Financial Accounting Theory
Craig Deegan
Chapter 8
Unregulated corporate reporting decisions:
considerations of systems-oriented theories
Slides written by Craig Deegan and Michaela
Rankin
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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 entity’s 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 organisation’s 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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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
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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
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Examples of empirical studies (cont.)
• 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 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)
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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 organisation’s objectives, or
is affected by the achievement of an organisation’s
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 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
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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
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
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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 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
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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
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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 practices—non-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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