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Working Paper 06-23 Business Economics Series 06 September 2006
Departamento de Economía de la EmpresaUniversidad Carlos III de Madrid
Calle Madrid, 12628903 Getafe (Spain)Fax (34) 91 624 9608
EARNINGS MANAGEMENT AND CORPORATE SOCIAL RESPONSIBILITY *
DIEGO PRIOR1, JORDI SURROCA2 and JOSEP A. TRIBO3
Abstract Drawing on stakeholder-agency theory and the earnings management framework, we explore the relationship between discretionary accounting accruals and corporate social responsibility. We hypothesize a positive connection between corporate social responsibility and earnings management. We argue that managers may satisfy the interest of stakeholders as an entrenchment strategy once these managers have followed earnings management practices, thereby damaging the long-term interests of shareholders. Also, we expect that the positive connection between corporate social responsibility and financial performance is negatively moderated when combined with earnings management practices. We empirically demonstrate our theoretical contention making use of a database comprising of 599 firms from 32 different nations for the period 2002-2004.
Keywords: Corporate social responsibility, earnings management. 1 Universitat Autònoma Barcelona. Department of Business Administration. Edifici B. Campus Bellaterra. Cerdañola (08193) Barcelona (Spain). (34) 93- 5811539. [email protected] 2 Business Department, Carlos III, C/ Madrid 126 (Getafe), 28903. Phone: (34) 916248640. E-mail: [email protected]
3 Business Department, Carlos III, C/ Madrid 126 (Getafe), 28903. Phone: (34) 916249321. E-mail: [email protected] * The authors wish to thank Fundación Ecología y Desarrollo, Sustainable Investment Research International (SiRi Company), and Analistas Internacionales en Sostenibilidad (AISTM) for their helpful comments and access to the SiRi ProTM database. We also acknowledge the financial support of the Comunidad de Madrid (Grant # s-0505/tic/000230) and Ministerio de Ciencia y Tecnologia (Grant #SEC2003-03797 and # SEC003-04770). The usual disclaimers apply.
2
1. INTRODUCTION
The recent scandals of Enron or Worldcom, that few years before were ranked within
the most admired companies in terms of social responsibility, have spawned an ongoing
debate regarding the misuse of social responsibility strategies to camouflage accounting
malpractices.
According to the instrumental view of stakeholder theory (Jones, 1995; Donaldson
and Preston, 1995), corporate social responsibility (CSR) is seen as a mechanism to achieve
greater financial performance. By behaving in a responsible way, firms obtain the continued
support from their stakeholders necessary to have access to valuable resources that secure
the long-term survival and success of the firm (Freeman, 1984).
However, recent studies have questioned this optimistic view of CSR. Pagano and
Volpin (2005) described how firms use concessions to workers – a particular dimension of a
firm’s CSR – as an entrenchment mechanism to prevent take-over threats. Also, Barnea and
Rubin (2005) argued that improvements in CSR can be connected to expropriation of small
shareholders by large blockholders which, in turn, reduce financial results.
Drawing on this negative side of a firm’s CSR, we study a particular type of agency
problem that may appear in firms that implement vigorous CSR policies. This issue refers to
the accounting adjustments carried out by managers in order to improve profits – the so-
called earnings management (EM) practices.
The EM literature has provided different explanations of why managers may
manipulate earnings (Healy and Wahen, 1999; Dechow and Skinner, 2000). First, to
influence short-term stock prices and fulfill capital market expectations. Second, to carry out
lending contracts clauses. Last, to obtain bonus in presence of management compensation
contracts. This manipulation of earnings seeks to improve manager’s private benefits at the
expense of shareholders and benefiting the rest of stakeholders – employees, suppliers,
3
customers, etc. Hence, the so-called stakeholder-agency theory provides a useful foundation
for the study of the connection between EM and CSR (Hill and Jones, 1992). According to
this view, managers have relationship not only with stockholders but also with other
stakeholders of the firm. Consequently, managers may give concessions to the different
stakeholders as a way to create organizational inertia (Hannan and Freeman, 1984). Due to
this inertia, improvements in monitoring may be difficult to achieve since established
routines and procedures are not easily alterable (Hill and Jones, 1992). This results in a
wider scope for managers to behave opportunistically. Hence, CSR may be used
instrumentally by managers for their own advantage when they are incurring in agency costs
like earnings manipulation. We, therefore, hypothesize that managers misuse corporate
social initiatives as an entrenchment strategy to gain the favor of stakeholders when they are
conducting EM practices.
The study of the link between corporate social responsibility and EM has been
ignored in the existing literature. However, some indirect pieces of evidence exist to support
this relationship. Previous studies connected EM and CSR separately to different
characteristics of the firm where agency problems are more likely. In particular, when
research and development (R&D) investments are high and when large blockholders
compose the ownership structure. Concerning to R&D expenditures, Waddock and Graves
(1997) and McWilliams and Siegel (2000) suggested that R&D investments are associated
with CSR practices. At the same time, Nagy and Neal (2001) showed that firms may use
R&D investments as an income-smoothing device. The combination of both pieces of
evidence suggests, therefore, a positive relationship between CSR and EM through the R&D
investment channel.
Concerning to the ownership structure, companies owned by large blockholders have
both larger levels of CSR and higher likelihood of managing earnings. For example, Carlson
4
and Bathala (1997) examined the connection between large shareholdings and EM, and
showed that EM practices are present in those firms with institutional ownership. In a similar
vein, Bae et al (2005) identified such practices in firms with external related blockholders,
whereas the presence of external unrelated blockholders decreases the importance of EM
practices (Yeo et al., 2002). Concomitantly, some authors studied the linkages between the
intensity of CSR policies and the presence of large blockholders. Barnea and Rubin (2005)
argued that large blockholders, differently to small ones, may fully benefit of being
associated to a firm with large CSR ratings. This is so because external investors or
consumers associate social responsible practices of a firm with the social sensibility of the
controlling blockholder that allows such practices. However, these blockholders only bear
the proportion corresponding to their stake of the cost necessary to implement CSR policies.
