Financial Accounting Theory Craig Deegan Chapter 9 Extended

Financial Accounting Theory Craig Deegan Chapter 9 Extended systems of accounting—the incorporation of social and environmental factors within external reporting Slides written by Craig Deegan Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 1

Learning objectives • In this chapter you will be introduced to: various perspectives of the responsibilities of business – explanations of the relationship between organisational responsibility and organisational accountability – the relationship between accounting and accountability – various theoretical perspectives that can explain why organisations might voluntarily elect to provide publicly available information about their social and environmental performance – Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 2

Learning objectives (cont. ) some recent initiatives in social and environmental accounting – the concept of sustainable development and how organisations are reporting their progress towards the goal of sustainable development – the relationship between sustainability and eco-efficiency and eco-justice issues – some of the limitations of traditional financial accounting in enabling users of reports to assess a reporting entity’s social and environmental performance – Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 3

Introduction • In recent years there has been increasing discussion about sustainable development and triple bottom line (TBL) and sustainability reporting – TBL reporting is reporting that provides information about the economic, environmental and social performance of an entity Sustainability reporting represents a departure from sole economic focus that was traditional in external reporting • A review of the Global Reporting Initiative’s Sustainability Reporting Guidelines provides insight into the types of social, environmental and economic information that could be disclosed in a sustainability report • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 4

Introduction (cont. ) The terms sustainability reporting and TBL reporting are often considered to be synonymous • Strictly speaking however, sustainability reporting would require more than just TBL reporting and it would question three separate ‘bottom lines’ given sustainability would require social, economic and environmental aspects to be considered together • Sustainability reporting would also address specifically how current activities are impacting the abilities of future generations to satisfy their own needs. Current TBL reports do not address such issues • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 5

Responsibilities of business • Moves to provide information about social and environmental performance, whether through sustainability or TBL reports, implies management of these organisations consider they have an accountability for social and environmental performance, as well as economic performance – • not a view held universally Increasing community pressures for organisations to make a commitment to sustainable business practices, and corporate reporting is tending to respond to this pressure Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 6

Responsibilities of business (cont. ) • If sustainability becomes part of the expectations held by society, it must—consistent with legitimacy theory—become a business goal • Providing information about social and environmental performance will increase the trust a community has in the organisation Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 7

Sustainability • Brundtland Report placed sustainability on the business worldwide agenda • Sustainable development defined as: ‘… development that meets the needs of the present world without compromising the ability of future generations to meet their own needs’ (World Commission on Environment and Development, 1987) • Inter-generational and intra-generational equity central to the agenda Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 8

Sustainability (cont. ) • Should organisations be responsible for the sustainability of their business practices? • Will they embrace this responsibility in the absence of specific legislation? Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 9

How does an entity determine its responsibilities? • What do its relevant stakeholders consider business responsibilities to be? • Based on personal judgement of the management involved as to who are the relevant stakeholders • Has implications for the information disclosed • Perceived responsibility and accountability go hand in hand Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 10

Accountability • The duty to provide an account (not necessarily financial) or reckoning of those actions for which one is held responsible • Two responsibilities or duties responsibility to undertake certain actions – responsibility to provide an account of those actions – Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 11

To whom is business responsible? • Many organisations making public statements that responsibilities extend beyond shareholders to encompass communities in which they operate and society as a whole • If sustainability embraced then responsibility also owed to future generations • If an organisation accepts a responsibility for the sustainability of its business practices, then it should produce an account of its responsibilities— it should provide a sustainability report Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 12

Stages of sustainability reporting • Stage 1: Why report? – • Stage 2: To whom to report—who are the stakeholders? – • tied to managerial motivations for reporting—if motivations are based on managerial reasoning then disclosures could be aimed at powerful stakeholders Stage 3: What to report? – • relates to management’s motivations involves dialogue with identified stakeholders Stage 4: What format for the disclosures? We will consider each of these stages in turn. Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 13

Stage 1: Why report? Different accounting theories will provide alternative explanations about why an entity might decide to report social and environmental information • We should remember that most social and environmental reporting is voluntary (an interesting issue in itself given the high level of regulation for financial reporting), therefore we can use various positive theories to explain or predict the voluntary decision to report • As we appreciate, different theories make different assumptions and therefore will tend to give different explanation of the reporting phenomena • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 14

