Financial Accounting TheoryCraig DeeganChapter 8Unregulated corporate reporting decisions: considerations of systems-oriented theories Slides written by Craig Deegan

Learning ObjectivesIn this chapter you will be introduced to:how community or stakeholders perceptions can influence the disclosure policies of an organisationhow Legitimacy Theory, Stakeholder Theory and Institutional Theory can be applied to help explain why an entity might elect to make particular voluntary disclosuresorganisational 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

Learning objectives (cont.)how the respective power and information demands of particular stakeholder groups can influence corporate disclosure policiesthe view that a successful organisation is one that is able to balance or manage the demands, including information demands, of different stakeholder groups

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

Political Economy TheoryLegitimacy 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

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 theoryclassicalbourgeois

Classical Political Economy TheoryRelated 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

Bourgeois Political Economy TheoryDoes 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

Legitimacy TheoryOrganisations seek to ensure they operate within the bounds and norms of their respective societiesactivities are perceived to be legitimate

Bounds and norms not static so require organisation to be responsive

Relies on the notion of a social contract

Legitimacy versus legitimationLegitimacy is the status or condition which exists when an entitys 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

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 organisations conduct that shapes legitimacy

Information disclosure is vital to establishing corporate legitimacy

Social contractRepresents the implicit and explicit expectations that society has about how the organisation should conduct its operationslegal requirements might provide the explicit terms of the contract, while other non-legislated societal expectations embody the implicit termsTraditionally the optimal measure of performance was profit maximisationPublic expectations have changed so organisations are now required to address human, environmental and other social issues

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.

Implications of not meeting social contractSociety 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 operationsmay lead to sanctions such as legal restrictions on operations, limited resources provided or reduced demand for products

Legitimacy and changing community expectationsCommunity expectations are not staticAs community expectations change, organisations must also adapt and changeLegitimacy can be threatened even when the organisations performance is not deviating from societys expectationsperhaps the organisation has failed to make disclosures that show it is complying with community expectationsOr, perhaps previously unknown information about the organisation comes to light (perhaps through the media)part of the organisation shadow is revealed

Actions to legitimise activitiesAdapt 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 organisations present practices, output and values

Attempt, through communication, to become identified with symbols or values which imply legitimacy

Communication to maintain legitimacySeek 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 disclosurePublic disclosure in such places as annual reports, sustainability reports and websites can be used to implement each of the previous strategiesPerspective adopted by many researchers of social responsibility reportingHighlights the strategic nature of financial statements and other related disclosures Disclosures might be substantive or symbolicsubstantive disclosures would reflect actual changes in corporate activitiessymbolic disclosures do not reflect real change but are made to appear consistent with social values and expectations

Empirical tests of Legitimacy TheoryUsed 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

Examples of empirical studiesPatten (1992):examined the change in the extent of environmental disclosures of US oil firms around the Exxon Valdez oil spill in Alaskalegitimacy theory suggested that they would increase disclosure in the annual report after the spillfound the increase in disclosure occurred across the industry

Examples of empirical studies (cont.)Deegan and Rankin (1996):used Legitimacy Theory to explain changes in annual report, environmental disclosure policies around proven environmental prosecutionsprosecuted firms disclosed significantly more environmental information in the year of prosecution than any other yearprosecuted firms disclosed more positive environmental information than a matched sample of non-prosecuted firms

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 concernsfound increased disclosure over time associated with increased environmental group membershipdisclosures mostly positivepositive relation between environmental sensitivity of industry and disclosure

Examples of empirical studies (cont.)Gray, Kouhy and Lavers (1995):performed longitudinal study of UK social and environmental disclosures from 1979 to 1991related trends to Legitimacy Theory, with specific reference to Lindbloms 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

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 governments choice of an accounting frameworkrelated to a desire to increase the legitimacy of an organisation

How management determines societys expectationsLegitimacy Theory proposes a relationship between corporate disclosure and community expectationsManagement has been found to rely on the media to provide an insight into community perceptions, with the media being observed to shape community expectations (ODonovan 1999)ODonovan (1999) provided evidence that corporate managers believe that:the media shapes public concernsannual report disclosures are a means of winning back the support of the community after adverse media coverage

Impact of media attentionIslam and Deegan (2008) reviewed the social and environmental disclosure practices of Nike and Hennes & Mauritz from 1987 to 2005found 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 reportTheir 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