As a consequence, blockholders would incite managers to adopt policies that improve a
firm’s CSR. Similarly, Neubaum and Zahra (2006) found that long-term institutional owners,
which are generally controlling blockholders, affect positively a firm’s CSR. In sum, the
relationship between CSR and EM can be inferred from these two lines of research: one that
relates CSR to the presence of large blockholders and R&D investments, and the other
connecting the latter to EM practices.
Finally, we invoke risk considerations to explain the relationship between a specific
type of accounting malpractice that reduces volatility (i.e, income smoothing) and the natural
tendency of managers to collude with different stakeholders – like a firm’s competitors
(Spagnolo, 2005) – in order to reduce uncertainty.
To investigate the robustness of the connection between EM and CSR, in the
empirical section we detract the effect of corporate financial performance (CFP) from the
EM variable. We consider CFP because it is widely-recognized as a key determinant of CSR
5
(Waddock and Graves, 1997). Remarkably, our results show that after controlling for CFP,
the positive relationship between EM and CSR still holds.
Furthermore, our results highlight the perverse effects of combining CSR with EM,
calling into question some social demands on good-performing firms to devote part of their
financial resources to improve their CSR. Accordingly, if these improvements are connected
with EM practices, they may damage the long-term wealth of firms.
The reminder of the article is structured as follows. Section 2 summarizes the most
relevant literature akin to the objectives of this work and develops the hypotheses. Section 3
is methodological and describes the sample, variables and empirical models to be tested. The
empirical results obtained are presented in Section 4. The final section of the article
illustrates the main conclusions of this research and offers a discussion of the significance of
our results.
2. THEORETICAL FRAMEWORK AND HYPOTHESES
2.1. Managerial entrenchment, earnings management and corporate social responsibility
The growing importance of governmental regulations, the amplified role of the
media, and the increased pressure from customers and unions have intensified the scrutiny of
managerial actions. Because stakeholders are engaged in monitoring and disciplining
managers, a stakeholder-agency approach (Hill and Jones, 1992) appears as an appropriate
framework to connect agency costs like earnings management practices and executive
entrenchment initiatives associated with a firm’s CSR. Under the stakeholder-agency
approach, managers are agents monitored by different stakeholders. This means that if the
manager wants to pursue her/his own interests, like improving a firm’s earnings in order to
obtain a further remuneration, she/he should define corporate social responsibility actions to
6
satisfy the interests of different stakeholders. These actions are defined as those “taken by
the firm intended to further social goods beyond the direct interests of the firm and that
which is required by law” (McWilliams and Siegel, 2001).
Stakeholder theory, which is one of the components of the aforementioned
stakeholder-agency theory, has deep roots in the notion of CSR (Carroll, 1979; and Freeman
1984). Freeman’s main argument is that executives are responsible for managing and
coordinating the constellation of competitive and cooperative interests of various
stakeholders. The instrumental approach of stakeholder theory (Donaldson and Preston,
1995; Jones, 1995) advocates for the formulation and implementation of processes that
satisfy stakeholders because they control key resources and suggests that stakeholder
satisfaction, in turn, will ensure the long-term survival and success of the firm (Freeman,
1984; Waddock and Graves, 1997). Hence, stakeholders that own resources relevant to the
firm’s success will be more willing to offer their resources to the extent that their different
claims and needs are fulfilled. This, in turn, will improve financial objectives (Jones, 1995;
Hillman and Klein, 2001).
However, the strategic value of stakeholder relationships has been subject to some
criticism. According to Sternberg (1997), stakeholder theory undermines private property
and accountability, because it transfers to all stakeholders the right to determine how
owner’s assets will be used. Moreover, stakeholder framework stipulates that owner’s assets
should be used not for the benefit of shareholders, but of all stakeholders. As a consequence,
stakeholder orientation is incapable of providing better corporate governance, corporate
financial performance or managerial conduct.
A possible explanation of the doubtful positive link between a stakeholder orientation
and the firm performance is provided by Williamson (1993), who invoked agency theory
arguments –the second component of the aforementioned stakeholder-agency theory.
7
According to this author, agency problems between owners and managers are aggravated
when managers act on behalf of non-shareholder stakeholders.
In this paper, we develop this line of research hypothesizing that CSR may be used
instrumentally in a negative way. When managers follow certain value-diminishing
practices, they may seek the connivance of different stakeholders to validate their practices.
The way to lure stakeholders is by satisfying their interests and implementing policies aimed
at improving a firm’s CSR. The problem, as Sternberg (1997) has already pointed out, is that
the implementation of such social policies may be incompatible with all legitimate business
objectives and undermines basic property rights.
The study of the connection between EM practices and CSR has been neglected in
previous literature. Notwithstanding, in the following paragraphs we develop three
arguments grounded on stakeholder theory and agency framework, the two theories that
stakeholder-agency theory relies on, to justify the existence of a positive association between
EM and CSR. The arguments we provide explain the relationship between EM and CSR on
the basis of their mutual connection with 1) a firm’s intangible resources, 2) the corporate
ownership structure, and 3) managerial risk aversion.
The first argument examined refers to the role of the firm’s intangible resources.
