounting and Control Differences n Entities n Funds n Consolidation n Assets/Depreciation n Revenue (cash versus accrual) n Budgets

19. 19 Bureaucracy n Bureaucracy is the oldest form of management n Does not receive a fair shake in press n Perhaps overused in welfare state n But it is necessary for many functions n Lack of understanding leads to misguided attempts at reform that can backfire

20. 20 Unequal Race n Efficient production of public goods is more difficult than private goods (lack of customer discipline on managers) n Always room for improvement in current practices

21. 21 Market for Audit Services n Recent collapse of auditing in US n Blamed on “bad” people n But there is a larger story of “bad” policy n We need to trace what happened over the preceding quarter century in the audit market in US n The we can better able to understand both the causes as well as the cures

22. 22 Market for Accounting Governance n Desirability of a single set of rules has become a consensus n There are good reasons to question this consensus n Does there exist a right set of standards that will fix our accounting troubles: wrong search n Even if the answer is yes, what is the major hurdle that standard setters face in their search –They can’t tell which rules are better

23. 23 What can we do to help them find better rules? n Better information about the consequences of their prescriptions n This can’t happen with an accounting monopoly of FASB in US or IASB in the world n Likely to get stuck in a corner solution, with no possibility of getting evidence on what can be better n Consider regulatory competition –Unfortunately, the accounting world is headed in the other direction

24. 24 Summary n Sectoral differences in accounting arise from market differences n Market developments will not necessarily eliminate them n We should expect sectoral differences in accounting to persist globally, even as economy-wise differences diminish over time

25. 25 Thank You n The paper and slides will be available at n http://www.som.yale.edu/faculty/sunder/ research.html n or email to shyam.sunder@yale.edu