The Legitimacy Theory And CSR Disclosure Accounting Essay

The issue of corporate social responsibility has got a lot of attention in the business and political world since the early 1990's and the major reason behind this was corporate scandals. Organizations had started to realize that the basis on which they were achieving economic growth was unsustainable and hence there was a need to develop a process which would intend at balancing economic growth with environmental sustainability and societal expectations. In fact the origin of corporate social responsibility can be found in the 1950s and 60s whereby successful companies were trying to link corporate social responsibility to the power that business holds in society. The theoretical progresses were subdivided in ethical and accountability and the stakeholder approach to strategic management.

CSR can be distinguished from the three terms which are included in its designation phrase and these words are; 'Corporate', 'social' and 'responsibility'. Hence CSR can be explained as being the responsibilities that a company undertakes for the society within which it carry out its operations. To be specific, CSR require a business to identify its stakeholders and include their needs and values in the tactical day to day decision making process of the company. Consequently the society within which a business function and which identify the number of stakeholder to which the organization owe a responsibility can be broad depending on the type industry within which it operate. The different stakeholders to which a company is accountable can be illustrated using the figure below:

http://www.industryplayer.com/images/corporate_social_responsibility.jpg

Figure 1: stakeholder of a business

According to figure 1, a business must respond to two aspects which evolve during their operating process and these are:

The quality of management which is represented by the inner cycle and it is both in terms of people and processes.

The nature of and the extent to which their processes impact on the society in various areas.

The stakeholders who are outside take more interest in the activities undertaken by the company, i.e. most of them look at what has the company actually done. Their objective is to fid out if the company has done good or bad in terms of its product and services, the treatment it gives it its labour force and in terms of the impact of its activities on the environment and local communities.

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There seems to be an infinite number of definitions of CSR, ranging from the simplistic to the complex, and a range of associated terms and ideas including `corporate sustainability, corporate citizenship, corporate social investment, the triple bottom line, socially responsible investment, business sustainability and corporate governance'. It has been suggested that `some researchers distort the definition of corporate social responsibility or performance so much that the concept becomes morally unintelligent, conceptually meaningless, and utterly unrecognizable'(Orlitzky 2005); or CSR may be regarded as `the universal remedy which can solve several social evil such as the global poverty gap, social exclusion and environmental degradation' (Van Marrewijk 2003).

Some definitions of CSR which are commonly accepted are:

The notion of companies looking beyond profits to their role in society is generally termed corporate social responsibility (CSR)..It refers to a company linking itself with ethical values, transparency, employee relations, compliance with legal requirements and overall respect for the communities in which they operate. It goes beyond the occasional community service action, however, as CSR is a corporate philosophy that drives strategic decision-making, partner selection, hiring practices and, ultimately, brand development. [1] 

South China Morning Post, 2002

The social responsibility of business encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time. [2] 

Archie B. Carroll, 1979

CSR is about businesses and other organizations going beyond the legal obligations to manage the impact they have on the environment and society. In particular, this could include how organizations interact with their employees, suppliers, customers and the communities in which they operate, as well as the extent they attempt to protect the environment. [3] 

The Institute of Directors, UK, 2002

Why is CSR relevant today?

CSR has become famous in the language and strategy of business and by the growth of dedicated CSR organizations globally. Governments and international governmental organizations are increasingly encouraging CSR.

CSR is rapidly becoming a major part of all business management courses and a key global issue because of three trends which are easily identifiable:

1. Changing expectations of the society

Following recent corporate scandals which have lead to the decrease in the trust that the public has on regulatory bodies and companies to control corporate excess, customers and the general public tend to expect more from the company with which they trade.

2. Rising affluence

This is true not only in developed countries but also in developing countries. Rich customers have enough money to select the product they want to buy and as the society need work and inward investment will not impose severe rules which will penalize companies which invest their money elsewhere. In other words if a company is investing its money in CSR activities and for this reasons its product become more costly, the affluent consumers will not punish the organization and they will buy its product.

3. Globalization

Nowadays the least mistake made by companies is instantly make known to the public via the media. On top of that, increasing internet communication between people having the same opinion and the consumers, authorize them to spread their message and giving them the opportunity to take collective action that is they can boycott a product. In other words if a company is taking actions which is against the environment and the society, the public may takes action against the business.