According to the stakeholder theory, maintaining good relationships with key stakeholders –
enhancing CSR – may be an organizational, intangible resource that would lead to more
efficient or effective use of the rest of resources (Orlitzky et al., 2003). The link between
corporate responsibility actions and strategic resources of the firm has been suggested in
previous studies (see for instance, Pfeffer and Veiga, 1999; McWilliams and Siegel, 2000;
Buysee and Verbeke, 2003; Haesli and Boxall, 2005). For example, McWilliams and Siegel
(2000) emphasized the relevance of R&D investment coordinated with corporate social
responsibility. In a situation in which customers are sensitive to environmental issues, the
8
firm that produces environmental-friendly goods and services signals to customers that the
company is concerned about social issues. Certainly, R&D activities facilitate this task by
making firm’s technology more flexible, allowing the incorporation of customers’
preferences in recognizable attributes of the produced goods. This improves customer
satisfactions and, consequently, the firm’s CSR. Likewise, a firm that aims to manage its
human capital efficiently must be sensitive about social issues as it involves the firm’s
workers. Otherwise, these workers would be less willing to acquire firm-specific human
capital or even tempted to leave the firm (Buysee and Verbeke, 2003; Haesli and Boxall,
2005).
At the same time, an increase in the proportion of intangible assets linked to
improvements in CSR gives management discretion that may be used to manipulate earnings.
As suggested by the earnings management literature (see Healy and Wahen, 1999; Dechow
and Skinner, 2000 for a review), managers may have powerful incentives to manage their
firm’s earnings, due to the fact that they are generally evaluated and compensated on the
basis of CFP. Importantly, this literature has documented instances in which firms have
engaged in EM practices related to intangible investments. A paradigmatic example is R&D.
R&D activities are characterized by three main traits: (1) they are inherently risky, (2) they
require long-term investments in projects that may have a negative impact on more
immediate performance, and (3) they demand high managerial autonomy to be effective
since managers face a wide range of complex strategic choices. These characteristics can
stimulate managerial opportunistic behavior and increase agency costs. In this sense, several
studies showed that R&D investments favor the management of earnings to achieve certain
goals (Baber et al., 1991; Clinch, 1991; Dechow and Sloan, 1991). Moreover, these studies
pinpointed that this and other kinds of intangible investments favor managerial entrenchment
initiatives that hedge managers against the actions of shareholders. More than likely,
9
shareholders would be concerned because EM practices have a cost in long-term results. We
consider improvements in a firm’s CSR beyond a certain level as an example of an
entrenchment strategy that is triggered when managers follow EM practices.
Our second argument relies on the effect of corporate ownership on both EM and
CSR. One aspect of the ownership structure is the managerial stake. In this sense, one of the
main predictions of Pagano and Volpin’s (2005) theoretical model is that generous social
concessions – specifically, large wage policy – are likely to be used as an entrenchment
policy to deter hostile takeovers in firms contingent on different managerial stakes. At the
same time, entrenchment is connected with the existence of EM practices. Teshima and
Shuto (2005) showed that EM practices are frequent for certain values of managerial
ownership where entrenchment is more likely – for intermediate values of concentration.
Combining these elements, we can connect EM with social concessions as an entrenchment
mechanism contingent on managerial ownership. Additionally, practices like EM not only
enhance managerial wealth but also give managers the necessary resources to improve
stakeholders’ interests. Thus, there is a “natural” collusion between managers implementing
EM practices and stakeholders.
Another aspect of the ownership structure is the presence of blockholders that may
eventually expropriate the minority. A firm with a limited set of large blockholders leans
more towards social-friendly policies. This is so because blockholders receive the full
benefits associated with CSR, but only bear a portion of the costs to implement such policies
(proportional to their stakes). This association between ownership concentration and CSR
found support in some recent studies (Barnea and Rubin, 2005; Neubaum and Zahra, 2006).
A remarkable aspect is that EM practices are more likely in those firms with such an
ownership structure – institutional blockholders (Carlson and Bathala, 1997; Bae et al.,
10
2005). Hsu and Koh (2005) also provided evidence supporting the link between institutional
ownership and EM.
Our last argument that justifies a positive connection between EM and CSR is that
managers who smooth earnings, which is a particular type of EM, show a bias against
volatility. A way to reduce the overall volatility of a firm’s structural parameters is by
“colluding” with other firms (Spagnolo, 2005). Our view is that this managerial preference
for collusion should also be translated internally into agreements with stakeholders to satisfy
their interests.
These three arguments justify the existence of an indirect relationship between EM
and CSR. Moreover, we have argued that there is an entrenchment motive that also explains
a non-spurious connection between these two variables. As aforementioned, a manager that
manipulates earnings has high incentives to engage in entrenchment strategies to avoid
future actions shareholders may take after EM practices damage the long-term results. A
rather natural strategy for managers is to lure stakeholders by satisfying their interests
through policies aimed at improving a firm’s CSR. This leads to the following hypothesis:
Hypothesis 1: There is a positive connection between CSR and EM that is not
spurious. Firms that manage their earnings are more likely to have superior CSR
ratings.
2.2. The role of financial performance in explaining the relationship between earnings management and social responsibility
To check the robustness of our first hypothesis, we test whether or not EM practices
still have a positive influence on CSR once we detract the effect of other relevant
determinants of CSR, such as a firm’s financial performance. We are particularly interested
in analyzing the link between EM and CSR net of the effect of CFP because it may well be
11
the case that EM determines financial performance and the latter, in turn, affects CSR. Under
this scheme, the effect of EM on CSR would vanish once we incorporate in our estimations a
financial performance variable. Thus, according to this view, there would not be
entrenchment and CSR is simply the consequence of increases in financial performance due
to EM. The central argument draws on a stream of stakeholder theory called slack resources
hypothesis (Waddock and Graves, 1997) that connects greater CFP to a surplus of resources
that gives firms the needed financial wherewithal to attend social issues (McGuire et al.
