Download PowerPoints Chapter 08

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
8-1
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
8-2
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
8-3
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
8-4
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
8-5
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
8-6
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
8-7
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
8-8
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
8-9
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
8-10
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
8-11
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
8-12
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
8-13
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
8-14
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
8-15
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
8-16
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
8-17
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
8-18
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
8-19
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
8-20
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
8-21
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
8-22
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
8-23
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
8-24
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
8-25
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
8-26
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
8-27
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
8-28
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
8-29
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
8-30
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
8-31
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
8-32
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
8-33
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
8-34
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
8-35
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
8-36
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
8-37
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
8-38
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
8-39
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
8-40
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
8-41
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
8-42
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
8-43
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
8-44
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
8-45
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
8-46
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
8-47
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
8-48
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
8-49
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
8-50
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
8-51