FINANCIAL ACCOUNTING THEORY
Craig Deegan
CHAPTER 8
Unregulated corporate reporting
decisions: considerations of
systems-oriented theories
Slides written by Craig Deegan
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Learning objectives
8.1 Understand how community or stakeholders’ perceptions
can influence the disclosure policies of an organisation and,
conversely, how corporate disclosures can influence
community and stakeholder perceptions.
8.2 Understand the fundamentals of Legitimacy Theory,
Stakeholder Theory and Institutional Theory and appreciate
that these theories have much in common with each other.
8.3 Understand that the above theories are, in large part,
derived from Political Economy Theory, and that Political
Economy Theory can be considered as having two
branches.
8.4 Understand how Legitimacy Theory, Stakeholder Theory and
Institutional Theory can be applied to help explain why an
entity might elect to make particular voluntary disclosures.
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Learning objectives (cont.)
8.5
Understand what we mean by ‘organisational legitimacy’ and
how corporate disclosures within such places as annual
reports and corporate websites can be used as a strategy to
maintain or restore the legitimacy of an organisation.
8.6
Understand that the legitimacy attributed to an organisation
can change across time and understand how corporate
disclosures can be used as a means of establishing,
maintaining or repairing legitimacy.
8.7
Understand how, pursuant to Stakeholder Theory, the
respective power and information demands of particular
stakeholder groups can influence corporate disclosure
policies.
8.8
Understand that Stakeholder Theory can be considered as
having an ethical branch and a managerial branch.
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Learning objectives (cont.)
8.9
Understand that corporate disclosure of information can be
used as a means of managing powerful stakeholder groups.
8.10
Understand the view that a successful organisation is one
that is able to balance or manage the demands (sometimes
conflicting), including information demands, of different
stakeholder groups.
8.11 Understand that institutional pressures exist that cause
organisations to take on organisational forms and practices
that are considered ‘legitimate’.
8.12 Understand that due to institutional pressures there can be a
‘decoupling’ between the way an organisation appears to be
operating and how it is actually operating.
8.13 Be aware of some of the limitations of the theories discussed
in this chapter.
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Systems-oriented theories
• Legitimacy Theory, Stakeholder Theory and
Institutional Theory – the theories we discuss in this
lecture – are all systems-based theories
• These theories focus on the role of information and
disclosure in the relationships between
organisations, the State, individuals and groups
• The entity is perceived as being influenced by, and
influences, the society in which it operates
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The organisation viewed as
part of a broader social system
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Political Economy Theory
• Legitimacy Theory, Stakeholder Theory and Institutional
Theory are derived from Political Economy Theory
• The political economy is ‘the social, political and economic
framework within which human life takes place’ (Gray, Owen
& Adams 1996, p.47)
• The argument is that economic issues cannot be investigated
in the absence of considering the political, social and
institutional framework within which economic activity takes
place – must all be considered within ‘context’
continued
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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
generally derive from this branch
• Does not question or study the various class
structures within society
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Legitimacy Theory
• Legitimacy Theory is a widely used theory
• Within Legitimacy Theory, organisations seek to ensure they
operate within the bounds and norms of their respective
societies
– that is, they want their activities to be perceived as
‘legitimate’
• Bounds and norms are not static so require organisation to be
responsive
• Legitimacy Theory (and Stakeholder Theory and Institutional
Theory) can be used to help explain why an entity might elect
to make particular voluntary disclosures
• Accounting disclosures are a strategy used by the firm to
manipulate the firm’s relationships within the social system
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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
• Legitimacy theorists often rely upon the notion that
there is a ‘social contract’ between the organisation
and the society in which it operates
continued
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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 perceived
legitimacy
• Information disclosure is vital to establishing
corporate legitimacy
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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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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.
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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 – which is
often considered as being the same as being
‘legitimate’
• 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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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
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Phases of legitimation
Three broad phases are often identified by researchers,
these being:
•gaining legitimacy phase
– ‘liability of newness’
– acceptance of community won through communication
•maintaining legitimacy phase
– need to anticipate changing community perceptions
– the more the organisation ‘trades’ on its legitimacy, the
more important it is that the organisation protects it
•repairing (defending) lost legitimacy phase
– often a reactive process to unforseen crises
– much of the legitimacy theory-related research relates to
this phase
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Actions to legitimise activities
• Dowling and Pfeffer (1975) suggest the following
strategies when legitimacy has been threatened:
– 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
• Consistent with Dowling and Pfeffer’s strategies,
Lindblom (1993) suggests a number of strategies
managers might adopt when legitimacy is threatened:
– 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
• Again, public disclosure of information is an important
element of all of the above strategies
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Abandonment of legitimising
efforts
• There might come a time where legitimising efforts
are deemed to be of limited use
• Consider Tilling and Tilt’s (2010) research of
Rothmans Australia – a tobacco manufacturer
• There came a point where legitimising efforts were
abandoned
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Phases of the legitimation process
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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 legitimation strategies
• This is a 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
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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, and often,
to explain changing patterns of 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
continued
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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 ‘positive’ environmental
information than a matched sample of non-prosecuted firms
continued
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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
continued
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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
• 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
continued
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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
continued
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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 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
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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
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The difference between
legitimation and accountability
• If a company makes disclosures because of
concerns about its legitimacy then the disclosures
are effectively being motivated by survival or
profitability considerations rather than by a desire to
demonstrate greater accountability
• There is much evidence to suggest that many
corporate disclosures are a legitimation device and
not an accountability mechanism
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Issues not currently addressed
by Legitimacy Theory
• Legitimacy Theory is a very widely used theory, particularly in
the social and environmental accounting area.
• Because of its widespread use it is relevant to consider some
of the ‘apparent gaps’ in the theory
• Gaps include:
– A lack of detail about how ‘legitimacy’ can be measured
 This would be a subjective exercise. Perhaps consider the flow of
resources to the organisation as a ‘proxy’ for legitimacy
continued
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Issues not currently addressed by
Legitimacy Theory (cont.)
– What disclosures are more effective in the legitimation
process?

