Financial Accounting TheoryCraig DeeganChapter 9Extended systems of accountingthe incorporation of social and environmental factors within external reporting Slides written by Craig Deegan

Learning objectivesIn this chapter you will be introduced to:various perspectives of the responsibilities of businessexplanations of the relationship between organisational responsibility and organisational accountabilitythe relationship between accounting and accountabilityvarious theoretical perspectives that can explain why organisations might voluntarily elect to provide publicly available information about their social and environmental performance

Learning objectives (cont.)some recent initiatives in social and environmental accountingthe concept of sustainable development and how organisations are reporting their progress towards the goal of sustainable developmentthe relationship between sustainability and eco-efficiency and eco-justice issuessome of the limitations of traditional financial accounting in enabling users of reports to assess a reporting entitys social and environmental performance

IntroductionIn recent years there has been increasing discussion about sustainable development and triple bottom line (TBL) and sustainability reportingTBL reporting is reporting that provides information about the economic, environmental and social performance of an entitySustainability reporting represents a departure from sole economic focus that was traditional in external reportingA review of the Global Reporting Initiatives Sustainability Reporting Guidelines provides insight into the types of social, environmental and economic information that could be disclosed in a sustainability report

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 togetherSustainability 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

Responsibilities of businessMoves 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 performancenot a view held universallyIncreasing community pressures for organisations to make a commitment to sustainable business practices, and corporate reporting is tending to respond to this pressure

Responsibilities of business (cont.)If sustainability becomes part of the expectations held by society, it mustconsistent with legitimacy theorybecome a business goal

Providing information about social and environmental performance will increase the trust a community has in the organisation

SustainabilityBrundtland 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

Sustainability (cont.)Should organisations be responsible for the sustainability of their business practices?

Will they embrace this responsibility in the absence of specific legislation?

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

AccountabilityThe duty to provide an account (not necessarily financial) or reckoning of those actions for which one is held responsible

Two responsibilities or dutiesresponsibility to undertake certain actionsresponsibility to provide an account of those actions

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 responsibilitiesit should provide a sustainability report

Stages of sustainability reportingStage 1: Why report?relates to managements motivationsStage 2: To whom to reportwho are the stakeholders?tied to managerial motivations for reportingif motivations are based on managerial reasoning then disclosures could be aimed at powerful stakeholdersStage 3: What to report?involves dialogue with identified stakeholdersStage 4: What format for the disclosures?

We will consider each of these stages in turn.

Stage 1: Why report?Different accounting theories will provide alternative explanations about why an entity might decide to report social and environmental informationWe 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 reportAs we appreciate, different theories make different assumptions and therefore will tend to give different explanation of the reporting phenomena

Theories to explain why report? social and environmental disclosureLegitimacy Theory and social contractdisclosures linked to providing evidence that entity is complying with the expectations of society

Stakeholder Theorydisclosure depends on expectations of powerful stakeholders if the managerial perspective of stakeholder theory is embraced

Accountability Modelan acceptance of a responsibility to report

Theories to explain why report? social and environmental disclosure (cont.)Institutional Theoryorganisations will adopt particular practices because of institutional pressures

Positive Accounting Theorydisclosure depends on positive wealth implicationsconsider submission of the Business Council of Australia on page 394 of the text

Why report? and its links to views about the responsibility of businessConsider the views of Milton Friedmanreporting 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?

Differing views of business responsibilityFriedmanrejected the view that corporate managers have any moral obligationsstated that the business of business is businessresponsibility to increase profits as long as stays within the rulesthis view often held by the mediaapplauds profitable organisationsAlternative vieworganisations earn their right to operate in the communityartificial entities that society chooses to createorganisations do not have an inherent right to resourcesconsequently accountable to society for how it operatessocietal expectations may exceed profitability

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 Roddicks 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.

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 stakeholdersIf, by contrast, managers adopt a broader ethical perspective then disclosures would be aimed at stakeholders impacted by the operations of the entitybut still cannot address all information needs, so some prioritisation will be necessaryIt 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

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

Stage 4: How to report?Conventional financial accounting does not appear to provide a foundation for social and environmental disclosuresTriple 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 forthAn attempt can also be made to place a cost on the externalities of business

How to report? Limitations of traditional financial accountingFor 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

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 stakeholderstransactions not directly impacting the entity are ignoredignores externalities caused by the reporting entity, some relating to social and environmental implications of the entitys operationssustainability and the entity assumption are mutually exclusive

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 entitythat is, and simplistically stated, the recognition of expenses in part relies upon the using up of assetsassets 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 entitytherefore, 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

How to report? Triple Bottom Line ReportingTriple bottom line reporting refers to the disclosure of information about the social, economic and environmental performance of an entityBut is the bottom line metaphor appropriatecan social and economic impacts be measured through a bottom line?Seems to indicate that we must manage all the bottom lines in a similar mannerappropriate?Seems to suggest that social, economic and environmental performance are separate to one anothernot really the case in practice

How to report? Relevance of measures such as GDPPerformance of governments is related to outputs of systems of national accountse.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

How to report? The Global Reporting InitiativeGlobal Reporting Initiative (GRI) established 1997The GRI Sustainability Reporting Guidelines is the most comprehensive framework for how to report that is currently availableThird versionG3released in 2006Made up of various core and additional performance indicatorsNot mandatory and hence many organisations are selective about what information they select for disclosureApart from the GRI, a number of other organisations have produced reporting guidelines

Monetising environmental costs and benefits accounting for externalitiesAs we have already discussed, financial accounting typically ignores environmental impacts, therefore experimental approaches to full-cost profit calculation are being developedMarket prices do not reflect the scarcity of resources involved or harm resources causePerception 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 under-pricing the environment leads to over use and damage to the environment

Monetising environmental costs and benefits (cont.)If done comprehensively this would involve some life-cycle analysisconsideration of the inputs and outputs from raw material acquisition to disposal

Often referred to as true prices

A sustainable cost calculationA number of researchers are attempting to develop approaches to place a cost on the social and environmental impacts of organisations still very experimentalFor 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 companys 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.

Alternative approaches to social and environmental reportingthe example of Baxter InternationalApproach 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

BSO/OriginPlace 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

Landcare LtdSeeks to determine the notional costs that would be incurred if the organisation was to have zero environmental impactSustainable 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 beginningSustainable cost calculation involves two elementscosts required to ensure inputs have no adverse environmental impactscosts required to remedy any environmental impacts that arise

Watercare servicesIdentifies 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

Social auditingPurpose of social auditing is for an organisation to assess its performance in relation to societys requirements and expectations

Results form the basis of an entitys publicly released social accounts, which in themselves are often incorporated into a triple bottom line or sustainability report

Consider the Body Shops social performance report which is based on their social audit

Social Auditing StandardsReleased in 1998 by the Council on Economic Priorities (US body)SA8000focuses on issues associated with human rights, health and safety, and equal opportunities

In 1999 ISEA launched standard AA1000concerned with the processes of setting up and operating social and ethical accounting and auditing systems

Concluding commentsSocial and environmental reporting is a rapidly evolving areaOnly 20 years ago, almost no companies were producing social and/or environmental reportsNow many large listed companies are providing such reportsAs concerns for global warming, social justice and environmental protection increase we can expect this form of reporting to continually evolve