According to these three trends, more importance is given to brand which lead to the success of companies and thus there is a shift in the relationship between companies and customers whereby the latter are better informed and feel more powerful to put their belief into action. From the standpoint of businesses, the parameters within which they operate are more and more affected by bottom-up, working class campaigns, NGOs and consumer activists leading to a change in the relationship between consumers and the company.

CSR is becoming more and more important in our fast developing world as brands are built on perceptions and concepts which appear to have higher values.

Theoretical Frameworks and CSR Disclosure

The Legitimacy Theory

While there is no generally accepted theory for explaining CSR disclosure practices, recent research in the CSR literature has primarily relied on legitimacy theory (Deegan 2002, p. 285). Indeed, "it is probable that legitimacy theory is the most widely used theory to explain environmental and social disclosures" (Campbell, Craven and Shrives, 2003, p. 559) while, according to Gray, Kouhy and Lavers (1995), legitimacy theory has an advantage over other theories in that it provides disclosing strategies that organisations may adopt to legitimate their existence that may be empirically tested.

The Legitimacy theory, according to Ness & Mirza (1991), argues that the voluntary disclosure of social responsibility information can be perceived as a strategy to reduce political costs. Social theory reporting has been explained from a Legitimacy Theory perspective

LT has been considered as widely accepted theory to shed light on social reporting practices of a firm. It states that firms will take actions to ensure that their operations are obvious to be legitimate from the point of view of the society within which the organization is assumed to operate. That is, they will attempt to establish resemblance between social values associated with or indirect by their activities and the norms of acceptable behavior in the larger social system of which they are part.

Legitimacy Theory specifies a social contract between the organisation and society. Legitimacy is defined by Lindblom (1992) as:

"...a condition or status which exists when an entity's value system is congruent with the value system of the larger social system of which the social system of which the entity is a part. When a disparity, actual or potential, exists between the two value systems, there is a threat to the entity's legitimacy".

Hence, Legitimacy Theory implies that managers will not undertake any actions that will be considered as illegitimate in society. By engaging in social reporting, they tend to enhance the relevance of the financial statement as well as that of earnings by making people to believe in the reliability of what is being reported in the financial statements and by providing additional information on issues other than earnings and financial information. This may however redirect the interest of users away from the earnings figure.

Institutional theorists (e.g Fogarty, 1992) observe that organizations need to respond to social expectations. Public expectations have undergone significant changes in the last decades such that profit maximization is not the sole measure of performance expected from the economic entity. There are a lot of implicit and explicit expectations from society vis-a-vis the operations of the organization. According to Heard & Bolce (1981), with sensitive societal expectations, it is anticipated that successful businesses will react to attend to human, environmental and other social consequences of their activities.

In spite of being unregulated, social and green reporting has increased in annual reports of organizations. Empirical tests of the Legitimacy Theory by Hogner (1982) revealed that the extent of social disclosures in the annual reports varied in response to society's expectations of corporate behavior. Deegan & Rankin (1996) found that prosecuted firms for environmental charges increased their green reporting while Gray, Kouhy & Lavers (1995) found that firms use corporate social reporting to fill the legitimacy gap.

It is assumed that the economic entity will have the 'legitimate' right to continue to operate in society to the extent that it fulfils the societal expectations. Otherwise, there will be a breach in the social contract between the entity and the society, and sanctions, such as fines, legal actions, and a fall in the demand of its product, will be taken. Society may revoke the organization's 'licence to operate' or contract to continue its operations, for instance. Under Legitimacy Theory, not only the rights of investors are considered, but a much bigger picture of the public at large is considered.

Furthermore, it is also expected that the organisation for its survival will have to adapt to the changing expectations of society. Downling & Pfeffer (1975) refer to communication strategies, that the entity can use in order to legitimate or maintain the legitimacy of its activities. Reference is made to the public disclosure of information, in annual reports, for instance, to let the public know and educate them about the actions and performance of the firm and hence the manipulation of society's expectations, is made. In the same vein, they argue that one of the functions of annual reports would be to legitimate the existence of the organisation. Therefore, Legitimacy Theory proposes a relationship between corporate disclosures and societal expectations, as evidenced by a lot of research (Deegan & Ratkin (1996); Gray,Kouhy & Lavers).