1988, 1990; Kraft and Hage, 1990; and Preston et al., 1991).
The positive impact of CFP on CSR, however, has been questioned on the basis of
various arguments. First, a short-sighted argument such that managers, especially recently-
appointed ones who are trying to acquire greater seniority, tend to pursue short-term policies
that focus exclusively on financial results at the expense of long-term social issues (Preston
and O’Bannon, 1997). Second, managers may behave opportunistically and follow
entrenchment practices (Jones, 1995), as we have extensively developed in the previous
section.
Our approach considers that an executive pursues CSR as an entrenchment
mechanism to gain the favor of large blockholders and other stakeholders and avoid their
scrutiny when she/he engages in EM practices. Moreover, social expenditures will “justify”
in the eyes of the shareholders the expected decrease in long-term profits as a consequence
of implementing EM practices. Hence, EM has a direct effect on CSR, even when we detract
from this variable the effects due to CFP. This means that managers complement accounting
manipulations to increase profits with other non-financial actions aimed at improving
stakeholders’ interests. For example, managers may invest in long-term projects that involve
a substantial proportion of intangible assets like R&D or human capital investments. These
types of investments allow, on the one hand, the use of R&D expenditures to manage
12
earnings across different periods (Baber et al., 1991; Clinch, 1991; Dechow and Sloan,
1991). On the other hand, they define long-term relations with a set of stakeholders while
providing them with valuable intangible assets (e.g., human capital). This will improve a
firm’s CSR regardless of the financial performance. This is our second hypothesis to be
tested:
Hypothesis 2: The implementation of EM practices has a positive impact on a firm’s
CSR even when we detract the effect of financial performance. That is, EM explains
significant variations in CSR regardless of the financial results.
2.3. Performance consequences of combining earnings management and corporate social responsibility
A last aspect we address in this article refers to the financial performance
consequences of a CSR policy that is triggered by the existence of EM practices. As
aforementioned, the instrumental stakeholder theory (Donaldson and Preston, 1995) argues
that good management implies good relationships with key stakeholders and this, in turn,
improves a firm’s financial performance (Freeman, 1984; Waddock and Graves, 1997).
We argue that when firms improve their CSR as a consequence of implementing EM
practices, the positive effect of CSR on CFP should be clearly diminished. This statement
relies on the fact that managers who undertake accounting adjustments tend to overinvest in
those activities that enhance a firm’s CSR as an entrenchment strategy. Social concessions
emerging from this strategy are unproductive and, because they are costly, they are expected
to have a marginal negative impact on financial performance. For example, a manager may
overinvest in on-going complex projects employing different stakeholders to satisfy their
interests and, at the same time, manage earnings in order to give these stakeholders large
concessions.
13
Along these lines, several studies justified the existence of a non-positive linkage
between social and financial performances. Rowley (1997) emphasized that a large levels of
CSR may involve connections with a wide set of stakeholders with conflicting objectives,
which can result in an excessively rigid and resource-consuming organization. A manager
who engages in EM practices, which we hypothesized to influence CSR, would attempt to
involve as many stakeholders as possible, as a way to gain support to validate her/his actions
and become indispensable (entrenchment strategy). This reduces, as aforementioned, the
flexibility of the organization and damages the financial results. Additionally, some authors
remain skeptical about the supposed positive externalities caused by CSR. Friedman (1970)
and Jensen (2001) argued that social responsible initiatives are investments without pay-offs
and, therefore, against the shareholder’s best interest.
The preceding discussion suggests that the level of earnings manipulation moderates
negatively the connection between corporate social responsibility and profitability. Hence,
our last hypothesis reads:
Hypothesis 3: The level of accounting manipulation will negatively moderate the
relationship between CSR and financial performance; the greater the EM, the less
positive the effect of CSR on CFP.
3. EMPIRICAL ANALYSIS
3.1. Sample and Data
Our sample is composed of 599 industrial firms included in the 2002-2004 SiRi
ProTM database. This is compiled by the Sustainable Investment Research International
Company (SiRi) – the world’s largest company specialized in the analysis of socially
responsible investment based in Europe, North America, and Australia. SiRi comprises
14
eleven independent research institutions, such as KLD Research & Analytics Inc. in the USA
or Centre Info SA in Switzerland, and it provides detailed profiles of the leading
international corporations. Companies are analyzed according to their reporting procedures,
policies and guidelines, management systems, and key data. This information is extracted
from financial accounts, company documentation, international databases, media reports,
interviews with key stakeholders, and ongoing contact with management representatives.
The profile of each firm contains over 350 data points that cover all major stakeholder issues
such as community involvement, environmental impact, customer policies, employment
relations, human rights issues, activities in controversial areas (e.g. alcohol), supplier
relations, and corporate governance.
We complement these data on corporate responsibility with financial data from the
COMPUSTAT Global Vantage database for the year 2000 through 2005. The Global
Vantage database contains balance sheets, income statements, cash flow statements, and
stock data, all of which have been standardized to accommodate the wide variety of financial
accounting practices across countries and industries. The final sample is an incomplete panel
data of 599 companies from 32 different countries. In our sample, information on social
issues is available across the three years under analysis (2002-2004) for 356 firms, and 497
companies show information for more than one year.
3.2. Measures
Discretionary accruals (DA). There are several ways to measure earnings management.
Recent empirical studies in accounting and finance have used the approach consisting in
dividing current accruals into its discretionary and nondiscretionary components. Following
Jones (1991) and Dechow et al. (1995), we define current accruals as:
15
( ) ( )Accruals CA Cash CL STD DEP= ∆ −∆ − ∆ −∆ − [1]
Where ∆CA is the change in current assents; ∆Cash is the change in cash; ∆CL is the
change in current liabilities; ∆STD is the change in debt included in current liabilities; and
DEP is the depreciation and amortization.