Theories to explain ‘why report? ’ social and environmental disclosure • Legitimacy Theory and social contract – • Stakeholder Theory – • disclosures linked to providing evidence that entity is complying with the expectations of society disclosure depends on expectations of powerful stakeholders if the managerial perspective of stakeholder theory is embraced Accountability Model – an acceptance of a responsibility to report Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 15

Theories to explain ‘why report? ’ social and environmental disclosure (cont. ) • Institutional Theory – • organisations will adopt particular practices because of institutional pressures Positive Accounting Theory – disclosure depends on positive wealth implications § consider submission of the Business Council of Australia on page 394 of the text Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 16

‘Why report? ’ and its links to views about the responsibility of business • Consider the views of Milton Friedman—reporting is not about responsibilities; rather, it is about enhancing business profitability • A broader view of business responsibilities would accept that regardless of the impacts of profitability, stakeholders have a right to know about the social and environmental implications of an organisation • Where do we think corporations sit in terms of the above views? Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 17

Differing views of business responsibility • Friedman rejected the view that corporate managers have any moral obligations – stated that ‘the business of business is business’ – responsibility to increase profits as long as stays within the rules – this view often held by the media—applauds profitable organisations – • Alternative view – – – organisations earn their right to operate in the community artificial entities that society chooses to create organisations do not have an inherent right to resources consequently accountable to society for how it operates societal expectations may exceed profitability Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 18

Differing views about business responsibility (cont) • Anita Roddick, founder of the Body Shop, made the following statement (2007): In terms of power and influence, you can forget the church, forget politics. There is no more powerful institution in society than business, which is why I believe it is now more important than ever before for business to assume a moral leadership. The business of business should not be about money, it should be about responsibility. It should be about public good, not private greed. • Consider how Roddick’s view contrasts with Milton Friedman or with the statement made by the Business Council of Australia (2005). The BCA stated: The litmus test for any activity or responsibility is whether the performance of that activity or responsibility can reasonably be seen to be contributing to the growth of shareholder value. Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 19

Stage 2: To whom to report? If managers overwhelmingly motivated by the desire to increase shareholder value then reporting will be aimed primarily at satisfying the expectations of powerful stakeholders • If, by contrast, managers adopt a broader ethical perspective then disclosures would be aimed at stakeholders impacted by the operations of the entity—but still cannot address all information needs, so some prioritisation will be necessary • It is emphasised that the decision of whom to report to is directly related to the previous issue of ‘why report? ’ One cannot be considered in isolation from the other • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 20

Stage 3: What to report? • First of all, establish that there is a demand for information • Identify information needs through dialogue with stakeholders • Negotiate a consensus among competing stakeholder needs and expectations Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 21

Stage 4: How to report? Conventional financial accounting does not appear to provide a foundation for social and environmental disclosures • Triple bottom line reporting is an alternative, although it is not the same as sustainability reporting. A true sustainability report would consider such issues as the carrying capacity of the eco-system, impacts on future generations and so forth • An attempt can also be made to place a cost on the externalities of business • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 22

How to report? Limitations of traditional financial accounting • For the following reasons, financial accounting is not seen as a useful vehicle for promoting social and environmental disclosures • Financial accounting focuses primarily on the information needs of those involved in resource allocation decisions. By contrast, sustainability concerns all stakeholders • The notion of ‘materiality’ tends to preclude the reporting of social and environmental information, given the difficulty in quantifying costs Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 23

How to report? Limitations of traditional financial accounting (cont. ) • Reporting entities frequently discount liabilities to present value, which tends to make future clean-up expenditures appear trivial • Financial accounting adopts an entity assumption where the entity is treated as distinct from its owners and other stakeholders transactions not directly impacting the entity are ignored – ignores externalities caused by the reporting entity, some relating to social and environmental implications of the entity’s operations – sustainability and the ‘entity assumption’ are mutually exclusive – Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 24

How to report? Limitations of traditional financial accounting (cont. ) • Expenses are defined to exclude the recognition of any impacts on resources not controlled by the entity that is, and simplistically stated, the recognition of expenses in part relies upon the using up of assets – assets are defined in terms of ‘control’, hence if something is not controlled – such as the environment then it is not an asset of the reporting entity – therefore, the use or abuse of the environment is ignored from a financial accounting perspective (unless fines are imposed) – • Externalities caused by the entity cannot be reliably measured, and so typically are not recognised given the recognition criteria provided in such documents as the IASB Framework Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 25