Stakeholder Theory

Stakeholder theory (Gray, Kouhy & Lavers 1995b, p. 53) state that "the corporation's continued existence requires the support of the stakeholders and their consent are required and hence the activities of the business are adjusted according to that approval. The more powerful the stakeholders, the more the company must adapt. Social disclosure is thus seen as part of the dialogue between the company and its stakeholders".

Within the Stakeholder's point of view, the success of a business depends on its capacity to balance the differing demands of its various stakeholders. The definition of 'stakeholder' has altered considerably over the past four decades. At one end of the range the shareholder was believe the sole or principal stakeholder. This definition was based on arguments proposed by the Noble prize winner, Mr. Milton Friedman's view. According to him, the sole moral responsibility of a business is to maximize profits.

Freeman (1983), however, expands the definition of stakeholder to include a broader selection of constituents including opposing groups such as interest groups and regulators. He defines stakeholders as "any group or individual who can affect or is affected by the achievement of the organisation's objectives". Stakeholder Theory states that managers ought to serve the interests of all those who have a "stake" in the firm. Stakeholders include shareholders, employees, suppliers, customers and the communities in which the firm operates - a collection which Freeman terms the "Big Five". Therefore, all groups in an area in which the firm operates and all individuals in such area are stakeholders.

Given that CSR reporting is attempted to underline how the company relates to society in the course of its different social activities, the stakeholder theory can be seen as a guideline which will direct firms to have proper way of disclosing CSR as they will know what type of actions stakeholders are expecting from them.

Corporate Governance

Corporate governance can be defined as a set of rules and regulations according to which the behavior of a company is affected. Another aspect of it is that it is also concerned with the relationships which exists among different stakeholders of the company and with the goals which the company has in view. Shareholders, board of directors, employees, customers, creditors, suppliers, and the community at large are the main stakeholders of a business.

Gabrielle O'Donovan defines corporate governance as 'an internal system encompassing policies, processes and people, which serves the needs of shareholders and other stakeholders, by directing and controlling management activities with good business know-how, objectivity, accountability and integrity. Sound corporate governance is reliant on external marketplace commitment and legislation, plus a healthy board culture which safeguards policies and processes.

An essential part of corporate governance is to create a system that try to decrease or eradicate the principal agent problem which will ensure accountability of certain individuals in the business. Corporate governance has several areas of discussion such as the effect of a system of corporate governance in economic efficiency whereby more emphasis has to be put on shareholders' welfare.

Principles of corporate Governance

Honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization forms an essential part of corporate governance.

The most important part in corporate governance is to see whether the management has been able to develop a model which is in line with the standards of the corporate participants. In addition to this they must evaluate this model from time to time to ensure that it is effective. Hence the management should do their wok honestly and ethically, particularly concerning conflicts of interest and disclosure in financial reports.

Commonly accepted principles of corporate governance include:

Rights and equitable treatment of shareholders: company should respect the rights of shareholders and help shareholders to implement those rights. They can help shareholders exercise their rights by effectively communicating information that is understandable and accessible and encouraging shareholders to participate in general meetings.

Interests of other stakeholders: Organizations should be aware of the legal and other obligations that all legitimate stakeholders have.

Role and responsibilities of the board: The board needs a variety of skills and understanding to be able to deal with various business issues and have the aptitude to review and challenge management performance. It needs to be of adequate size and have an apt level of commitment to fulfill its responsibilities and duties. There are issues about the appropriate mix of executive and non-executive directors.

Integrity and ethical behavior: Ethical and responsible decision making is not only important for public relations, but it is also a crucial part in risk management and avoiding lawsuits. businesses should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. It is important to understand, though, that reliance by a company on the integrity and ethics of individuals is bound to eventual failure. Because of this, many organizations establish Compliance and Ethics Programs to minimize the risk that the firm steps outside of ethical and legal boundaries.