The existing EM literature focuses on the analysis of unexplained or discretionary
accruals (DA), which is a proxy for management discretion on reported earnings. Non-
discretionary accruals (NDA), on the other hand, are not related to EM because they simply
reflect business conditions. To estimate DA and NDA, we use the most popular accrual
model in the literature, the Jones (1991) model. This model separates accrual into DA and
NDA by regressing total accruals on the change in sales (∆Sales) and property, plant and
equipment (PPE). In previous literature, all variables including the constant in the cross-
sectional regression are deflated by lagged total assets (At-1). In addition to this constant
scaled by lagged total assets, Kothari et al (2005) also included a non-deflated constant term.
Finally, in the Jones model, discretionary accruals are estimated cross-sectionally each year,
using all firm-year observations in the same two-digit SIC code. In our application, however,
we do not have enough observations to perform a cross-sectional estimation in each two-
digit SIC code. A solution to this problem is to perform cross-sectional estimations for
pooled data with dummy variables denoting each sector. This estimation strategy has been
used in several papers (Kang and Sivaramakrishnan, 1995; Han and Wang, 1998). Moreover,
as we make use of an international database, it is expectable to find large differences in the
level of earnings management across countries (Leuz et al., 2003). Due to all these reasons,
and considering the number of sectors (14) and countries (32) in our data, we propose the
following modification of the Jones model:
16
( ) ( )
0 1 2 3, 1 , 1 , 1 , 1
17 49
4 18
1it it it
i t i t i t i t
j it j it itj j
Accruals Sales PPEA A A A
Sector Country
α α α α
α α ε
− − − −
= =
⎛ ⎞ ⎛ ⎞ ⎛ ⎞∆= + + +⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟
⎝ ⎠ ⎝ ⎠ ⎝ ⎠
+ + +∑ ∑ [2]
Where Sector and Country sets are dichotomous variables that capture industry and
country effects. The expected portion of total accruals, the non-discretional component, is
calculated using the regression coefficients from equation [2]:
( ) ( )
0 1 2 3, 1 , 1 , 1
17 49
4 18
1ˆ ˆ ˆ ˆ
ˆ ˆ
J it itit
i t i t i t
j it j itj j
Sales PPENDAA A A
Sector Country
α α α α
α α
− − −
= =
⎛ ⎞ ⎛ ⎞ ⎛ ⎞∆= + + +⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟
⎝ ⎠ ⎝ ⎠ ⎝ ⎠
+ +∑ ∑ [3]
From the non-discretionary accruals, NDA, we compute the discretionary accruals,
DA, as follows:
, 1
J Jitit it
i t
AccrualsDA NDAA −
⎛ ⎞= −⎜ ⎟⎜ ⎟⎝ ⎠
[4]
Where the superscript J is designed to denote the Jones model. In the Jones model,
the change in sales is used to control for firm growth since working capital is closely related
to sales, while PPE is used to control for depreciation expenses contained in accruals. As a
result, NDA are the expected accruals given the firm’s growth and fixed assets, while DA
represents the unexpected accruals.
Dechow et al. (1995) proposed a modified version of Jones model, which was
designed to better control for discretionary accruals when the manipulation is made
oversizing (anticipating) the sales. Therefore, the nondiscretionary component of total
17
accruals is computed using the estimates obtained from the original Jones model. We define
nondiscretionary accruals as:
( ) ( )
0 1 2 3, 1 , 1 , 1
17 49
4 18
1ˆ ˆ ˆ ˆ
ˆ ˆ
M J it it itit
i t i t i t
j it j itj j
Sales REC PPENDAA A A
Sector Country
α α α α
α α
−
− − −
= =
⎛ ⎞ ⎛ ⎞ ⎛ ⎞∆ −∆= + + +⎜ ⎟ ⎜ ⎟ ⎜ ⎟⎜ ⎟ ⎜ ⎟ ⎜ ⎟
⎝ ⎠ ⎝ ⎠ ⎝ ⎠
+ +∑ ∑ [5]
Where the superscript M-J denotes modified Jones model; ∆REC is the change in
receivables. Employing expressions [4] and [5], we measure the discretionary component of
total accruals as follows:
, 1
M J M Jitit it
i t
AccrualsDA NDAA
− −
−
⎛ ⎞= −⎜ ⎟⎜ ⎟⎝ ⎠
[6]
Defining the equation this way, the modified Jones model assumes that all changes in
credit sales in the event period result from earnings management practices. In the current
study, we use a cross-sectional version of the modified Jones model, where discretionary
accruals (DA) are the residuals from regression [5] estimated for each year, including
dummy variables to control for sector and country effects. Our results are robust to different
specifications of discretionary accruals. In particular, we repeated the analysis using the
standard Jones model and also the recent extension of Kothari et al. (2005). This latter
proposal consists in including the returns on assets as an additional explicative variable of
accruals.
Corporate social responsibility (CSR). This has been notoriously difficult to
operationalize in the past (Waddock and Graves, 1997) because it is a multidimensional
18
construct (Carroll, 1979) that should capture a wide range of items – ideally, one for each
relevant stakeholder (Waddock and Graves, 1997). We use SiRi ProTM data, which includes
eight research fields. The first provides a general overview of a company and the last field
reports the level of involvement in the so-called controversial business activities. The
remaining sections are devoted to measure the level of a firm’s responsibilities to its
stakeholders: community, corporate governance (shareholders), customers, employees,
environment, and vendors and contractors. In order to generate a corporate sustainability
rating, these research fields are evaluated separately and rated on scales ranging from 0
(worst) to 10 (best). Then, each rating is weighed according to four criteria that are ranked in
a 0-10 scale. According to the SiRi methodology, the final weight for each stakeholder is
captured through the mean value of four scaled items: Transparency, principles, management
and operations. In this study, our measure of corporate social responsibility is the weighed
average of the scores provided by SIRI on a firm’s primary stakeholders (worker, customers,
suppliers, shareholders, community, and environment).
Corporate financial performance (CFP). We use the return on assets (ROA). We
rely on accounting measures because they are more sensible than market measures to
managers’ manipulations. As pointed by Orlitzky et al. (2003: 408), “indicators such as ROA
and ROE are subject to managers’ discretionary allocations of funds to different projects and
policy choices, and thus reflect internal decision-making capabilities and managerial
performance rather than external market responses to organizational actions”.
Control variables. We control for standard variables used the literature (Waddock
and Graves, 1997; Hillman and Keim, 2001): The Intangible resources are measured
through the intangible assets divided by revenues. Leverage is approached through the ratio
19
of accounting value of total debt to the total value of assets. Firm risk has been
operationalized using beta as reported in Compustat Global Vantage (e.g., Hillman and
Keim, 2001). Finally, we control for size and financial resources. Size is approximated using
total revenues, which is widely recognized as a determinant of a firm’s financial and social
responsibility. For financial resources, we use the ratio of cash-flow to current liabilities.
3.3. Analysis
To test our hypotheses, we use a two-stage procedure. In the first stage, we estimate a
cross-sectional version of the modified Jones model. Our measure of earnings management
is, therefore, the result of applying the expression [6]. Once the discretionary accruals are
computed, we employ fixed-effects regression analyses to test our hypotheses. Fixed-effect
estimations prevent endogeneity problems relying on the eventual correlation between the
fixed unobservable heterogeneity and some explanatory variables. In particular, we expect
the unobserved determinants of CSR to be perfectly correlated with a firm’s CFP. Thus, we
have to estimate in differences (fixed-effect estimation). Additionally, we lagged some
independent variables one period to prevent endogeneity problems that are not linked to the
constant unobservable heterogeneity. In particular, we lagged by one period the variable
CFP in the specification of CSR (see equation [7]) because instrumental stakeholder theory
establishes that the latter variable is a determinant of the former. Conversely, in the
specification of CFP (see equation [8]) we lagged the variable of CSR because, as we
mentioned in the theoretical section, more available financial resources may affect a firm’s
CSR - Slack Resources Hypothesis (Waddock and Graves, 1997)-. Also, in specification [8]
we have lagged the variable of Discretionary Accruals because bad financial results may
trigger earnings manipulations. Finally, in both specifications [7] and [8] we have lagged
20
two control variables: Leverage and Risk because debt capacity as well as a firm’s risk
depends on its financial and social results.
As aforementioned, in our empirical application, we rely on two basic specifications,
one explaining CSR and the other explaining CFP. The main dependent variable in both
cases is the earnings management variable. Additionally, we consider the same set of control
variables in explaining financial performance and social responsibility.
In order to explain CSR and test Hypotheses 1 and 2, we rely on the following
regression:
( ) ( ) ( )
( ) ( ) ( ) ( )1 2 3 41
5 6 7 81 1
tan
' 'it it it it
i itit it it it
CSR Discretionary accruals CFP In gible resources
Leverage risk Size Financial resources
λ λ λ λ
λ λ λ λ η ε−
− −
= + + + +
+ + + + + + [7]
It is important to note that Intangible resources, Leverage and Risk are intended to
control for a possible spurious correlation between Discretional accruals and CSR, as
described in the theoretical section. Intangible resources are connected to intangible
investments; Leverage is inversely related to blockholder expropriating impulses (de la
Bruslerie, 2006) and risk is connected to managerial risk aversion.
To study the expected direct impact of earnings management activities on CSR, as
stated in Hypothesis 1, we exclude CFP from specification [7]. This hypothesis is confirmed
when 2λ is positive and significant. To test the real strength of discretionary accruals, we
accompany in the specification this variable with a strong determinant of CSR: the CFP
variable (Hypothesis 2). In this way, we account the effect that financial performance may
have on our main variables. Hypothesis 2 is confirmed when the coefficient of discretionary
accruals 2λ is positive and significant in the estimation that includes the variable of financial
performance (Model 3 of Table 2).
The second specification is aimed at explaining financial performance. As
mentioned, we employ the same control variables as in specification [7] and the earnings
21
management variable. Additionally, in accordance with the instrumental stakeholder theory,
CSR is contemplated as a predictor variable. Finally, in order to identify whether or not
discretionary accruals moderate the connection between CSR and financial performance, we
use an interaction term constructed by multiplying discretionary accruals and CSR. Hence,
the specification is:1
( ) ( )
( ) ( ) ( )( )
1 2 31 1
4 5 61 1
7 1 8 9
tan
) ( ) (
it it it
it it it
it it i itit
CFP CSR Discretionary accruals
Discretionary accruals CSR In gible resources Leverage
Risk Size Financial resources
β β β
β β β
β β β η ε
− −
− −
−
= + +
+ × + +
+ + + + +
[8]
From this specification, Hypothesis 3 is confirmed when the coefficient of the
interaction term 4β is negative and significant.
4. RESULTS
Table 1 reports means, standard deviations, and correlations among all variables used
in the study. The analysis of the correlation matrix shows initial evidence of the positive
relationship between CSR and discretionary accruals, although it is not significant at 10
percent. Also in Table 1, we observe that discretionary accruals are positively related to
financial performance, and financial resources (all .01p < ), and negatively related to risk
(all .01p < ).
