CH 08

Financial Accounting Theory Craig Deegan
Chapter 8 Unregulated corporate reporting decisions: considerations of systems-oriented theories Slides written by Craig Deegan and Michaela Rankin
Copyright 2006 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting Theory 2e by Deegan
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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
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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
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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
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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
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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
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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
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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
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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
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Legitimacy versus legitimation

Legitimacy 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
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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
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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
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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 organisations present practices, output and values Attempt, through communication, to become identified with symbols or values which imply legitimacy
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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
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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
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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
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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
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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 nonprosecuted firms
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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
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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 Lindbloms strategies
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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
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How management determines societys 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 (ODonovan 1999)
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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
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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
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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
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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
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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)
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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
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Right to informationaccountability
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
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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
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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
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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
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Stakeholder power
Organisation 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 organisation
e.g. labour, finance, influential media, ability to legislate, ability to influence consumption of the organisations goods and services
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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
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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
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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
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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
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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
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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
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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
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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
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Mimetic isomorphism
Organisations 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
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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
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Normative isomorphism
Pressures 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
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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
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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
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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
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CH 08

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Financial Accounting Theory Craig Deegan

Learning objectives (cont.)

Political Economy Theory

Political Economy Theory (cont.)

Classical Political Economy Theory

Bourgeois Political Economy Theory

Legitimacy versus legitimation

Implications of not meeting social contract

Actions to legitimise activities

Communication to maintain legitimacy

Role of public disclosure

Empirical tests of Legitimacy Theory

Examples of empirical studies

Examples of empirical studies (cont.)

Examples of empirical studies (cont.)

Examples of empirical studies (cont.)

Examples of empirical studies (cont.)

How management determines societys expectations

Legitimacy Theory versus Positive Accounting Theory

Many similarities between Legitimacy Theory and Stakeholder Theory

Ethical branch of Stakeholder Theory

Ethical branch of Stakeholder Theory (cont.)

Primary versus secondary stakeholders

Accountability involves two responsibilities

Reporting is assumed to be a responsibility rather than demand driven

Testing of ethical branch of theory

Managerial branch of Stakeholder Theory

Managerial branch of Stakeholder Theory (cont.)

Expectations of stakeholders considered to impact on operating and disclosure policies

Stakeholder power (cont.)

The role of information

Examples of empirical studies

Neu, Warsame and Pedwell (1998)

Ethical view versus managerial view

Provides a complimentary perspective to both legitimacy theory and stakeholder theory

Institutional Theory (cont.)

Isomorphism and decoupling

Mimetic isomorphism (cont.)

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