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Unformatted text preview: ACCT3003 Issues in Accounting Theory 2009 Topic 8: Social and environmental reporting Solutions to topic review questions 9.1 9.4 This is an interesting question and one that has certainly raised much debate in the past. To answer it we possibly need to firstly consider how we would define accounting. If our definition of accounting is restricted to providing information about the financial performance of an entity to individuals that primarily have a financial interest in the organisation then we might argue that the environment has limited relevance to accounting other than if particular cash flows relate to the use or abuse of the environment (for example, fines for misuse, purchase or sale of pollution permits, recognition of contingent liabilities in relation to clean‐ups, and so on). However, once we accept that organisations are accountable for not only their economic, but also their social and environmental performance then the role of accounting in fulfilling this accountability becomes relevant. In this sense we are directly relating the practice of accounting with the notion of accountability. In doing so we can rely on the perspective of accountability provided by Gray, Owen and Adams (1996, p. 38), this being the duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible. Hence, adopting this broader perspective which links accounting with accountability we can argue that if stakeholders expect an organisation to take certain actions (or perhaps, to refrain from taking particular actions) then that organisation has a responsibility to provide information (an account) to enable others to determine whether the expectations have been met. Therefore, if we accept that many people within society expect an organisation to be accountable for its environmental performance, and to act responsibly, then the role of the accounting system should become apparent. Accounting does not have to be confined to the provision of financial accounting alone, and the audience should not be narrowly defined as just including shareholders. Arguably, conventional financial accounting practices discourage us from embracing sustainable business practices. There are a number of reasons for this, including the following. Issues in Accounting Theory 2009 Solutions: Topic 8 1 The accountants’ notion of materiality tends to preclude the reporting of social and environmental information. As highlighted in Gray, Owen and Adams (1996), another issue that arises in financial accounting is that reporting entities frequently discount liabilities, particularly those that will not be settled for many years, to their present value. This tends to make future expenditure less significant in the present period. This has particular relevance to future ‘clean‐up costs’ and remediation costs. Financial accounting adopts the ‘entity assumption’, which requires the organisation to be treated as an entity distinct from its owners, other organisations, and other stakeholders. If a transaction or event does not directly impact on the entity, the transaction or event is to be ignored for accounting purposes. This means that the externalities caused by reporting entities will typically be ignored, thereby meaning that performance measures (such as profitability) are incomplete from a broader societal (as opposed to a ‘discrete entity’) perspective. In financial accounting and reporting, expenses are defined in such a way as to exclude the recognition of any impacts on resources that are not controlled by the entity (such as the environment), unless fines or other cash flows result. For example, under the International Accounting Standards Board’s conceptual framework (as discussed in Chapter 6), expenses for financial reporting purposes are defined as: … decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. (Paragraph 70b) An understanding of expenses therefore requires an understanding of assets. Assets are defined as resources ‘controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (paragraph 49a, emphasis added). The recognition of assets therefore relies upon control, and hence environmental resources such as air and water, which are shared and therefore not controlled by the organisation, cannot be considered as ‘assets’ of that organisation. Thus their use, or abuse, is not considered as an expense. There is also the issue of ‘measurability’. For an item to be recorded for financial accounting purposes it must be measurable with reasonable Issues in Accounting Theory 2009 Solutions: Topic 8 2 accuracy. As paragraph 83 of the IASB Framework for the Preparation and Presentation of Financial Statements states: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability. Trying to place a value on the externalities caused by an entity often relies on various estimates and ‘guesstimates’, thereby typically precluding their recognition from the financial accounts on the basis of the potential inaccuracy of the measurement. Taken together, the above limitations of financial accounting do tend to indicate that financial accounting practices do not provide an ‘ideal’ vehicle to encourage corporations to embrace sustainable business practices. Economic rationality as defined by economists and many accounting researchers is generally accepted as meaning to undertake activities that maximise one’s own wealth. It is very much related to self‐interest and takes the attitude that one cannot ever have too much wealth. As should be clear, economic rationality as briefly defined above, and sustainability, are mutually inconsistent. Consideration of one’s own self‐ interest and the pursuit of continually increasing profits or wealth (which in turn are associated with more and more consumption) cannot be sustained indefinitely. It is generally accepted that what might be described as economically rational behaviour is totally irrational when it comes to trying to solve the ongoing environmental and social problems of the planet. The Brundtland Report defined sustainable development as ‘development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’. Any move towards