------------------------------- Insert Table 1 about here -------------------------------
Tables 2 and 3 show the results of regression analyses. In Table 2, we test the effect
of a firm’s EM practices on CSR (Hypothesis 1). Also, we study the strength of this effect by
incorporating CFP as an additional predictor the discretionary accruals (Hypothesis 2).
Model 1 tests the direct effect of discretionary accruals on CSR. Results indicate that the
1 In both specifications, [7] and [8], we have also included significant temporal dummy variables to control for potential temporal effects.
22
effect of EM practices on social responsibility is positive and significant ( 0.0472β = ,
.05p < ), providing support for Hypothesis 1.
---------------------------------------- Insert Table 2 about here
----------------------------------------
Hypothesis 2, as aforementioned, is tested in Model 3. We find that the discretionary
accruals variable is also significant ( 0.044β = , .05p < ) in the specification that includes
the variable of financial performance, indicating that even when we detract the effect of this
variable on the discretionary accruals, this latter still have an impact on CSR. This conforms
to Hypothesis 2.
Concerning the rest of variables, as expected, we find that CSR is positively related to
size and risk (all .01p < ).
The regression results presented in Table 3 test Hypothesis 3 regarding the role of
discretionary accruals as moderator of the relationship between CSR and financial
performance. To test this hypothesis, we use an interaction term formed by multiplying the
CSR and discretionary accruals variable. As previously stated, we expect the interaction term
to be negative; suggesting that generous social concessions, defrayed through accounting
manipulation, reduce financial performance. Also, we test whether social performance has an
impact on financial performance.
---------------------------------------- Insert Table 3 about here
----------------------------------------
Results presented in Table 3 show that the coefficient for CSR is positive ( .05p < )
while for the interaction term is negative and significant ( .01p < ), explaining financial
performance. These results provide support for Hypothesis 3 on the negative moderating
effect of the EM practices in the relationship between CSR and CFP. Concerning the direct
effect of EM variable, it is remarkable to state that it is positive in the contemporaneous
23
specification ( 0.0858β = , .01p < in Model 2), as expected, given that EM practices are
aimed at improving financial performance. However, when we have lagged this variable by
one period (Models 3 and 4) to prevent potential endogeneity, we have found that these
practices have a negative impact on financial performance. This suggests that EM practices
are effective only in the short-term but not in the medium-term (one period ahead), which is
one of the reasons why managers define entrenchment policies like improvements in CSR
policies.
Turning our attention to the rest of variables, we find that financial performance
increases with increases in risk ( .05p < in Model 4) and financial resources ( .01p < , in all
models).
5. DISCUSSION AND CONCLUSION
It is frequently argued that managers pursue their own private objectives to the
detriment of shareholders and, by extension, to the rest of stakeholders. Recent corporate
scandals like those of Enron, or WorldCom, Arthur Andersen, Tyco International, and
Adelphia, have revealed how important the earnings management – social responsibility –
financial performance nexus is. Some of these firms occupied high positions in social
responsibility rankings. At the same time, they were benefiting from flexible accounting
principles to influence earnings, thereby reporting performance figures greater than real
values.
In this paper we have investigated the relationship between corporate social
responsibility (CSR) and earnings management (EM) practices. The results found confirm
the existence of a positive relationship between both variables. Firms that manage their
earnings show superior levels of CSR once we control for different variables that may justify
24
the existence of a spurious correlation (intangible resources, expropriating risks and firm’s
risk). We interpret these results as evidence of a managerial entrenchment strategy.
Managers who carry out EM practices have a natural impulse to collude with other
stakeholders as a hedging strategy against disciplinary initiatives of shareholders, especially
the minority ones, whose long-term interests may be damaged by these practices.
A second remarkable result that we have found is that the connection between EM
and CSR is robust to the inclusion of variables like financial performance. This result
suggests that the linkage between EM and CSR is not explained through the effect EM
practices on a firm’s CFP. What increases a firm’s CSR is not only the inflated financial
results but also the set of entrenchment initiatives aimed to satisfy stakeholders’ interests.
Finally, we demonstrated that the combination of EM practices and a CSR policy is
costly for the firm as the increase of social concessions to stakeholders justified by means of
reported CFP improvements has a marginal negative impact on the financial performance. In
other words, we found that the connection between social and financial performance
weakens in high earnings management contexts.
5.1 Implications for Research
This work is a bridge between the corporate governance literature and stakeholder
theory. According to this latter line of research, the management of stakeholders is a way of
improving financial results (Jones, 1995; Donaldson and Preston, 1995), whereas corporate
governance emphasizes the difficulty to conciliate the demands of a wide set of stakeholders
(Jensen, 2001; Tirole, 2000). Thus, a desirable objective is to define some criteria to
distinguish those situations where improvements in CSR are aimed at increasing financial
performance from those situations where the objective is to entrench the manager. These
latter situations have been characterized in previous studies like those by Pagano and Volpin
25
(2005) and Cespa and Cestone (2004). These authors connected social concessions to
workers as an entrenchment strategy to avoid takeovers.
Our main result is that the implementation of EM practices is a key element that
distinguishes both types of situations. Accounting performance manipulations are associated
with the entrenchment dimension of a firm’s CSR. Thus, shareholders should be aware of the
perverse effect of connecting accounting adjustments on financial results with a generous
spending in social issues. This practice has significant negative effect on performance in the
long-term.
5.2 Policy implications
The conclusions derived from this study are important for both investors and public
authorities. Investors should not take for granted that firms with a large CSR behave fairly.
Our results show that these firms may perfectly be involved in EM practices. Also, public
authorities should be aware that a firm’s CSR is the outcome of different firm’s investments.
