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Corporate Codes of Ethics, National Culture, and Earnings Discretion: International Evidence

Abstract

This study examines the role of codes of ethics in reducing the extent to which managers act opportunistically in reporting earnings. Corporate codes of ethics, by clarifying the boundaries of ethical corporate behaviors and making relevant social norms more salient, have the potential to deter managers from engaging in opportunistic financial reporting practices. In a sample of international companies, we find that the quality of corporate codes of ethics is associated with higher earnings quality, i.e., lower discretionary accruals. Our results are confirmed for a subsample of firms more likely to be engaging in opportunistic reporting behavior, i.e., firms that just meet or beat analysts’ forecasts. