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. diego.prior@uab.es 2 Business Department, Carlos III, C/ Madrid 126 (Getafe), 28903. Phone: (34) 916248640. E-mail: jsurroca@emp.uc3m.es

3 Business Department, Carlos III, C/ Madrid 126 (Getafe), 28903. Phone: (34) 916249321. E-mail: joatribo@emp.uc3m.es * 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.

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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,

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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

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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

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(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

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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.

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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

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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,

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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.,

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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

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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

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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.

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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

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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:

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( ) ( )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

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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