Thus, promoting a specific type of social responsible behavior may result in inefficient
overinvestment in such activities. This situation may perfectly be accompanied, as we have
found, with misbehaviors like earnings management.
5.3 Future research
A natural extension of our work is to focus on more specific dimensions of a firm’s
CSR in order to study which are the most relevant stakeholders that a firm particularly cares
about when it manages its earnings. Also, it may be worth to conduct this fine grained
analysis differentiating by sectors and institutional frameworks. A second extension is the
incorporation in the analysis of variables of ownership structure. We expect a different
connection between CSR and EM when large blockholders are institutions instead of
individuals. Also, managerial ownership is a clear determinant of entrenchment policies.
26
Additionally, it may worth considering whether or not our results are robust comparing
different countries. The exploration of this issue may be relevant given the significant
differences that exist in top management orientation across countries. In Anglo-Saxon
countries, managers are inclined to satisfy shareholders interest, while in Continental Europe
and Japan, managers have traditionally been more sensible to the construction of long-term
relationships with employees, banks, and suppliers. Remarkably, there are also significant
differences in the level of earnings management across countries (Leuz et al., 2003). Hence,
the connection between EM and CSR will clearly depend on the institutional context. The
study of this and other issues is left for future research.
27
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TABLE 1
Descriptive Statistics and Correlations a
N Mean St. Dev. 1 2 3 4 5 6 7 1. CSR 1449 52.7832 15.1333 2. Financial performance 3437 4.7431 9.8487 0.0852* 3. Discretionary Accruals 2211 -0.0271 0.1084 0.0317 0.1668* 4. Intangible resources 2871 0.3347 0.9823 -0.1609* -0.2004* -0.0438 5. Leverage 3526 24.9704 16.2009 0.0748* -0.1816* -0.0128 -0.016 6. Financial resources 3474 0.9740 19.5384 0.0722* 0.0764* 0.0688* -0.0157 -0.0486* 7. Size 3547 17315 32775 0.1598* 0.0449* -0.0154 -0.0495* 0.0161 -0.0252 8. Risk 3100 0.9305 0.7962 -0.1173* -0.2473* -0.0790* 0.1102* -0.1032* 0.0189 -0.0569*
a * Means that the correlation is significant at 1% level.
32
TABLE 2
Results of Fixed-Effects Regression Analyses of Social responsibility on Financial Performance and Discretionary Accruals a
(1) (2) (3)
Dependent variable: CSR CSR CSRDiscretionary Accruals 0.0472**
(2.0000)0.0444**(1.8800)
Financial performance (-1) 0.0052**(1.9800)
0.0049**(1.8600)
Intangible resources -0.0606(-0.5400)
-0.0889(-0.8000)
-0.0677(-0.6100)
Leverage (-1) 0.0191(0.3000)
0.0417(0.6300)
0.0452(0.6900)
Risk (-1) 0.1193***(2.7500)
0.1265***(2.9100)
0.1243***(2.8700)
Size 0.2945***(2.6200)
0.2988**(2.6500)
0.2989***(2.6600)
Financial resources -0.4156(-0.5000)
-1.1405(-1.2500)
-1.1321(-1.2400)
Constant 0.1900***(5.2400)
-0.1053***(-2.5900)
0.1495***(3.5400)
R2 Within 27.13% 27.12% 27.59%F test 30.25 (0.000) 30.24 (0.000) 27.38 (0.000)Hausman Test 19.56 (0.000) 90.62 (0.000) 399.24 (0.000)N 1159 1159 1159
a Standardized regression coefficients are shown in the table. In parentheses the p-values. Notation (-1) means that the variables are lagged by one period in order to prevent endogeneity problems. * p ≤ 0.10; ** p ≤ 0.05; *** p ≤ 0.01
33
TABLE 3 Results of Fixed-Effects Regression Analyses of Financial Performance on Discretionary Accruals and CSR a
(1) (2) (3) (4)
Dependent variable: CFP CFP CFP CFP
CSR(-1) 0.0635**(2.0900)
0.0601** (2.0100)
Discretionary Accruals 0.0858***(4.0500)
Discretionary Accruals (-1) -0.0676***(-3.1300)
-0.0761*** (-3.5600)
Discretionary Accruals × CSR (-1) -0.0480*** (-2.3800)
Intangible resources 0.0639(0.5400)
0.0820(0.7100)
-0.0031(-0.0300)
-0.0251 (-0.2200)
Leverage (-1) 0.0640(0.9300)
0.0448(0.6700)
0.0536(0.7900)
0.0614 (0.9200)
Risk (-1) 0.1150*(1.6300)
0.1391**(2.0100)
0.1343(1.9300)
0.1351** (1.9600)
Size 0.1471(0.9500)
0.2139(1.4400)
0.2359*(1.5900)
0.1754 (1.1600)
Financial resources 29.8384***(18.4600)
29.0811***(18.1900)
30.4047***(18.9300)
30.2432*** (19.1300)
Constant 0.8375***(16.3700)
0.7956***(15.8800)
0.8274***(16.4600)
0.8348*** (16.7100)
R2 Within 58.05% 59.96% 58.86% 60.46% F test 63.67 (0.000) 68.37 (0.000) 65.81 (0.000) 52.36 (0.000) Hausman Test 82.50 (0.000) 79.99 (0.000) 110.74 (0.000) 123.52 (0.000)
N 701 701 701 701
a Standardized regression coefficients are shown in the table. In parentheses the p-values. Notation (-1) means that the variables are lagged by one period in order to prevent endogeneity problems. * p ≤ 0.10; ** p ≤ 0.05; *** p ≤ 0.01