The Control System of the Firm

Abstract

Purpose: The aim of this chapter is to review the arguments for internal control systems. This will be done by providing an account of theories that explain the existence and necessity of internal control. We will also describe two contrasting theoretical perspectives that help explain the design and adoption of internal controls.

Synopsis: Why do control processes exist in organizations? The modern theory of the firm focuses on the need for cooperation to achieve common goals. In this case the organization consists of a group of consciously coordinated activities for the accomplishment of common objectives. One prerequisite however, is that the group`s effort to achieve this end should be performed at the right time and in the right way, and with the right proportions. Thus people’s understanding of common goals becomes a fundamental variable. Man is considered rational only to a limited extent, due to, for example cognitive limitations. Because differences among personal goals may exist, it is possible that an employee will substitute the goals of the firm with his/her own goals. Accordingly, a control system that provides incentives to reconcile differences so that efforts are coordinated toward the established objectives of the organization is needed. Agency theory provides a primarily economic explanation for the form of control systems. This theory has been controversial but has nonetheless been applied in a wide variety of fields such as finance, marketing, organization behaviour and accounting. At the heart of agency theory lies the separation between ownership and control. One person (the principal) engages another person (the agent) to perform some service. An agency problem arises if the cooperative behaviour, which would maximize the group’s welfare, is not consistent with each individual’s self-interest. Because owners of resources will have less information than those who manage the resources, these agents may take advantage of the situation for their own benefit. As a result, different contracting arrangements and controls need to be designed in order to mitigate agency-related problems. Institutional theory provides a contrasting explanation for adoption and form of controls. This theory suggests that controls are adopted in order to gain legitimacy, as symbolic displays and imitation of practices from the outside environment. Management looks to management fads, industry norms and firm traditions when adopting and implementing new control processes.