sustainable development, as defined in the Brundtland Report therefore requires that something other than short‐term self‐interest should drive decision making. It implies that wealth creation for current generations should not be held as the all‐consuming pursuit, and that consumption and personal wealth creation by us (now), while perhaps being considered as economically ‘rational’ (using the definition often applied in the economics literature) is not necessarily rational from a global and intergenerational perspective. Hence, the quest towards sustainable development ultimately relies upon people not being driven solely by their own self‐interest, and not putting wealth creation above all else. If we believed the assumptions embraced by Positive Accounting Theorists, as 3 9.5 9.6 Issues in Accounting Theory 2009 Solutions: Topic 8 described in Chapter 7, that all action is driven by self‐interest then there would be little hope that people will ever consider the needs of future generations. Perhaps we need to hope that the assumptions of PAT theorists are not always right? The advocates of PAT would only believe that the managers of organisations would embrace sustainable development if it was in the direct interests of the managers to do so (often referred to as ‘enlightened self‐ interest’). 9.7 Externalities can be defined as impacts that an entity has on parties (not necessarily restricted to humans) external to the organisation, parties which typically have no direct relationship with the organisation. Financial accounting practices can tend to ignore externalities because of the way the elements of financial accounting are defined, and because accounting adopts an entity assumption. In relation to the entity assumption adopted within financial accounting, this assumption requires the organisation to be treated as an entity distinct from its owners, other organisations and other stakeholders. The implication is that if a transaction or event does not directly impact on an entity, the transaction or event is to be ignored for accounting purposes. This means that the externalities caused by reporting entities will typically be ignored, thereby meaning that performance measures are incomplete from a broader societal perspective. In relation to the definition of the elements of accounting, definitions of assets and expenses as provided in various conceptual framework projects throughout the world (and as developed by the IASB) rely upon a notion of control. For example, in the IASB Framework assets are considered to be resources ‘controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity’ (paragraph 49a, emphasis added). If something is not controlled, such as the waterways, the air, the local national parks, then it is not considered to be an asset. As such, any reduction in the quality of the ‘public’ resource will not be considered an expense of an entity (unless there are some associated cash flows, for example, environmental fines). Also, local communities are not ‘assets’ of an entity from a financial accounting perspective and hence any health problems caused to them by the entity’s operations will typically be ignored (unless, again, some legal action has been instigated). Such externalities caused by the reporting entity will be ignored. As indicated in Deegan (1996), and using a rather extreme example, under traditional financial accounting if an entity was to destroy the quality of water in its local environment, thereby killing all local sea creatures and coastal Issues in Accounting Theory 2009 Solutions: Topic 8 4 vegetation then to the extent that no fines or other related cash flows were incurred, reported profits would not be directly impacted. No externalities would be recognised and the reported assets/profits of the organisation would not be affected. 9.11 It has been argued by some authors that the concept of the triple bottom line is severely restricting as, firstly, the term bottom line conveys the impression of something which can be measured in a single number. The economic profit figure is the summation, in a common currency, of all the income and expenses figures over a period of time. Brown, Dillard and Marshall (2005) demonstrate that it is highly problematic, and probably impossible in practice, to reduce all environmental impacts, or all social impacts, to a common currency. Secondly, the economic bottom line is commonly understood among managers as being a metric which should be maximised. Brown, Dillard and Marshall (2005) argue that it is difficult to apply this objective of maximisation to nature. While there could be agreement on maximising a factor such as biodiversity, there is no commonly accepted understanding of what this might mean and how it could be measured. Even more problematic is knowing which social metric should be maximised. Thus, attempting to equate the notion (and management) of the bottom lines of social and environmental with the more conventional economic bottom line is not possible in practice. Therefore attempting to report upon, or manage, all three bottom lines in a common manner is not appropriate. Thirdly, if it is not possible to adopt metrics that treat each of the bottom lines equally, then the notion of three separate bottom lines might give the impression that the economic, social and environmental are not interconnected. Many people believe this would be a fundamental misconception, and from a social and environmental sustainability viewpoint could be highly damaging. Hence, from the above discussion, it is questionable whether triple bottom line can lead to separate and meaningful bottom lines for social, environmental and economic performance. 