Project Earnings Manipulation: An Ethics Case Based on ... - SSRN

Issues in Accounting Education Vol. 15, No. 1 February 2000

Project Earnings Manipulation: An Ethics Case Based on Agency Theory Jeffrey R. Cohen, Laurie W. Pant, and David J. Sharp ABSTRACT: The impact of accounting information on ethical behavior has been extensively documented. Additionally, agency theory is a widely accepted behavioral perspective. Despite this, there is an absence of instructional material in the accounting education literature that ties ethical issues to an agency-theory context. The primary objective of this case is to highlight control system ethical issues using an agency-theory context. Students explore their own reactions to a prohibited but unmonitored cost allocation action. Thus, this case is positioned to fill this void in any accounting course that covers agency theory or management control systems.

S

DECISION

ue Davies, a single mother with two school-aged children, was a project manager in Pure Marine’s Membrane and Related Equipment Group. It was a Friday afternoon late in September with Indian Summer in full force. She sat in her office considering how to account for the last $2 million of a $5 million Technical Improvement R&D expenditure that had just arrived in her internal mail for cost allocation. She had originally approved the expenditure over a year ago for Project K(3), but she was now unsure whether to charge the last $2 million to the nearly completed K(3), or to two recently started projects.

PURE MARINE

Since its founding in 1948, Pure Marine had maintained industry leadership in the large-scale provision of clean water. For almost 50 years, the

company had developed membranebased and other advanced technology systems for municipal and industrial markets. The technology is used for desalination and wastewater treatment as well as the production of highly pure water. These markets currently account for about 52 percent of Pure Marine’s revenues and 37 percent of total earnings. The other two major business areas include operation or ownership/operation of water treatment facilities for Jeffrey R. Cohen is an Associate Professor at Boston College, Laurie W. Pant is a Professor at Suffolk University, and David J. Sharp is an Associate Professor at the University of Western Ontario. The authors are grateful for helpful comments received from Dan Daly, Ganesh Krishnamoorthy, Sue Ravenscroft, Arnie Wright, and from the many students who have helped us pretest this case.

Electronic copy available at: http://ssrn.com/abstract=1100979

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Issues in Accounting Education

customers (26 percent of revenues and 43 percent of profits) and a consumer products group providing household bottled water, purification systems, and bleach and cleaning products (22 percent of revenues and 20 percent of earnings). For the last 20 years Pure Marine has been a publicly held company, and the before-tax net profit last year was about 10 percent of sales. Overall, the company has been growing steadily. Current annual targets are 20 percent growth in revenues and profits, and this year’s total revenue was about $120 million. During the past nine years, revenue grew at an average annual rate of 16 percent while earnings per share grew at an average annual rate of 30 percent. These increases kept Pure Marine at the top of a strong and steadily growing industry. While a substantial portion of Pure Marine’s recent growth has come from the supply of its own equipment in either an own-and-operate or a service mode, the membrane and related equipment business was also an important contributor to the business mix. For example, a recent boom in construction of semiconductor chip plants caused a resurgence in the company’s capital equipment business by dramatically increasing its activities in the manufacture of very large ultra-pure water systems for companies like Digital and Motorola. A typical order for Pure Marine’s Membrane and Related Equipment averaged about $5 million, and in a typical year Pure Marine received about a dozen such orders. Projects took approximately 18 months from the order to completion. Pricing was based on cost estimates prepared under the direction of project managers who were responsible for delivering the completed project to the customer. The project managers reported to the Membrane and Related Equipment Group Vice President (see

Figure 1). Each project was unique, depending on specific water conditions as well as local environmental, sociopolitical, and economic issues. Too frequently for the Group Vice President (VP), the unique nature of each project had led to cost overruns, sometimes causing significant project losses. Senior management looked very unfavorably on these substantial losses. Worse yet, the Group VP was often surprised about these cost overruns, because the company had a very poor costinformation system. Costs were only accumulated at the completion of construction, and only then did these overruns get reported. To make matters worse, little detail was provided that could identify these cost overruns in the cost reports. An expensive and lengthy search was required to obtain information on which part(s) of the project has cost overruns. In short, top management had very little information and was poorly informed about the operation of the Membrane group. Consequently, the Group VP was reluctant to waste time on what was already “water under the bridge,” believing his time was better spent on current projects and preventing future overruns. Much discussion had taken place about how to avoid these surprises, and, as a consequence, systems analysts were scheduled to implement a better cost-tracking system. The new system could not be applied to current projects, including K(3) and the two recently started projects, but all new projects starting in the next fiscal year would use the new cost system. For all current projects, including K(3) and the two recently started projects, the Group VP could only hope that surprises would be minimal. The Membrane and Related Equipment Group was under pressure to contribute to the management’s aggressive

Electronic copy available at: http://ssrn.com/abstract=1100979

Cohen, Pant, and Sharp

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FIGURE 1 Organization Chart: Pure Marine, Inc.