To date, relatively little insight has been provided into the type of
disclosures that are most effective in establishing, maintaining, or
repairing legitimacy. More theoretical development is necessary.

What medium of disclosure is most effective in legitimising the
organisation?

Do different stakeholders react differently to different types of
disclosures, or disclosures provided in different media?

Which social groups actually confer legitimacy?
• Assumes that disclosure strategies are driven by self interest
– a simplistic assumption
– certain actions become institutionalised rather than be driven by
legitimation strategies
continued
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Issues not currently addressed by
Legitimacy Theory (cont.)
• Researchers who apply Legitimacy Theory typically do not
consider actions that are aimed at legitimising the broader
social system
– A predominant focus on organisational-level legitimacy. More
attention should be given to efforts to legitimise broader social
systems. According to Archel et al (2009):
...researchers should think more broadly about the legitimation
strategies undertaken by organisations. Whilst disclosure strategies
might be undertaken to inform, educate or even manipulate society
in a manner intended to provide legitimacy to the organisation,
researchers should also consider whether the disclosures might
have a broader impact in terms of efforts to legitimise particular
economic, social and political systems that potentially undermine the
interests of particular stakeholders (such as employees).
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Stakeholder Theory
• We will now turn our attention to Stakeholder Theory
• There are two broad branches of Stakeholder
Theory, these being the:
– ethical (moral) or normative branch
– positive (managerial) branch
• There are 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 (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
continued
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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
• 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)
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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)
• 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)
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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 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 investorowned corporation on the basis of some underlying moral or
philosophical principles.
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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
continued
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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
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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
continued
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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 are 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) are
responsive to the expectations of multinational buying companies,
with the multinational buying companies in turn being responsive
to the expectations of Western consumers (whose expectations
about working conditions, child labour, and so on – which are
unobtrusive events – are influenced by the Western media)
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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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Diagrammatic representation of differences between the
ethical and managerial branches of Stakeholder Theory
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Institutional Theory
• The last theory we will consider in this lecture is Institutional
Theory.
• Institutional Theory provides an explanation about why
organisations tend to take on similar characteristics, form and
processes (including similar reporting practices)
• 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 – the
meaning of ‘institution’
• According to Scott (2008):
– Institutions are comprised of regulative, normative and
cultural-cognitive elements that, together with associated
activities and resources, provide stability and meaning to
social life.
• Meyer, Boli, and Thomas (1987, p. 13) provide a
slightly different meaning of ‘institution’ but one
which is consistent with the above definition:
– We see institutions as cultural rules giving collective
meaning and value to particular entities and activities,
integrating them into larger schemes.
continued
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Institutional Theory (cont.)
• The theory links organisation practices to societal
values
• Organisational form tends towards some form of
homogeneity
– ‘deviants’ will have problems gaining or maintaining
legitimacy
– Certain ways ‘of doing things’ are seen as legitimate – they
become ‘institutionalised’
– Once process become institutionalised they effectively
become ‘beyond the discretion of individuals and
organisations’
continued
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Institutional Theory (cont.)
• Formal organisational structures and practices might be
considered by society as legitimate
• However, this does not necessarily mean they are the most
efficient choice in terms of technical efficiency
• Organisations conform to institutionalised approaches (also
referred to as ‘myths’ within the literature) by building gaps or
‘buffers’ between the formal structures which people see (the
‘myths’ that maintain legitimacy) and the actual work processes
that create internal functional and technical efficiency (Meyer and
Rowan, 1977)
• The formal structures and procedures of an organisation – which
are the structures and procedures projected to others – reflect the
rationalised institutional rules of the wider institutional
environments in which organisations operate
• The status of an organisation’s legitimacy reflects the ‘social fit’ of
the organisation within its environments
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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,
including their reporting practices
• Consider how the World Bank has been able to
influence reporting practices in developing countries
(Neu and Ocampo 2007)
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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
continued
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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’
• Again, provides a rationale for why reporting
approaches, and other corporate processes, tend to
take on similar form
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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
• Sometimes a joint consideration of different theoretical
perspectives can provide a more holistic understanding of
particular practices
• With Chapters 7 and 8 in mind we can see that we have a variety
of different insights into why management might voluntarily elect
to make particular disclosures or to embrace particular
organisational forms
• However, it should also be appreciated that there are a number of
other theories ‘out there’ that we have not discussed which also
provide insights into what motivates managers to undertake
particular activities, inclusive of reporting
• Researchers therefore have much choice when selecting
amongst competing theories
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