What does the notion of legitimacy and social contract have to do with corporate disclosure policies?
In recent years, corporations have increasingly used their annual reports to voluntarily report information relating to their social actions, particularly those concerning the natural environment (Gray et al.1995). More specifically, corporations have been changing their disclosure policy towards the “triple bottom line reporting”, where in addition to economic performance, social and environmental issues of the company’s performance are given (Deegan 2002).
This has drawn the attention of researchers, and a number of theories have been postulated as to why companies disclose such information. According to Deegan and Rankin (1999), there is increasing evidence that the willingness to make such disclosures may be motivated by an intention to moderate the perceptions of the corporation which are held by important groups within society. Furthermore, organisations might use the disclosures as a defend policy when the organisation’s legitimacy is in threat (ibid).
In this study, we will focus on the role of social contracts and organisation legitimacy, and how can these aspects influence managers’ policies to corporate reporting. We will first examine the underlying literature of legitimacy theory and social contracts. This will help us understand the importance and the role of social contracts that act as a motivation for managers to voluntary disclose information, and its ability to influence such disclosures. At a later point, we will give empirical evidence supporting (or criticising) our findings.
Legitimacy theory and social contract
Researchers have adapted the “system-oriented theories” to address the issue of corporate disclosures. The system-oriented theory, as explained by the Legitimacy theory and Stakeholder theory, argues that the organisation is influenced and has influence upon the society it operates. Both Legitimacy and Stakeholder theory derive from a broader perspective of political economy theory. As Deegan(2002) explain, political economy theory does not consider company’s reports as neutral and biased documents, but rather as a product of the interchange between the corporation and its environment in an attempt to reconcile and accommodate a variety of sectional interests (Deegan, 2000).
Similar to the legitimacy theory, stakeholder theory supports the same view of the relationship between legitimacy and corporate disclosures. The theory suggests that expectations of various stakeholders will have an effect on the disclosure policies of the company. Different groups will have different views about how the company should operate, and each group will have a different impact on the company. Therefore, the company will not respond to all the stakeholders equally, but rather paying more attention to the more powerful groups. Due to their similarity, Deegan (2002) argues that the two theories should not be treated independently.
Under the notion of legitimacy theory, organisations attempt to establish congruence between the social values associated with or implied by their environmental activities, and the norms and values of the society in which they are part (A. Savage 1998). These bounds and norms are not considered to be fixed, but rather change over time. Therefore, organisations need to be responsive to the environment in which they operate (Deegan 2002).
A “social contract” exists between the organisation and the society in which it operates. The social contract is used by the society to represent their implicit and explicit expectations of how the organisation should conduct its operations. Traditionally, the firm’s profit was considered to be the measure of the organisations legitimacy (Ramanathan 1976). However, over the past decades public expectations have changed, and more attention is given to social issues. It is expected that companies should repair or prevent damage to physical environment, ensure health and safety of consumers and employees.
According to Mathews (1996 p.26), “the society provides companies with their legal standing and the authority to own and use natural resources and to hire employees. The organisations have no natural right to these benefits, and in order to allow their existence, society would expect the benefits to exceed the costs to society”. The society allows the corporation to operate as long as it meets their expectations. Again considering the Legitimacy Theory, the organisation should consider the rights of the public at large, not merely those of its investors. If the company fails to meet these expectations, the society would react by imposing sanctions, for example legal restrictions or high taxes, fines, demand reduction of the company’s products, eliminating the supply for labour and financial capital top the business.
Heard and Bolce (1981) argue that with such high social expectations, a successful corporation would react and attend to the environmental and social consequences of their activities. Thus, organisations would take various actions to ensure that their operations are perceived legitimate. They will attempt to establish congruence between “the social values associated with or implied by their activities and the norms of acceptable behaviour in the larger social system of which they are part” (Dowling and Pfeffer, p.110).
M. Garcial-Ayuso et al. (1998) suggest three conditions to be fulfilled in order for legitimacy theory to represent a consistent basis for the analysis and understanding of environmental disclosures. Namely they are:
Corporate environmental reporting to be a result of public pressure
Some individuals from the public have valid concerns on the environmental performance of the company
The information provided by the company is biased and unreliable
Many different views are taken on the legitimising purposes of accounting. Puxty (1986) states that “by claiming to provide truth and open communication, social accounting mystifies social relations and legitimate power and domination. Consequently… accounting is not a desirable activity, as it is a means of sustaining the system circumventing its internal contradictions, and deserves the habermasian communication of the distorted communication” (Puxty 1986, p.105).
Taking a different view, Näsi et al. (1997) argue that a company’s performance is legitimate when it is socially accepted. Under this notion, accounting appears as a desirable activity, and it is the existence of legitimacy gaps that give a negative picture. D. Campbell et al. (2000) suggested that with regard to community disclosure, legitimacy gaps will be wider in those companies that are better known to society and that are more liable to have questions asked them by society. On the other hand, less well-known companies will have structurally lower social cost liabilities and will thus have less reason to enter into disclosure narrative with regard to community involvement.
Dowling and Pfeffer suggest a strategy of communication as a means to legitimize its activities. Through communication, the organisation can attempt to alter the definition of social legitimacy so that it conforms to the organisation’s present practises (Dowling and Pfeffer 1975). Moreover, through communication the organisation can attempt to become identified with symbols, values or institutions that have a strong base of legitimacy. Having this in mind, Lindblom(1994) proposed other strategies that the company can take if its legitimacy is under question. These strategies rely on the use of the external disclosures, which is the focus of our study. Lindblom’s strategies are:
Seek to educate and inform its(organisation) “relevant publics” about changes in the organisation’s performance and activities
Seek to change the perceptions of the “relevant publics”- but not change its actual behaviour
Seek to manipulate perception by deflecting attention from the issue of concern to other related issues through an appeal to, for example, emotive symbols
Seek to change external expectations of its performance
The above strategies have also been suggested by (Näsi et al., 1997: 301) as a means of reducing the legitimacy gap mentioned above.