CEO

Membrane and Related Equipment Group VP

Water Treatment Group VP

Project Manager (Sue Davis)

Project Manager

Project Manager

Project Manager

Consumer Products Group VP

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growth targets by delivering not only completed projects but profitable ones. Sue Davies had been a project manager with Pure Marine for three years, and reported to the Group Vice President. Like the other project managers, she had once or twice underestimated the cost of projects over that period. Fortunately for her, none had led to a loss. But today, near the end of the fiscal third quarter, she was sitting very uneasily in her office. She was responsible for three projects in various stages of completion. One, Project K(3), due “in” within the next quarter, was a $7 million water treatment facility for a midsize city. The initial geological analysis had not revealed certain environmental problems that surfaced halfway through the construction. Further, the total cost of special insurance for handling the relocation of specially constructed gas lines had not been anticipated. Together, these overruns, including all of the last $2 million of the technology development costs, threatened to increase K(3)’s project cost to $8.2 million, nearly 30 percent over budget. These cost overruns could not be passed along as price increases to the client and would result in a sizable loss. The K(3) problem could not have come at a worse time. Senior management was looking for strong fourth-quarter results to reach profit targets. Sue’s compensation included a salary of $97,500 and a lump-sum bonus based on the overall profit margin of projects under her responsibility. If Project K(3), her only project to be completed this year, came in at the company’s standard profit target of 10 percent before tax, Sue would earn a bonus of $20,000. Any profits below that on Project K(3), while not jeopardizing her future prospects, would mean no bonus for the year. A loss would cause her some embarrassment.


Sue pondered allocating costs among projects. She was responsible for two other projects that were just starting, and she was considering whether she should charge some or all of the last $2 million of technology development costs noted at the start of this case to these new projects. Company policy required that all contract costs be assigned to the project for which they were initially incurred. Management used this approach to reinforce the need for precise cost estimates at the time of the bid. The first $3 million of the technology development costs had already been charged to Project K(3). These development costs had originally been authorized by Sue and the former head of R&D (who had recently left the company for an outside lucrative position) as a requirement for Project K(3). However, the two new projects would likely experience cost savings arising from similar technology development efforts. Sue reasoned that this might provide some leeway in determining the allocation of the technological improvements generated by these engineering initiatives. If she allocated some of the last $2 million in costs to the other two projects, the total cost of Project K(3) would be correspondingly lower, increasing the current year’s profitability. It was very unlikely that the Group VP or Sue’s successor would discover and question the allocation to the other two projects. However, even if they did question the allocations, Sue felt that she might also be able to explain the allocation as a clerical oversight. A bonus would help make a down payment on the new minivan she needed for all the car pooling she inevitably did. She sat in her office, considering whether to charge some or all of the $2 million of costs to the new projects.


QUESTIONS:

1) Establishing the accounting facts and the behavioral context: How much cost should be charged to unfinished products if K(3) is to (a) break even? (b) earn a normal level of profit? What would be the impact on Sue Davis’ compensation (and possible effect on her performance review) of these allocations? 2) Making a decision: As Sue Davies, how would you allocate the last $2 million? What criteria would you use? Prepare a

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brief (half-page) “memorandum to file” with your decision and reasons, and hand this in before class. 3) Review of relevant accounting rules: Does Accounting for Contracts provide useful guidelines in this situation? Is the decision material? Does it matter? Why? 4) Review of impact on other stakeholders: Who are the stakeholders in this decision? What are their rights and expectations? What is Sue’s obligation to each?