Disclosure and transparency: Organizations should simplify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement measures to independently validate and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

Nevertheless "corporate governance," despite some weak attempts from various quarters, remains a vague and often misunderstood expression. For quite some time it was confined only to corporate management. It is something much broader, for it must include a fair, efficient and transparent administration and strive to meet certain well defined, written objectives. Corporate governance must go well beyond law. The quantity, quality and frequency of financial and managerial disclosure, the degree and extent to which the board of Director (BOD) exercise their trustee responsibilities (largely an ethical commitment), and the commitment to run a transparent organization- these should be constantly evolving due to interplay of many factors and the roles played by the more progressive/responsible elements within the corporate sector.

CG and CSR Disclosure

Following recent accounting and ethical scandals in firms such as Enron, WorldCom and Parmalat, corporate governance is being regarded as an important issue in the business world due to the fact that rules and regulations have become stricter with regard to societal expectations. In this respect the concept of corporate governance has start to cover some part of CSR. Previous researches has tended to study CG and CSR issues separately and not as combined manifestation in the fast developing business world where CG issues may also have impact on CSR disclosure and firms performance. Examples of studies that have directly or indirectly link CSR and CG are those that talk about the influence of CG reforms on business ethics most often in a particular region( mainly Rossouw 2005; Kimber and Lipton,2005; Ryan 2005); the role of socially responsible investors and shareholder activism (Aguilera et al., 2006; McLaren, 2004; Monks et al., 2004; Guay et al., 2004; Sjöström, 2008) and of employee relations (Deakin and Whittaker, 2007; Jones et al., 2007); and, perhaps most remotely, those that critically examine the stakeholder approach, frequently referring to an agency perspective (Hill and Jones, 1992; Jensen, 2001; Sternberg, 1997; cf. Kolk and Pinkse, 2006).

There is several corporate governance practice which helps to find out whether corporate social responsibility should be disclosed or not, for example the Global Reporting Initiative (GRI) comes across several indicators such as independence and expertise of directors which help to identify economic, environmental and social risks and opportunities and find out whether the financial and non financial goal have been achieved and hence based on this firms will decide whether CSR should be disclosed or not.

Corporate governance and corporate social responsibility is therefore expected to be more integrated in the field of business disclosure practices. Nowadays companies are required to disclose other types of information, like what the business has done for the welfare of the society, and not only financial information. For this reason the number of firms which publish voluntary reports has increased. According to the triple bottom line, a business reports strategy and operational performance within three primary dimensions and these are financial, stakeholder and environmental performance. Thus these reports shows that there is proper planning in the business as the latter selects the most important issues to be included in the triple bottom line plan and report. This report is usually included in the annual report which shows that the corporate governance structure does indeed have an impact on CSR disclosure.

According to Tricker (1984), CSR disclosure can be viewed as a strategy which leads to towards closing a perceived legitimacy gap between management and shareholders, especially foreign shareholders. Non executive directors are seem as a mechanism which not only acts in the best interest of the owner but also in the interest of other stakeholders and they advise about the presentation of the the companies' activities. Zahra and Stanton(1988) said that members in the corporate governance team are more likely to concers about honour and obligations and they would make disclosures which would improve their social prestige and honour.

Board Size and CSR Disclosure

One important element of corporate governance mechanism is the board of directors as they see whether the business is properly managed by their agents. Previous studies have proposed that bigger board size can increase communication and coordination problem and decrease the ability of the board to control management and on the other hand small board can decrease agency conflicts between managers and shareholders (Lipton and Lorsh, 1992; Eisenberg et al., 1998; Raheja, 2003). Jensen (1993) found that large board size result in less effective coordination, communication and decision making is more likely to be controlled by the CEO. Thus it can be forecasted that ineffective coordination in communication and decision making will result in low quality financial disclosure due to the fact that managers have not been able to perform their roles efficiently.

Independent Non Executive Directors and CSR disclosure

Previous empirical governance literature that board independence will foster board effectiveness. The difference between socially responsible firms' and non socially responsible firms' board structures was studied by Webb (2004) and she found that socially responsible firms had more independent directors than non socially responsible firms. Independent directors has the objective to safeguard shareholders interest and they also play an important role in enhancing the corporate image. They are seen as an important tool to keep an eye on management behavior (Rosenstein and Wyatt, 1990) and hence this results in more voluntary disclosure. Forker (1992) found out that the higher number of independent directors supervise the quality of financial disclosure.

CEO Duality and CSR disclosure

When a person hold the position of CEO and boar chairman, CEO duality occurs (Rechner and Dalton, 1989). This combination reflects leadership and corporate governance issues. However vesting these two powers in only one person gives that latter a strong base which can erode the board's ability to exercise effective control (Tsui and Gul, 2000). Therefore, companies with the CEO duality offer greater power to a person, which enable him to make decisions that do not maximize the shareholders wealth and will help improved monitoring quality and reduce benefits from withholding information that may consequently result in enhancing quality of reporting.

Audit Committee and CSR disclosure

Prior researches have proven that audit committee plays an effective role in enhancing the corporate governance standards. Wright (1996) found that audit committee composition is strongly related to financial reporting. McMullen and Raghunandan (1996) provide support for the association between the presence of an audit and more reliable financial reporting.

The existence of an audit committee was significantly and positively related to the extent of voluntary disclosure (Ho and Wong, 2001; Bliss and Balachandran, 2003).

Audit committee roles is providing a mean for review of the company's processes for producing financial data and its internal control, thus its existence is in producing high quality financial reporting. According to Mauritian Code of Corporate Governance (First Edition,Revise April 2004), the board should establish an audit committee with majority of independent directors. The existence of audit committee with a higher proportion of independent directors should reduce the agency cost and improve the internal control that will lead to greater quality of disclosures (Forker, 1992).

Managerial ownership

The agency theory predicts that the principal-agent problem between managers and shareholders arises when managers hold little equity in the corporation. This will lead to managers to engage in an opportunistic behavior (Jensen and Meckling, 1976). Past studies had showed that an increase in management ownership will reduce the agency problems and improved managers' incentive to provide more disclosure. Mohd Nasir and Abdullah (2004) investigated the influence of ownership structure in explaining the level of voluntary disclosures among the financially distressed firms and found that management shareholding levels have a significant and positive association with the level of voluntary disclosures. Coffey and Wang (1998) found that managerial control (percentage of stock owned by insiders) is positively related to charitable giving.

The above findings were in contrast to Guan Yeik (2006) and Eng and Mak (2003). In his study, he examined the relationship between managerial ownership and corporate social responsibility and he found that managerial ownership was significantly negatively related to corporate social disclosure. In his study, he found that managerial ownership level of 45 percent above will influence the corporate to have lower social disclosure. Eng and Mak (2003) found that lower managerial ownership is associated with increased voluntary disclosures.

Foreign ownership

Ramasamy and Ting (2004) examined a comparative analysis of corporate social responsibility awareness by using levels of corporate social disclosure as a measurement of corporate social responsibility (CSR) awareness. In their study, they used employee perception towards CSR awareness. The respondents were questioned on their management of CSR within the company, such as awareness of corporate social responsibility, attitudes to CSR in the company, the types of CSR activity and the respondent involvement in CSR. The results show a low level of awareness in both countries, although companies tend to exhibit a relatively higher level of awareness.

Chambers et al. (2003) investigated CSR reporting in seven countries through analysis of websites of the top 50 companies in Asia. This study investigated the penetration of CSR reporting within countries; the extent of CSR reporting within companies and the waves of CSR engaged in. The findings in Chambers et al. (2003) showed that, there are fewer CSR companies in the seven selected Asian countries compared with UK and Japan companies.

The mean for the seven countries studied, show a score of 41 percent which is under half the score for the UK (98 percent) and Japan companies (96 percent). Thus by involvement of foreign shareholders in Mauritian Listed companies will enhance the extent of corporate social disclosure in Mauritius.

Haniffa and Cooke (2005) found a significant relationship between corporate social disclosure and foreign shareholders indicated that companies use corporate social disclosure as a proactive legitimating strategy to obtain continued inflows of capital and to please ethical investors. Foreign shareholdings in Mauritian listed companies have considerably increased.