Module 4 Social Determinants of Financial Reporting

Introduction Traditionally, the only measure of firm performance was profit However, public expectations have changed so that organisations are now required to address human, environmental and other social issues Community perceptions can influence the disclosure policies of an organisation

Systems-oriented theories Two systems-oriented theories- Legitimacy theory Stakeholder theory Focus on the role of information and disclosure in the relationships between organisations, government, individuals and groups The entity is influenced by, and influences the society in which it operates

Political Economy Theory Legitimacy Theory and Stakeholder Theory are derived from Political Economy theory Political economy ‘is the social, political and economic framework within which human life takes place’ Economic issues cannot be investigated in the absence of considering the political, social and institutional framework within which economic activity takes place

Political Economy Theory— continued Corporate reports not considered neutral and unbiased, but are a product of the interchange between the corporation and its environment Legitimacy Theory and Stakeholder Theory can be applied to help explain why an entity might elect to make particular voluntary disclosures

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 upon the notion of a ‘social contract’

Legitimacy and legitimation Legitimacy is the status or condition which exists when an entity’s value system is perceived as congruent with that of the society legitimation is the process which leads to an organisation being viewed as legitimate. This ‘process’ can include corporate disclosures.

Social contract Represents the implicit and explicit expectations that society has about how the organisation should conduct its operations

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

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

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

Role of public disclosure Public disclosure in such places as annual reports 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

Empirical tests of Legitimacy Theory Used by 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

Conclusions from tests of Legitimacy Theory Increase in disclosures following social incidents or environmental dissasters, and around proven environmental prosecutions Increased disclosure over time associated with increased environmental group membership Disclosures mostly positive

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, with the media being observed to shape community expectations

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 Why is it important to be legitimate?

Stakeholder Theory

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 and Reed 1983) Examples include shareholders, creditors, government, employees, employee’s families, local communities, and future generations

Stakeholder Theory Two branches of Stakeholder Theory: ethical (moral) or normative branch positive (managerial) branch

Ethical branch of Stakeholder Theory Normative theory - what ‘should’ happen All stakeholders have the right to be treated fairly by an organisation Management should manage the organisation for the benefit of all stakeholders Each group merits consideration in its own right and has right to be provided with information, even if not used Issues of stakeholder power are not directly relevant

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

Managerial 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 Expectations of stakeholders considered to impact on operating and disclosure policies

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 eg. labour, finance, influential media, ability to legislate, ability to influence consumption of the organisation’s goods and services

Stakeholder power—continued 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

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

Examples of empirical studies Too early to draw overall conclusions from this area of research 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

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

Legitimacy and Stakeholder Theories Many similarities between Legitimacy Theory and Stakeholder Theory (managerial branch) should not be treated as two separate theories but two (overlapping) perspectives of the issue set within a ‘political economy’ framework Stakeholder theory specifically considers the different stakeholder groups within society, and how they could best be managed not society as a whole like Legitimacy Theory

For Tutorials Required reading Self assessment questions Text chapter 8 Self assessment questions Questions from module 4 Answers in tutorials