9.12 While it is true that many accountants would not have given any consideration to the notion of sustainable development, it is nevertheless an issue that is of direct relevance to the accounting profession. Moves towards sustainable development (accepted by many to be a global imperative) Issues in Accounting Theory 2009 Solutions: Topic 8 5 require new systems of providing information—and accountants are very well placed to be involved with this. In many countries, issues associated with sustainable development have led to the introduction of various community‐based initiatives. For example, the requirements being introduced around the world to measure and report carbon‐related emissions. Accountants are getting involved in measuring, reporting and verification issues associated with carbon emissions. They are also getting involved with issues associated with the recognition and valuation of tradeable pollution permits. As sustainable development becomes more of a priority and concern for the community, it is expected that there will be increased demand for information about entities’ social and environmental performance (two components of sustainability, the other one being financial performance), and firms will be expected to react to this concern, or else risk being in breach of their ‘social contract’. Accountants are already reacting to this increasing demand. Throughout the world professional accounting bodies have established taskforces to address the issues, and the major accounting firms (for example, the ‘Big 4’) typically have special divisions which consider social and environmental accountability and reporting issues. As a further indication of the relevance of sustainability‐related issues to the accounting profession, many accounting education programs within universities and other educational institutions are explicitly considering social and environmental issues. Your institution must be considering the issue given that you have just read this answer! 9.14 A number of chapters in the textbook provide reasons why management typically prefers to be able to select its own methods of accounting, rather than being subject to mandated reporting requirements. Some arguments are based on an efficiency perspective, while other arguments are based on an opportunistic perspective. If we are to adopt an efficiency perspective, perhaps management prefer to have the option to select those methods of reporting which best reflect the underlying social and environmental performance of the entity, rather than having particular methods imposed upon them. From an opportunistic perspective, perhaps the managers would rather have the option to select those disclosures which provide the most favourable position of the organisation’s social and environmental performance. Currently, the reporting of social and environmental performance information is overwhelmingly voluntary. While many entities state that they are embracing Issues in Accounting Theory 2009 Solutions: Topic 8 6 the Global Reporting Initiative’s Sustainability Reporting Guidelines, evidence indicates that many organisations select those items of disclosure within the GRI Guidelines which provide the most favourable representation of the organisation’s performance—consistent with an opportunistic perspective. 9.17 (a) Positive Accounting Theory predicts that all individual action is ‘economically rational’—that is, the decision to undertake certain activities, such as report, is based on self‐interest tied to the goal of wealth maximisation. Hence, managers will elect social responsibility disclosures to the extent that it increases the value of the organisation. Managers would be motivated to do this as a result of various mechanisms that align the interests of the manager with increasing firm value, such as profit‐sharing bonus schemes, holding shares in the firm, the market for managers, and the market for corporate takeovers (these mechanisms are discussed in Chapter 7). Research which has adopted the PAT paradigm has suggested that social responsibility disclosures are made to reduce the political visibility that the firm is subject to, and hence, to reduce the wealth transfers that are associated with political scrutiny. (b) Legitimacy Theory predicts that firms will undertake various actions to ensure that they operate in a manner consistent with the norms and expectations of the community in which they conduct their operations. That is, that they comply with the terms of the ‘social contract’ (the theoretical notion of a social contract is discussed in Chapter 8). Hence, various social responsibility disclosures will be made in an effort to make legitimate the ongoing existence of the organisation. If it is considered that the community does not expect the firm to make social and environmental disclosures (that is, it is not part of the social contract), then no disclosures will be made. As the chapter indicates, where the legitimacy of an organisation has been brought into question (perhaps as the result of a major environmental accident or event), corporate management often use media such as the annual report in an effort to restore legitimacy. (c) As Chapter 8 explains, there are two branches of Stakeholder Theory—the managerial branch and the ethical (or normative, or moral) branch. Under the managerial branch, disclosures are used as one strategy to control the actions of powerful stakeholders. Powerful stakeholders are often considered as those parties who have resources which are important to the ongoing survival of the organisation. Under this perspective, it is the needs of the powerful Issues in Accounting Theory 2009 Solutions: Topic 8 7 stakeholders that are attended to over and above the needs of other parties affected by the entity’s operations. If the powerful stakeholders expect social responsibility disclosures then the firm is predicted to make them. By contrast, under the ethical or normative branch of stakeholder theory there is a view that disclosures are responsibility driven and that all stakeholders that are impacted by the operations of the entity have a right to information about its operations (the notion of right‐to‐know). Hence, under this perspective, social responsibility disclosures are made in response to an ethical responsibility, rather than in response to any desire to maximise wealth or to appease particular, powerful parties. (d) As Chapter 8 indicates, institutional theory provides a number of reasons why corporations might make corporate social responsibility disclosures. There is a view that organisational form and practices might tend towards some form of homogeneity—that