How to report? Triple Bottom Line Reporting Triple bottom line reporting refers to the disclosure of information about the social, economic and environmental performance of an entity • But … is the bottom line metaphor appropriate— can social and economic impacts be measured through a ‘bottom line’? • Seems to indicate that we must manage all the bottom lines in a similar manner—appropriate? • Seems to suggest that social, economic and environmental performance are separate to one another—not really the case in practice • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 26

How to report? Relevance of measures such as GDP • Performance of governments is related to outputs of systems of national accounts – e. g. gross domestic product (GDP) • Does not consider issues of resource efficiencies or equities with how resources are distributed • Experiments taking place to ‘green’ GDP Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 27

How to report? The Global Reporting Initiative • • • Global Reporting Initiative (GRI) established 1997 The GRI Sustainability Reporting Guidelines is the most comprehensive framework for ‘how to report’ that is currently available Third version—G 3—released in 2006 Made up of various ‘core’ and ‘additional’ performance indicators Not mandatory and hence many organisations are selective about what information they select for disclosure Apart from the GRI, a number of other organisations have produced reporting guidelines Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 28

Monetising environmental costs and benefits – accounting for externalities As we have already discussed, financial accounting typically ignores environmental impacts, therefore experimental approaches to fullcost profit calculation are being developed • Market prices do not reflect the scarcity of resources involved or harm resources cause • Perception that all costs associated with the production of goods or services (including use of ‘the environment’) should be reflected in the price of the goods or services - the practice of ‘underpricing’ the environment leads to over use and damage to the environment • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 29

Monetising environmental costs and benefits (cont. ) • If done comprehensively this would involve some life-cycle analysis – • consideration of the inputs and outputs from raw material acquisition to disposal Often referred to as ‘true prices’ Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 30

A ‘sustainable cost’ calculation • • A number of researchers are attempting to develop approaches to place a cost on the social and environmental impacts of organisations – still very experimental For example, Gray and Bebbington (1992, p. 15) state: – … sustainable cost can be defined as the amount an organisation must spend to put the biosphere at the end of the accounting period back into the state (or its equivalent) it was in at the beginning of the accounting period. Such a figure would be a notional one, and disclosed as a charge to a company’s profit and loss account. Thus we would be presented with a broad estimate of the extent to which the accounting profits had been generated from a sustainable source … our estimates suggest that the sustainable cost calculations would produce the sort of answer which would demonstrate that no Western company had made a profit of any kind in the last 50 years or so. Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 31

Alternative approaches to social and environmental reporting—the example of Baxter International • Approach most conservative of those considered in the textbook • Ignores any externalities caused by the business, and only includes costs and benefits directly related to cash flows • Attempts to demonstrate that by explicitly considering the environment, actual cost savings can be made • Still applies the usual ‘entity assumption’ Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 32

BSO/Origin • Place a notional value on the environmental costs imposed on society • This value is then deducted from profits (calculated using financial accounting methods) to determine a measure referred to as ‘sustainable operating income’ • Although consider many externalities, ignores many eco-justice considerations required to pursue sustainability Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 33

Landcare Ltd Seeks to determine the notional costs that would be incurred if the organisation was to have zero environmental impact • Sustainable cost: the amount which must be spent to put the biosphere at the end of the accounting period back into the state it was at the beginning • Sustainable cost calculation involves two elements • costs required to ensure inputs have no adverse environmental impacts – costs required to remedy any environmental impacts that arise – Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 34

Watercare services • Identifies the additional costs that would need to be incurred if the organisation was to meet the social and environmental standards that it believes are appropriate Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 35

Social auditing • Purpose of social auditing is for an organisation to assess its performance in relation to society’s requirements and expectations • Results form the basis of an entity’s publicly released social accounts, which in themselves are often incorporated into a triple bottom line or sustainability report • Consider the Body Shop’s social performance report which is based on their social audit Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 36

Social Auditing Standards • Released in 1998 by the Council on Economic Priorities (US body) SA 8000 – focuses on issues associated with human rights, health and safety, and equal opportunities – • In 1999 ISEA launched standard AA 1000 – concerned with the processes of setting up and operating social and ethical accounting and auditing systems Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 37

Concluding comments Social and environmental reporting is a rapidly evolving area • Only 20 years ago, almost no companies were producing social and/or environmental reports • Now many large listed companies are providing such reports • As concerns for global warming, social justice and environmental protection increase we can expect this form of reporting to continually evolve • Copyright 2009 Mc. Graw-Hill Australia Pty Ltd PPTs t/a Deegan, Financial Accounting Theory 3 e 38