financial accounting theory craig deegan chapter 8

Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan 8-1

Financial Accounting TheoryCraig Deegan

Chapter 8

Unregulated corporate reporting decisions: considerations of systems-oriented theories

Slides written by Craig Deegan and Michaela Rankin

8-2 Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan

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


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


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 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


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


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


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


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’


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


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


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, 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


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


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


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 information than non-prosecuted firms



• 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



• 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

• 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)– a US study on the choice of an accounting framework– related to a desire to increase the legitimacy of an

organisation


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 (O’Donovan 1999)


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


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


Ethical 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


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


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)


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


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


Testing of ethical branch of theory

• As involves normative perspectives about how the organisation should act, they cannot be validated by empirical observation

• Normative theory attempts to interpret the function of, or provide guidance about, the corporation


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


Managerial branch of Stakeholder Theory (cont.)

• Theories 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


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


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 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

• 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

• We need to understand the complementary roles normative and descriptive research play


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


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


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


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


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


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


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’


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


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


Concluding comments

• We can see that there is much overlap between the three theories just discussed

• Sometime a joint consideration of different theoretical perspectives can provide a more holistic understanding of particular practices

financial accounting theory craig deegan chapter 8

Documents

stakeholder theory

institutional theory

corporate reports

particular stakeholder

corporate disclosures

institutional framework

social contract legitimacy

information demands