Financial Accounting Theory Craig Deegan Chapter 8 Unregulated corporate reporting decisions: considerations of systems-oriented theories Slides written by Craig Deegan Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning Objectives In this chapter you will be introduced to: how community or stakeholders’ perceptions can influence the disclosure policies of an organisation how Legitimacy Theory, Stakeholder Theory and Institutional Theory can be applied to help explain why an entity might elect to make particular voluntary disclosures organisational legitimacy and how corporate disclosures within such places as annual reports can be used as a strategy to maintain or restore the legitimacy of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Learning objectives (cont.) how the respective power and information demands of particular stakeholder groups can influence corporate disclosure policies the view that a successful organisation is one that is able to balance or manage the demands, including information demands, of different stakeholder groups Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Systems-oriented theories Legitimacy Theory, Stakeholder Theory and Institutional Theory are all systems-based theories Focus on the role of information and disclosure in the relationships between organisations, the State, individuals and groups The entity is influenced by, and influences, the society in which it operates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political Economy Theory Legitimacy Theory, Stakeholder Theory and Institutional Theory derived from Political Economy theory Political economy is ‘the social, political and economic framework within which human life takes place’ (Gray, Owen & Adams 1996, p.47) Economic issues cannot be investigated in the absence of considering the political, social and institutional framework within which economic activity takes place Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Political Economy Theory (cont.) Corporate reports not considered neutral and unbiased, but are a product of the interchange between the corporation and its environment Two streams of Political Economy theory classical bourgeois Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Classical Political Economy Theory Related to the works of Marx Considers class interests, structural conflict, inequity and the role of the state Accounting reports and disclosures are a means of maintaining the favoured position of those who control scarce resources Focuses on the structural conflicts within society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Bourgeois Political Economy Theory Does not explicitly consider structural conflicts and class struggles Concerned with interactions between groups in an essentially pluralistic world Legitimacy Theory and Stakeholder Theory derive from this branch Does not question or study the various class structures within society Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy Theory Organisations seek to ensure they operate within the bounds and norms of their respective societies activities are perceived to be ‘legitimate’ Bounds and norms not static so require organisation to be responsive Relies on the notion of a ‘social contract’ Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy versus legitimation Legitimacy is the status or condition which exists when an entity’s value system is congruent with that of society Legitimation is the process which leads to an organisation being viewed as legitimate Legitimacy theory relies upon the notion that there is a ‘social contract’ between the organisation and the society in which it operates Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy versus legitimisation (cont.) To be considered legitimate it is not the actual conduct of the organisation that is important, it is what society collectively knows or perceives about the organisation’s conduct that shapes legitimacy Information disclosure is vital to establishing corporate legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social contract Represents the implicit and explicit expectations that society has about how the organisation should conduct its operations legal requirements might provide the explicit terms of the contract, while other non-legislated societal expectations embody the implicit terms Traditionally the optimal measure of performance was profit maximisation Public expectations have changed so organisations are now required to address human, environmental and other social issues Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Social contract (cont.) As Mathews (1993, p.26) states: The social contract would exist between corporations (usually limited companies) and individual members of society. Society (as a collection of individuals) provides corporations with their legal standing and attributes and the authority to own and use natural resources and to hire employees. Organisations draw on community resources and output both goods and services and waste products to the general environment. The organisation has no inherent rights to these benefits, and in order to allow their existence, society would expect the benefits to exceed the costs to society. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Implications of not meeting social contract Society allows the organisation to continue operations to the extent that it meets their expectations The organisation may find it difficult to obtain the necessary support and resources to continue operations may lead to sanctions such as legal restrictions on operations, limited resources provided or reduced demand for products Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy and changing community expectations Community expectations are not static As community expectations change, organisations must also adapt and change Legitimacy can be threatened even when the organisation’s performance is not deviating from society’s expectations perhaps the organisation has failed to make disclosures that show it is complying with community expectations Or, perhaps previously unknown information about the organisation comes to light (perhaps through the media) part of the ‘organisation shadow’ is revealed Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Actions to legitimise activities Adapt output, goals and methods of operation to conform to definitions of legitimacy Attempt, through communication, to alter the definition of social legitimacy so it conforms with the organisation’s present practices, output and values Attempt, through communication, to become identified with symbols or values which imply legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Communication to maintain legitimacy Seek to educate and inform the community about changes in performance and activities Seek to change perceptions but not behaviour Seek to manipulate perception by deflecting attention from the issue to other related issues Seek to change external expectations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Role of public disclosure Public disclosure in such places as annual reports, sustainability reports and websites can be used to implement each of the previous strategies Perspective adopted by many researchers of social responsibility reporting Highlights the strategic nature of financial statements and other related disclosures Disclosures might be substantive or symbolic substantive disclosures