Such strategies can be implemented through the annual reports, where the company communicates with the public. It is argued that annual reports are an important channel by which corporations communicate with interested members of society and they are considered to be a logical medium for communicating corporate attempts at legitimation of environmental activities (A. Savage 1998). Having these views in mind, we can see the strategic importance of financial statements and other related disclosures.
Once the legitimacy is gained, it is considered easy to maintain since it tends to be largely taken for granted (Ashforth & Gibbs, 1990). According to O’Donovan (2000) the real difficulty of the company to maintain its legitimacy is to identify the changes in public needs and wants over time. Organisations that do not keep up with the changes in social values run the risk of becoming isolated and not acting in respect to what the society may expect of them (ibid). Therefore, companies need to anticipate changes in the society and protect past accomplishments in order to maintain their legitimacy (Suchman, 1995).
Having seen the importance of disclosures as a strategy by companies to create congruence with social expectations, we now look at some case studies that address the issues discussed earlier.
Over the past two decades there has been a series of literature in the social accounting field that indicates a gradual increase in the amount of social disclosure appearing in company annual reports. Legitimacy theory has been employed by numerous researchers examining social and environmental reporting practices. The researchers tried to explain the existence of the disclosures as an attempt of managers to close legitimacy gaps (Lindblom, 1994) between society’s expectations and business practise or reputation. The majority of these studies have used only environmental disclosure as a category of social disclosure (e.g. Deegan &Rankin, 1996, Deegan &Gordon, 1996). On the other hand, community is relatively unexplored in comparison to environmental disclosure. According to Patten (1995), this may by partly due to difficulties for finding a measure system for social concern with regard to community issues. The extent to which companies are exposed to criticism or concern on social and environmental issues must vary by issue and area of concern, by sector, by company and over time.
The following studies of different companies examine the view of legitimacy theory in the disclosures of companies in several industries.
Patten (1992) examined the effect of the Alaska oil spill in the petroleum industry. Although the incident was from one company, Exxon Valdez, companies within that industry responded by increasing the amount of environmental disclosures in their annual reports. This was consistent with the legitimacy perspective, since the industry in the fear of social pressures, reacted to maintain its legitimacy in the eyes of the public.
In a study focusing on Australian companies from 1980 to 1991, 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. They found an increase of disclosure over time associated with environmental group membership. Moreover, similar to Patten’s findings mentioned above, they found a positive relation between environmental sensitivity of industry that the company belongs and the level of disclosure.
An interesting review of UK social and environmental disclosures by Gray, Kouhy and Lavers (1995) related the trends of the disclosures to Legitimacy Theory, with specific reference to Lindblom’s strategies. As observed by the authors, some firms of their sample in the need to change their performance used corporate social reporting to inform their relevant publics about this. Moreover, some companies considered being “dirty” and “irresponsible” attempted to alter perceptions of environmental performance and to distract attention from the central environmental issues. As we can see, the companies that were in threat of loosing their legitimacy reacted using Lindblom’s strategies. Therefore, companies are indeed concerned with social pressures and they use legitimisation strategies to justify their coexistence with the public and to continue their economic pursuits, which in turn allows for the organisation’s long term survival.
Neu et al. (1998) studied Canadian public company annual reports in the mineral extraction, forestry, oil, and chemical industries between 1982 and 1981. The authors suggested that organisations should use “a combination of acquiescence, compromise and defiance strategies within their environmental disclosures to respond to the concerns of relevant publics; further, the strategy adopted is influenced by the relative power of these publics” (Neu et al. 1998, p.279).
M. Garcia-Ayuso et al. study (1998) strongly suggests that Legitimacy Theory provides an appropriate framework for the explanation of environmental practices. The study of the environmental information disclosed by Spanish firms in the sample showed that environmental reporting is in response to external pressures and is generally selective, biased and apologetic. It is therefore suggested that such information does not give a true and fair view of the impact of environmental issues on the financial position of the firm. The writers take the view that it is unacceptable by managers, who are responding to stakeholders concerns on environmental issues, to disclose biased information intending to legitimise their performance and provide an illusory image of the firm’s environmental performance (M. Garcia-Ayuso et al. 1998).
The communication of the company to the public may not always take the form of the annual reports. In an Australian example a radio presenter was paid by companies to make positive comments for the firms’ operations. Deegan(2002) addresses the issue that managers used the radio broadcaster as an alternative strategy from disclosures within annual reports.
The study of BHP Ltd by Deegan, Ranking and Tobin (2002) found a strong association between the company’s disclosure policies and community concern. Consistent with the Media Agenda Theory, it was argued that media attention lead to increased community concern. The media did not really mirror the public priority concerns, but rather shaped them and influence public beliefs. The study showed that those issues emphasised by media were the ones mostly associated with corporate disclosures.
The empirical evidence supports the issues addressed at the earlier point of the study.
We have demonstrated the power of disclosure policies in shaping community concerns about what is considered legitimate in terms of corporate behaviour. However it is important to point out that there is increasing evidence to suggest that there are other and better ways to shape public concern and that is through increased press realises.
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