is, the structure of the organisation and the practices adopted by different organisations tend to become similar to conform with what is considered to be ‘normal’. Organisations that deviate from being of a form that has become ‘normal’ or expected will potentially have problems in gaining or retaining legitimacy. There are two main dimensions to Institutional Theory. The first of these is termed Isomorphism while the second is termed Decoupling. Both of these can be of central relevance to explaining voluntary corporate reporting practices. The term ‘isomorphism’ is used extensively within institutional theory and DiMaggio and Powell (1983, p. 149) have defined it as ‘a constraining process that forces one unit in a population to resemble other units that face the same set of environmental conditions’. That is, organisations that adopt structures or processes (such as reporting processes) that are at variance with other organisations might find that the differences might attract criticism. DiMaggio and Powell (1983) set out three different isomorphic processes. These three isomorphic processes are referred to as coercive isomorphism, mimetic isomorphism and normative isomorphism. Pursuant to coercive isomorphism, organisations will only change their institutional practices because of pressure from those stakeholders upon whom the organisation is dependant. This form of isomorphism is related to the managerial branch of Stakeholder Theory whereby a company will use ‘voluntary’ corporate reporting disclosures to address the economic, social, environmental and ethical values and Issues in Accounting Theory 2009 Solutions: Topic 8 8 concerns of those stakeholders who have the most power over the company. The company is therefore coerced (in this case usually informally) by its influential (or powerful) stakeholders into adopting particular voluntary reporting practices. Because these powerful stakeholders might have similar expectations of other organisations as well, there will tend to be conformity in the practices being adopted by different organisations—institutional practices will tend towards some form of uniformity. Mimetic isomorphism involves organisations seeking to emulate (perhaps copy) or improve upon the institutional practices of other organisations, often for reasons of competitive advantage and in terms of legitimacy. When an organisation encounters uncertainty then it might elect to model itself on other organisations. There are links between the pressures for mimetic isomorphism and pressures underlying coercive isomorphism. Unerman and Bennett (2004) maintain that without coercive pressure from stakeholders there would be unlikely to be pressure to mimic or surpass the social reporting practices (institutional practices) of other companies. Normative isomorphism relates to the pressures arising from group norms to adopt particular institutional practices. In the case of corporate reporting, the professional expectation that accountants will comply with accounting standards acts as a form of normative isomorphism for the organisations for whom accountants work to produce accounting reports (an institutional practice) which are shaped by accounting standards. In terms of voluntary reporting practices, normative isomorphic pressures could arise through less‐ formal group influences from a range of both formal and informal groups to which managers belong—such as the culture and working practices developed within their workplace. These could produce collective managerial views in favour of or against certain types of reporting practices, such as collective managerial views on the desirability or necessity of providing a range of stakeholders with social and environmental information through the medium of corporate reports. Turning to the other dimension of Institutional Theory, decoupling implies that while managers might perceive a need for their organisation to be seen to be adopting certain institutional practices, and might even institute formal processes aimed at implementing these practices, actual organisational practices can be very different to these formally sanctioned and publicly pronounced processes and Issues in Accounting Theory 2009 Solutions: Topic 8 9 practices. Thus, the actual practices can be decoupled from the institutionalised (apparent) practices. In terms of voluntary corporate reporting practices, this decoupling can be linked to some of the insights from Legitimacy Theory whereby social and environmental disclosures can be used to construct an organisational image very different from actual organisational social and environmental performance. Thus, the organisational image constructed through corporate reports might be one of social and environmental responsibility when the actual managerial imperative is maximisation of profitability or shareholder value. 9.24 Arguably, it would only be misleading to those people who wrongly believe that financial accounting practices generate a calculation of profit or loss that incorporates an estimate of the costs associated with the social and environmental externalities created by an organisation (and perhaps there are many such people who have this belief, meaning that financial accounting is potentially very misleading). For those people who are knowledgeable in respect of financial accounting, the profit figure would not be misleading as they know that financial accounting typically ignores the social and environmental externalities caused by an organisation. Such people would know that information about the environmental impacts of a corporation would need to be obtained from sources other than financial statements. Hence, in summary, the profits shown for an organisation may be misleading for some people, but not to others who are knowledgeable in relation to financial accounting. Nevertheless, because financial accounting does not recognise the expenses associated with the environmental damage being done (unless there are associated cash flows, for example relating to fines), financial accounting might act to provide information (for example, profit disclosures) that cause various stakeholders to support the