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TEACHING NOTES Teaching Objectives This control systems case links ethics and agency theory, two topics previously addressed separately in accounting educational materials (Cohen and Pant 1989). The major objective of the case is to demonstrate the role of management control systems in providing incentives and information signals in the context of a decision with a high level of ethical conflict. It illustrates the importance of: • Information asymmetry • Incentives, including profit-based rewards • Stakeholder analysis • The impact of individuals’ ethical beliefs in organizational behavior Students are required to make a decision about a cost allocation in which their bonus is at stake, and in which earning the bonus requires a questionable allocation. The role of different forms of control is highlighted. The case contributes an important dimension to accounting curricula. First, the frequency of control systems ethics cases is somewhat limited. Mintz (1992) expanded his second edition of ethics cases to include nine covering managerial accounting issues. While these employ a stakeholder framework for analysis, control system questions are indirectly addressed. Jennings and Henry (1999) use agency theory to examine a full disclosure question; however, their case focuses on financial and economics perspectives. The case presented here draws on the managerial agency issues raised in empirical research. See for example, Chow et al. (1988), and Chow et al. (1991) regarding budgetary slack, Harrell and Harrison (1994) for project cost allocation, and Rutledge (1997) for examining agency effects on managers’ level of ethical reasoning. As in these empirical studies, the question of interest in this case is whether the control systems’ factors of compensation and information asymmetry are motivators of unethical behavior. Drawing on the findings of Bruns and Merchant (1990), Merchant and Rockness (1994) and the pretest responses of the many full-time employees in the M.B.A. courses who commented on this case, the likelihood of profit manipulation to ensure a bonus appears highly realistic. The ethical issue in this case focuses on a manager’s profit manipulation behavior. The case illustrates that management control systems are a powerful determinant of an individual’s behavior (Macintosh 1994; Dirsmith et al. 1997; Pant and Yuthas 1998). These systems are established to motivate employees to implement the strategy of the firm by aligning corporate and individual rewards. However, textbooks (e.g., Horngren et al. 1998, Merchant 1997) note that many results are often counterproductive (e.g., slack, spend-it-or-lose-it). As organizations become flatter and knowledge is pushed further down into the organization, individuals will become even more responsible for decisions that significantly impact current profitability and future strategy (Johnson 1992; Lancaster 1998). Several of these will have ethical implications. The control system issues are framed within an agency-theory context. Agency research on control systems (Baimen 1990; Schultz et al. 1993; Stevens 1997) indicates that the willingness of individuals to undertake questionable actions is affected by the likelihood of being caught (information asymmetry) and the nature of the compensation (incentives). In the case presented here, the project manager


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has little chance of being discovered, and the opportunity to earn a bonus if she improperly allocates research and development costs. The propensity of managers to undertake profit manipulation initiatives has been documented by Merchant and Rockness (1994). Therefore, an objective of this case is to use an agency perspective to help students look closely at ways control systems impact employees’ ethical behavior. Role in the Curriculum The issues raised in this case are important for undergraduate, graduate, and professional training programs. Ethical and agency-theory frameworks join two previously separate discussions. (For excellent summaries of agency theory in control system contexts, see Anthony and Govindarajan [1998] and Macintosh [1994].) This case offers the opportunity to engage in complex thinking, as well as oral and written communication, about an ethical management control problem. Students are faced with the multiple factors that designers of control systems encounter. Class discussion could include several examples of this complexity, including: • Whether closer observation by superiors can eliminate many unethical behaviors. • The ability to evaluate performance when the behavior is/is not observable. • The impact of incentives such as profit-based bonuses on ethical behavior. • The dependence of control systems on the individual’s good intentions. Appropriate accounting curricula include cost and advanced cost accounting, planning and control systems, introductory courses that include managerial accounting issues, and courses covering ethical components (e.g., accounting theory courses). Finally, although international issues are not specifically raised in this case, all curricula could recognize that introducing cultural and socioeconomic differences would add even more complexity to management problems such as this. For example, Hofstede (1991) and Cohen et al. (1993a) discuss the influence of cultures with a collectivist orientation on the effectiveness of a Western-designed control system. Technological Change and Ethical Issues In cost and advanced cost accounting, and planning and control classes, the case can be discussed in the light of the Institute of Management Accountants’ (IMA) Report on Project Millennium (1997), which addresses the drastic changes brought about by technological advances as well as our increasingly competitive business environment. This report includes a call for managerial accountants and financial managers to anticipate the implications of financial information. The behavioral issue in this case serves as a means of examining the design of current and potential control systems. First, the use of the bonus compensation illustrates the tendency of individuals to adjust their behavior to the standard being rewarded. The case provides an opportunity to understand the problems of designing a system so that counterproductive behavior is not undertaken to meet the standard. Second, the implications of technology can be raised with this case. Supervisors will increasingly reduce their information gap regarding subordinates’ activities. Research about the impact of technology on control system design (Teece et al. 1997; Pant 1998; Pant and Yuthas 1998) can illustrate the extent to which technology will reduce distance and time lags, and make data and processes explicit

