Corporate Social Responsibility Reporting and Earnings Management: The Role of Political Costs

Article excerpt

Abstract

Recently, Francis, Nanda and Olsson (2008) proposed that earnings quality influence firms' disclosure decisions. We examine whether Corporate Social Responsibility (CSR) disclosure is related to earnings management and if the relationship is mitigated by political cost considerations or by the firm's ethical predisposition. We argue that the relationship between CSR reporting and earnings management is context-specific and we consider one particular context, the political environment. We test our hypotheses by regressing earnings management on CSR disclosure while controlling for other factors that may affect the level of earnings management. We find a significant relationship between CSR reporting and earnings management, and more specifically, we find evidence of a negative (complementary) relationship in the oil and gas industry while we find evidence of a positive (substitutive) relationship in the food industry. The evidence supports the view that the relationship between CSR reporting and earnings management is affected by the political environment and not by ethical considerations.

Key Words: Corporate social responsibility (CSR), earnings management, relationship between CSR and earnings management.

JEL Classification: M40.

(ProQuest: ... denotes formulae omitted.)

Introduction

Issues such as global warming, emission trading schemes and carbon taxes have pushed environmental issues into the mainstream. Conditions of employment and the treatment of employees by multinationals in developing and other countries have also focussed attention on social issues. Increasing concern about the sustainability of the world's resources has contributed to the rising importance of corporate social responsibility (CSR). With labels such as corporate citizenship, the triple bottom line, and more recently sustainability, the concept of CSR extends the accountability of firms beyond financial accountability to their shareholders and to other stakeholders.

However, maximising financial performance and firm value remain key objectives for all publicly traded companies. In fact, given that earnings are an important indicator of financial performance, managers can find themselves under pressure to use the flexibility afforded under generally accepted accounting practices (GAAP) to manage earnings to meet certain expectations or targets.3 For example, DeGeorge, Patel and Zeckhauser (1999) find that managers manage earnings upward to meet or beat analysts' earnings forecasts (see also Ghosh & Olsen 2009).

In this study, we examine the relationship between CSR reporting and earnings management. We consider two separate explanations. First, the ethics literature acknowledges that firms can, and should be, ethically responsible. For example, Hoffman (1986, p. 234) suggests that "although it may be tricky both conceptually and practically, corporations and other collectives can, must in fact, stand up to the demands of moral responsibility, even though their actions are carried out by individuals acting on their behalf". Furthermore, according to Chun (2005), ethical organisations will display integrity by being honest, sincere, socially-responsible, and trustworthy. Firms may demonstrate ethical commitment through philanthropic contributions and through using its resources and expertise to benefit society, e.g. reducing waste, employing minorities, and caring for the environment (Hoffman 1986). Thus, under an ethical perspective, firms that are socially responsible and make CSR disclosures would be less inclined to manage earnings (i.e., reporting earnings honestly and sincerely).

Second, Francis et al. (2008) propose that earnings quality - which is the inverse of earnings management - influences firms' disclosure decisions. They use voluntary disclosures to test this proposition, but their definition for voluntary disclosures excludes CSR disclosures. Francis et al. …