organisation thereby allowing it to remain in business (and to continue causing environmental damage). In a sense, if an organisation is shown to be generating record profits then this might legitimise the operations of the organisation. Because the accountant fails to identify the ‘costs’ associated with the damage being done (and there are various experimental approaches that could be used to measure the externalities of the organisation), the existence of such costs typically fails to be recognised by most stakeholders. In effect, the accountant acts to create a certain ‘reality’ in terms of what revenues and expenses are measured and therefore are visible and subject to some form of public scrutiny or monitoring. Issues in Accounting Theory 2009 Solutions: Topic 8 10 As a side issue, students might want to consider whether a change in financial accounting practices is necessary in assisting any quests towards more ecologically sustainable business practices. The BBC would not directly account for the job losses it creates other than by showing a subsequent decrease in salary costs. The social costs brought about by many people being out of work would not be recognised within the financial reports of BBC. In adopting the entity assumption, such social costs incurred by other parties will not be recognised unless they have direct cash flow consequences for the reporting entity. 9.28 Whether we believe that it is a limitation of financial accounting that BBC can record an increase in profits at the same time that other stakeholders—past employees—are negatively impacted is a matter of opinion. Certainly the way our system of financial accounting has been developed is to encourage the minimisation of expenses—which includes payments to employees—and to maximise the ability of the company to make dividend payments to shareholders. As Collison (2003, p. 7) states: Financial description of the factors of production in the business media, and even in textbooks, makes clear that profit is an output to be maximised while recompense to labour is a cost to be minimised. Furthermore, a high cost of capital may be described as an exogenous constraint on business, rather than as an indication of the size of resource flows to providers of capital. Financial Times contributors are fond of words like ‘ominous’ to describe real wage rises: such words are not used to describe profit increases. As Chapter 12 discusses, some accounting researchers whom we refer to as critical theorists consider that our whole system of accounting acts to support the interests of those with power (often proxied by financial wealth), and to undermine others (such as employees). Promoting performance indicators such as ‘profits’ will, it is argued, maintain the ‘favoured’ position of those in command of financial resources. 9.29 (a) The reason that tobacco companies can report large profits at the same time that their profits are causing many health problems throughout society is because generally accepted financial accounting practices ignore the social and environmental externalities caused by an organisation. The fact that many people will be come ill and need medical treatment (which will be subsidised by the government) as a Issues in Accounting Theory 2009 Solutions: Topic 8 11 result of using the organisations’ products does not mean that any costs will actually be recognised by the organisations. In large part this is because of the way financial accounting defines assets and expenses – both of which rely upon the notion of control. Further, financial accounting adopts the entity principle which means that impacts upon customers are ignored, unless the organisations are fined or decide to take responsibility for the health impacts caused by their products. This emphasises that financial accounting provides a very incomplete (and perhaps misleading?) picture of an organisation’s contribution to society. (b) The chapter has briefly considered some of the experimental approaches used to place a cost on the externalities caused by business entities (often referred to as ‘full‐cost accounting’). One approach to recognising the costs associated with their products would be to use various estimates of the likelihood of each customer developing health problems and then estimating the associated costs. Such estimates would be based on various medical research studies and would rely upon many estimates. The associated cost might then be deducted from accounting profit (as determined through accounting standards) to give some measure of sustainable profit (although, perhaps we can question whether a tobacco company could ever be deemed to be sustainable). Such an approach would represent a significant departure from current accounting practice. Another approach, which would not represent a significant departure from current accounting practices, would be for the tobacco companies to provide their conventional profit or loss calculation but to explicitly highlight that the profit or loss ignores the health implications of their products. In a supporting note they could they could then provide various statistics about the health impacts of tobacco and the costs incurred in treating the problems at various points and places in society. In it is interesting to note that companies such as British American Tobacco Australia do release social reports, and sustainability reports, which are available on their websites. Students should consider reviewing such reports and seeing how transparent the organisations are actually being in relation to the social impacts of their operations ‐ a thought‐provoking exercise. Obviously there could be a multitude of ways that could be used to place a notional cost on the damage being caused by the producers of 12 Issues in Accounting Theory 2009 Solutions: Topic 8 tobacco products, or to provide information about the impacts caused by tobacco. Whatever method is chosen, it can nevertheless be stated that a focus on profitability alone possibly provides a misleading picture of the performance of an entity. Issues in Accounting Theory 2009 Solutions: Topic 8 13 ...
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