Legitimacy Theory versus Positive Accounting TheoryLegitimacy 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

Stakeholder TheoryTwo branches of Stakeholder Theoryethical (moral) or normative branchpositive (managerial) branch

Many similarities between Legitimacy Theory and Stakeholder Theoryshould not be treated as two separate theories but two (overlapping) perspectives of the issue set within a political economy framework

Ethical (normative) branch of Stakeholder TheoryAll stakeholders have the right to be treated fairly by an organisationIssues of stakeholder power are not directly relevantManagement should manage the organisation for the benefit of all stakeholdersFirm is a vehicle for coordinating stakeholder interestsManagement have a fiduciary relationship to all stakeholders

Ethical branch of Stakeholder Theory (cont.)Where interests conflict, business managed to attain optimal balance among themEach group merits consideration in its own rightAlso have a right to be provided with information, even if not usedThis 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)

Definition of stakeholders Any identifiable group or individual who can affect the achievement of an organisations objectives, or is affected by the achievement of an organisations objectives (Freeman & Reed 1983)There are two branches to the above definitionProponents of the ethical branch of stakeholder theory would include both branches when identifying stakeholdersProponents of a managerial perspective of stakeholder theory would only consider the first branch (that is, those stakeholder who can affect the achievement of the firms objectives)

Primary versus secondary stakeholders Primary stakeholdersones without whose continuing participation the corporation cannot survive as a going concern

Secondary stakeholdersthose 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

Right to informationaccountabilityIn considering rights to information accountability is consideredthe duty to provide an account or reckoning of those actions for which one is held responsible

Accountability involves two responsibilitiesto undertake certain actionsto provide an account of those actions

Reporting is assumed to be a responsibility rather than demand driven

Testing of ethical branch of theoryAs 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.

Managerial branch of Stakeholder TheoryBy 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-centredstakeholders identified by the organisationextent to which organisation believes relationship needs to be managed in interests of the organisation

Managerial branch of Stakeholder Theory (cont.)Research undertaken under the managerial branch of stakeholder theory can be tested with empirical observationunlike normative ethical branch

Specifically considers the different stakeholder groups within society, and how they should best be managednot society as a whole like Legitimacy Theory

Expectations of stakeholders considered to impact on operating and disclosure policies

Stakeholder powerOrganisation will not respond to all stakeholders equally, but to the most powerful

Stakeholder power is a function of the stakeholders degree of control over resources required by the organisatione.g. labour, finance, influential media, ability to legislate, ability to influence consumption of the organisations goods and services

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

The role of informationInformation, 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 studiesRoberts (1992)found measures of stakeholder power and their related information needs can provide some explanation of levels and types of corporate social disclosuresNeu, Warsame and Pedwell (1998)firms more responsive (in terms of corporate environmental disclosure) to the concerns of financial stakeholders and government regulators than to environmentalistsIslam 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 (whos expectations about working conditions, child labour, and so on which are unobtrusive events - are influenced by the western media)

Ethical view versus managerial viewBy 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

Institutional TheoryProvides 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 organisationOrganisations 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

Institutional Theory (cont.)Links organisation practices to societal values

Organisational form tends towards some form of homogeneitydeviants will have problems gaining or maintaining legitimacy

Isomorphism and decouplingTwo 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 processescoercivemimeticnormative

Coercive isomorphismArises where organisations change their institutional practices because of pressure from those stakeholders upon which the organisation is dependentRelated to the managerial branch of stakeholder theoryBecause powerful stakeholders might have similar expectations of other organisations, there will tend to be conformity in practices across organisations, including their reporting practicesConsider how the World Bank has been able to influence reporting practices in developing countries (Neu and Ocampo 2007)

Mimetic isomorphismOrganisations often copy other organisations 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 organisationsenhances external stakeholders perceptions of the legitimacy of the organisation

Mimetic isomorphism (cont.)Without coercive pressure from stakeholders, it would be unlikely that there would be pressure to mimic othershence linkage between mimetic and coercive isomorphism

Normative isomorphismPressures from group norms to adopt particular institutional practices

Particular groups with particular training will tend to adopt similar practicesnon-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

Outcomes of isomorphismTendency 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

DecouplingAlthough 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

Concluding commentsWe 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