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and subordinates’ behavior transparent. This could lead to a speculative discussion about whether one consequence of increased technology will be the disappearance (or reduction) of many potentially unethical behaviors and situations. Management Control Systems, Strategy, and Ethical Issues In planning and control systems courses, this case can serve to initiate a discussion about the current and future role of control systems in implementing the strategy of the firm (Macintosh 1994; Dirsmith et al. 1997; Pant and Yuthas 1998). Students can first review the traditional objective of these systems to normalize behavior (to effectively and efficiently organize employee activity to achieve a known objective). This review can lead to an examination of future control systems. If the future environment means that organizational and subunit goals may not always be known, the means to accomplish tasks may not always be clear; and as organizations are becoming flatter, employees may be increasingly empowered to make and take responsibilities for decision making (Barney 1991; Lancaster 1998). Students can examine the possible implications for the ethical issues raised in changing the role of control systems in the organization. For example, Pant (1998) raises questions about whether these changes will create greater goal congruence or whether employees will conclude that the assignment of these additional responsibilities is merely another management ploy to extract extra effort from workers. Accounting Measurement and Ethical Issues Introductory courses that include management accounting issues serve as an excellent place to introduce the complexity of the role of accounting measures in the firm. The case illustrates that accounting does not simply represent economic behavior; it can cause this economic behavior. Different configurations of the control system can be looked at to anticipate the different responses by individuals being measured and evaluated (Worthy 1984; Finch and Mihal 1989). Additionally, a discussion of the role of an individual’s ethical character can be helpful in educating students about the different kinds of skills successful accounting leaders must possess (IMA 1997). The Nature of Ethical Issues Ethics courses can examine several of the ethical dimensions of the case. If undiscovered, the decision to allocate cost to future projects may appear to cause little harm. Students can evaluate the harmful consequences of the action. Their discussion can cover whether harm is actually a criterion for the probity of a behavior (Gaa 1994). This discussion can also include analyzing whether there is a relationship between the perception of harm and the willingness to perform the action (Jones 1991). The issues in the case can be interpreted from different philosophical perspectives including virtue ethics (MacIntyre 1984; Pincoffs 1986), stages of moral development (Kohlberg 1984; Rest 1986) and dimensions of moral judgment (see for example, Armstrong 1993) and utilitarianism (Cohen et al. 1993b). Finally, the case specifically addresses the stakeholder rights (see Freeman [1982] for a classic discussion of this popular approach to business ethics). Development of the Case The basic facts of this case were taken from an actual company located in suburban Boston. On-site visits and interviews were conducted with the Vice President


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of Operations, Research and Development, and Information Technology as well as the systems analyst responsible for developing and implementing the new costtracking system. The framework for information asymmetry and compensation was developed from the agency literature on management control systems (e.g., Chow et al. 1988; Baimen 1990; Sharp and Salter 1997). The case was first reviewed by students in a planning and control systems course for realism, and then pretested by undergraduate cost accounting classes and experienced M.B.A. students. The case has been used in universities in the U.S. and Canada in graduate planning and control systems classes and in three different managerial courses with accounting professionals, managers, and educators. It has also been used in executive education courses in a number of places in the U.S. and Canada (which follows essentially the same accounting for contracts). Class Process Students should be required to commit to a cost allocation decision, to be handed in before class. The distribution of these decisions can then easily be tabulated on a blackboard at the appropriate time. Responses should not be anonymous, as the instructor will also want to call on certain respondents at various times. (Note: In this coverage of issues, Question 2 is reserved for last so that students will have participated in discussing relevant case issues before publicly defending their position on Sue Davies’ decision.) Question 1—Cost Allocations Since this case emphasizes behavioral issues, discussing the accounting treatment serves to engage students in case details and establish contextual issues. These include the degree of discretion and incentive underlying Sue Davies’ decision and the materiality of the numbers. In class, the instructor can ask for a brief review of facts about Sue, the company, and the decision at hand in order to make the case explicit. This coverage should reveal that the company is growing quite quickly (possibly implying a need for financing, thus making the role of financial statements more critical than might otherwise be the case). At this point, the key cost allocations alternatives of $1.2 million and $1.9 million should be demonstrated (see Figure 2). FIGURE 2 Cost Allocation Alternatives—K(3) Pure Marine, Inc. Project K(3) Income Statement, 200X (in millions) Break Even Revenue Other Costsa Remaining R&D Total Cost Pretax Profit aTotal