would reflect actual changes in corporate activities symbolic disclosures do not reflect ‘real’ change but are made to appear consistent with social values and expectations Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Empirical tests of Legitimacy Theory Used by numerous researchers examining social and environmental reporting practices Used to attempt to explain disclosures Disclosures form part of the portfolio of strategies undertaken to bring legitimacy to, or maintain legitimacy of, the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies Patten (1992): examined the change in the extent of environmental disclosures of US oil firms around the Exxon Valdez oil spill in Alaska legitimacy theory suggested that they would increase disclosure in the annual report after the spill found the increase in disclosure occurred across the industry Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies (cont.) Deegan and Rankin (1996): used Legitimacy Theory to explain changes in annual report, environmental disclosure policies around proven environmental prosecutions prosecuted firms disclosed significantly more environmental information in the year of prosecution than any other year prosecuted firms disclosed more ‘positive’ environmental information than a matched sample of non-prosecuted firms Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies (cont.) Deegan and Gordon (1996): investigated the objectivity of environmental disclosure practices and trends over time, as well as whether environmental disclosures related to environmental group concerns found increased disclosure over time associated with increased environmental group membership disclosures mostly positive positive relation between environmental sensitivity of industry and disclosure Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies (cont.) Gray, Kouhy and Lavers (1995): performed longitudinal study of UK social and environmental disclosures from 1979 to 1991 related trends to Legitimacy Theory, with specific reference to Lindblom’s strategies Deegan, Rankin and Voght (2000): used Legitimacy Theory to explain how social disclosures in annual reports changed around the time of major social incidents or disasters Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies (cont.) Brown and Deegan (1998) emphasised the role of the media in shaping community expectations and showed that corporate disclosures responded to media attention Carpenter and Feroz (1992): undertook a US study on the government’s choice of an accounting framework related to a desire to increase the legitimacy of an organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

How management determines society’s expectations Legitimacy Theory proposes a relationship between corporate disclosure and community expectations Management has been found to rely on the media to provide an insight into community perceptions, with the media being observed to shape community expectations (O’Donovan 1999) O’Donovan (1999) provided evidence that corporate managers believe that: the media shapes public concerns annual report disclosures are a means of winning back the support of the community after adverse media coverage Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Impact of media attention Islam and Deegan (2008) reviewed the social and environmental disclosure practices of Nike and Hennes & Mauritz from 1987 to 2005 found a direct relationship between the extent of global news media coverage of a critical nature directed towards particular social issues and the extent of social disclosure in the annual report Their findings supported a view that: the media is able to influence community concerns in relation to unobtrusive issues (creates a legitimacy gap) managers will make disclosure responses to the media attention Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Legitimacy Theory versus Positive Accounting Theory Legitimacy Theory has been compared to the Political Cost Hypothesis of PAT Legitimacy Theory relies on the notion of a ‘social contract’ It does not rely on the economics-based assumption that all action is driven by self-interest and wealth maximisation or make assumptions about the efficiency of markets Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder Theory Two branches of Stakeholder Theory ethical (moral) or normative branch positive (managerial) branch Many similarities between Legitimacy Theory and Stakeholder Theory should not be treated as two separate theories but two (overlapping) perspectives of the issue set within a ‘political economy’ framework Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical (normative) branch of Stakeholder Theory All stakeholders have the right to be treated fairly by an organisation Issues of stakeholder power are not directly relevant Management should manage the organisation for the benefit of all stakeholders Firm is a vehicle for coordinating stakeholder interests Management have a fiduciary relationship to all stakeholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical branch of Stakeholder Theory (cont.) Where interests conflict, business managed to attain optimal balance among them Each group merits consideration in its own right Also have a right to be provided with information, even if not used This perspective of corporate responsibilities is not validated (or rejected) on the basis of empirical observations (that is, these researchers are providing argument about what should be and not what is) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Definition of stakeholders Any identifiable group or individual who can affect the achievement of an organisation’s objectives, or is affected by the achievement of an organisation’s objectives (Freeman & Reed 1983) There are two branches to the above definition Proponents of the ethical branch of stakeholder theory would include both branches when identifying stakeholders Proponents of a managerial perspective of stakeholder theory would only consider the first branch (that is, those stakeholder who can affect the achievement of the firm’s objectives) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Primary versus secondary stakeholders Primary stakeholders ones without whose continuing participation the corporation cannot survive as a going concern Secondary stakeholders those who influence or affect, or are influenced or affected by, the corporation, but they are not engaged in transactions with the corporation and are not essential for its survival Ethical branch does not differentiate between primary and secondary stakeholders Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Right to information—accountability In considering rights to information accountability is considered the duty to provide an account or reckoning of those actions for which one is held responsible Accountability involves two responsibilities to undertake certain actions to provide an account of those actions Reporting is assumed to be a responsibility rather than demand driven Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Testing of ethical branch of theory As the ethical branch embraces normative perspectives about how the organisation should act, it cannot be validated by empirical observation As Donaldson and Preston (1995, p.67) state: In normative uses, the correspondence between the theory and the observed facts of corporate life is not a significant issue, nor is the association between stakeholder management and conventional performance measures a critical test. Instead a normative theory attempts to interpret the function of, and offer guidance about, the investor-owned corporation on the basis of some underlying moral or philosophical principles. Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Managerial branch of Stakeholder Theory By contrast, this branch of stakeholder theory attempts to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders More organisation-centred stakeholders identified by the organisation extent to which organisation believes relationship needs to be managed in interests of the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Managerial branch of Stakeholder Theory (cont.) Research undertaken under the managerial branch of stakeholder theory can be tested with empirical observation unlike normative ethical branch Specifically considers the different stakeholder groups within society, and how they should best be managed not society as a whole like Legitimacy Theory Expectations of stakeholders considered to impact on operating and disclosure policies Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder power Organisation will not respond to all stakeholders equally, but to the most powerful Stakeholder power is a function of the stakeholder’s degree of control over resources required by the organisation e.g. labour, finance, influential media, ability to legislate, ability to influence consumption of the organisation’s goods and services Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Stakeholder power (cont.) Major role of management is to assess the importance of meeting stakeholder demands so as to achieve strategic firm objectives Expectations and power relativities of various stakeholders change over time Organisation must continually adapt operating and disclosure strategies Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

The role of information Information, including financial accounting and social performance information, is a major element employed to manage stakeholders Used to gain support or approval Also used to distract their opposition or disapproval Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Examples of empirical studies Roberts (1992) found measures of stakeholder power and their related information needs can provide some explanation of levels and types of corporate social disclosures Neu, Warsame and Pedwell (1998) firms more responsive (in terms of corporate environmental disclosure) to the concerns of financial stakeholders and government regulators than to environmentalists Islam and Deegan (2008) Garment suppliers in a developing country (Bangladesh) responsive to the expectations of multinational buying companies, with the multinational buying companies in turn being responsive to the expectations of western consumers (who’s expectations about working conditions, child labour, and so on – which are unobtrusive events - are influenced by the western media) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Ethical view versus managerial view By separately considering the two perspectives of Stakeholder theory, it could be construed that management might either be ethically aware, or focused on the survival of the organisation Management will arguably be driven by both ethical and performance considerations We need to understand the complementary roles normative and descriptive research play Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Institutional Theory Provides an explanation about why organisations tend to take on similar characteristics and form Particular organisational forms might be adopted in order to bring legitimacy to the organisation ‘Organisations conform because they are rewarded for doing so through increased legitimacy, resources and survival capabilities’ (Scott 1987, p.498) Provides a complimentary perspective to both legitimacy theory and stakeholder theory Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Institutional Theory (cont.) Links organisation practices to societal values Organisational form tends towards some form of homogeneity ‘deviants’ will have problems gaining or maintaining legitimacy Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Isomorphism and decoupling Two main dimensions of Institutional Theory are isomorphism and decoupling Isomorphism refers to ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’ (DiMaggio & Powell 1983, p.149) Three different isomorphic processes coercive mimetic normative Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Coercive isomorphism Arises where organisations change their institutional practices because of pressure from those stakeholders upon which the organisation is dependent Related to the managerial branch of stakeholder theory Because powerful stakeholders might have similar expectations of other organisations, there will tend to be conformity in practices across organisations, including their reporting practices Consider how the World Bank has been able to influence reporting practices in developing countries (Neu and Ocampo 2007) Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Mimetic isomorphism Organisations often copy other organisation’s practices for competitive advantage and to reduce uncertainty ‘Uncertainty is a powerful force that encourages imitation’ (DiMaggio & Powell 1983, p.151) Organisations within a particular sector adopt similar practices to those adopted by leading organisations—enhances external stakeholders’ perceptions of the legitimacy of the organisation Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Mimetic isomorphism (cont.) Without coercive pressure from stakeholders, it would be unlikely that there would be pressure to mimic others—hence linkage between mimetic and coercive isomorphism Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Normative isomorphism Pressures from ‘group norms’ to adopt particular institutional practices Particular groups with particular training will tend to adopt similar practices—non-compliance could result in sanctions being imposed by ‘the group’ Again, provides a rationale for why reporting approaches, and other corporate processes, tend to take on similar form Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Outcomes of isomorphism Tendency towards similar corporate structures and processes Isomorphic processes do not necessarily make the organisations more efficient In practice it is not easy to differentiate between the three types of isomorphism Strategies might be more about ‘show’ or ‘form’, rather than about substance Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Decoupling Although managers might see a need to be seen to be adopting particular structures and practices, actual organisational practices can be very different from the formally sanctioned and publicly pronounced processes and practices For example, the organisational image constructed through corporate reports and other disclosures might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profit or shareholder value Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e

Concluding comments We can see that there is much overlap between the three theories just discussed Sometimes a joint consideration of different theoretical perspectives can provide a more holistic understanding of particular practices Copyright  2009 McGraw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3e