$7.0 6.2 0.8 7.0 $0

costs of $8.2 million less remaining R&D cost of $2 million

10% Profit $7.0 6.2 0.1 6.3 $0.7

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Sue does not want to report a loss and has to report a 10 percent profit to earn her bonus. For K(3) to break even, Sue has to reallocate $1.2 million of the $2 million remaining R&D cost to other (next year’s) projects. That way, K(3) will cost exactly $7 million—the $8.2 million reported in the case less the $1.2 million reallocation. However, if K(3) has to earn a “normal” level of profit, then more of the R&D cost must be reallocated. The case states that her bonus is paid if the overall company “normal” profit margin is 10 percent before tax of sales is met. For K(3) this is $700,000 before tax. This works out to charging K(3) with $100,000 of R&D, and allocating the remaining $1.9 million to the two future projects. Question 3—Materiality Both company policy and Accounting for Contracts (Delaney et al. 1990) require direct R&D costs for contracts to be expensed as incurred (see the Appendix). The instructor can then ask whether the decision is material. The case implies that membrane group revenues are $60 million (12 projects at an average $5 million each), with pretax net margins around 10 percent; hence $1.2 million (pretax) is material for the membrane group. Total company revenues are nearly $120 million (membrane group revenue is 52 percent of total sales) with profits of $12 million (10 percent of sales). The $1.9 million pretax allocation causes a nearly 20 percent increase in total company profits (see Figure 3). Again, the analysis requires some assumptions. Based on sales of $120 million and $12 million profit, costs are $108 million. Assuming that K(3) earns a 10 percent profit with R&D of $.1 million, other costs are $107.9 million. If none of the $2 million of R&D is allocated to other projects, new total costs of K(3) are $109.9, and profit falls to

FIGURE 3 Pure Marine Total Company Profit Analysis Pure Marine, Inc. Total Company Income Statement, 200X (in millions) 10% Profit with R&D allocation Revenue Other Costsa R&D Total Cost Pretax Profit * a

107.9 0.1*

$120.0

Estimated Profit without R&D allocation 107.9 2.0

$120.0

108.0

109.9

$ 12.0

$ 10.1

Assumes K(3) earns a 10 percent profit. Total costs of $108 million (necessary to show a profit of $12 million) less allocated R&D cost of $0.1 million.


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$10.1. Using this calculation, the decision is very material at the corporate level as well. At this point students can be asked whether an immaterial impact would change the decision. Or are there more important principles affecting the issue? Finally, students could be asked how an auditor would set materiality. Question 4—Stakeholder Obligations Discussion could then move on to ethics discussion: Who are the stakeholders? What are their rights? What are Sue’s duties to each? (For a discussion of stakeholder theory, see Mintz [1992] or Cohen [1997].) Stakeholders include current shareholders, Sue and her family, others doing business with the company, potential investors and lenders (see Figure 4). Sue is entitled to make a decent living— and is entitled to the bonus, if she earns it legitimately. Her family has a big stake in it. Current and future shareholders and other capital providers are entitled to earn fair returns, but also to have financial statements that are not distorted. Those doing business with the firm (employees, customers, and suppliers) are also entitled to the organizational stability that comes with nonmanipulated statements. The morality of the various rationales elicited above can be discussed: Why is it right to arrange things so that she gets a bonus? The following points could come up: • Obviously it is what top management wants (profit for the year) and probably shareholders too. • Is it acceptable to act in your own self-interest? To what extent? • Isn’t the purpose of a management control system to align the interests of individual managers with the company? • Could cost allocations that create inflated current profits and lower future profits affect stakeholder decisions? If so, is this Sue’s concern? • Could technology-based companies that have to expense costs benefiting future business-generating ability to current projects be at a disadvantage? If so, is this Sue’s concern? FIGURE 4 Stakeholder Rights and Obligations Stakeholders

Rights

Obligations

Sue and her family

—Earning a decent living

—Trying to earn a bonus —Performing her professional best

Current and prospective shareholders/lenders

—Fair returns —Nondistorted statements

—Sue’s best effort to produce profitable projects —Sue’s responsibility for nondistorted statements

Employees, customers, suppliers

—Profitability to assure firm survival —Nondistorted statements

—Sue’s best effort to produce profitable projects —Sue’s responsibility for nondistorted statements

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The class can discuss the consequences to various stakeholders in the situation. They could address whether shareholders want paper profits this year or “real” (unbiased) information in financial statements. This discussion could elicit the distinction between economic and reported profits, and income manipulation. Usefulness of income numbers and expectations of users can be discussed here. After all, the allocation is only a question of the timing of the profits. Which timing better reflects shareholder expectations/rights regarding financial statements? Discussion can include ways in which current and future investors make decisions based on reported current profits, and how customers, suppliers, and employers are affected by financial reporting. Students can then comment on whether these issues should be of concern to Sue. Question 2—Basic Control System Issues and Ethical Situations At this point, the class should have had a good discussion of alternatives and reasons for them, the moral issues in the decision, and the role of the control system in trying to align personal and corporate interests. Now it is appropriate to move on to control systems and ethics issues. Control Systems and Behavior. The instructor can now tabulate on the board students’ allocations taken from their memoranda submitted before class. This can be followed by a discussion of reasons: those advocating $1.2 million or more to new projects can defend their decision to students who vote for all costs to be allocated to K3. The discussion will produce several justifications, including the entitlement to bonus, and shareholders’ interest in high profits this year. If it is raised, the class can discuss the company’s policy on cost allocation as stated in the case. Is the company policy just a nuisance? Can policy really provide clear rules that specify what a manager should do in every circumstance, or does a manager have the intelligence/initiative/authority to use policy merely as guidance, and not as the letter of the law? What is the role of a corporate culture that puts importance on its code of conduct (Molander 1987)? Information Asymmetry. The instructor can then ask the following question: Suppose Pure Marine had a very tight control system in which there was an active internal audit department, and top management monitored project costs carefully on a daily basis? Consequently, the cost allocation decision is likely to be readily apparent to top management. Would this make any difference to your allocation decision? Why? The instructor can take a second poll here, and tabulate the distribution. It is likely that some students in class may say that it makes no difference. The instructor can play devil’s advocate by taking the role of management or internal audit and ask any class participant to justify her/his decision to allocate costs the way s/he did. The instructor (or another student) should choose a student who allocates only a little to K3. A role play would be very effective here, with one student taking the role of internal auditor, the other, Sue Davies. The case clearly asserts that allocation to anything other than K(3) is contrary to policy. The instructor should move toward a conclusion that information asymmetry probably affects decisions, and that high asymmetry increases the likelihood of self-interested behavior. The instructor should ask those who say it makes no difference to justify their answer. They are in effect contending that the control system (at least the information asymmetry part of it) does not matter. Does it? Should it? If it


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does not matter, why have the control system at all? Incentives. The instructor can then move to the question of bonus, asking whether it would make a difference if no bonus were at stake. In the absence of a bonus, how does Sue decide what she should do? Does the bonus send a signal about what management expects Sue to do? The point to bring out is that Sue has to fall back on personal values, which will differ around the class, and that the bonus is—and should be—a powerful motivator. Again, the instructor can take a poll and tabulate results. Does the bonus motivate Sue to make a decision that is in the shareholders’ best long-term interests? Summary of Key Case Learning Points: 1. There are two key aspects to control systems: reduction of information asymmetry and incentives. 2. Individuals (managers) will, in general, make different choices in the same situation. 3. The control system is designed to reduce individual differences, and to motivate by providing clear signals and a supportive environment concerning relevant decisions. 4. Control systems based on bottom-line monetary incentives alone are not likely to serve shareholders’ long-run interests, let alone a thoughtful balancing of various stakeholders’ interests. Such systems will likely promote short-term behavior that is not in anyone’s best interests except perhaps Sue’s and her family’s. Their interest is legitimate, but it should not be dominant. Other stakeholders’ interests matter too. The control system should motivate Sue to consider all stakeholders, and balance their interests in as fair a way as possible.

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APPENDIX Accounting for Contracts (from Delaney et al. 1990, 157) Contract Costs Contract costs are costs identifiable with or allocable to specific contracts. Generally, contract costs would include all direct costs such as direct materials, direct labor, and any indirect costs (overhead) allocable to the contracts. Contract costs can be broken down into two categories: costs incurred to date and estimated costs to complete. The costs incurred to date would include pre-contract costs and costs incurred after contract acceptance. Pre-contract costs are costs incurred before a contract has been entered into, with the expectation of the contract being accepted and thereby recoverable through billings. Pre-contract costs would include architectural designs, costs of learning a new process, and any other costs, which are expected to be recovered if the contract is accepted. Contract costs incurred after the acceptance of the contract are costs incurred toward the completion of the project and are also capitalized in the construction-in-progress (CIP) account.

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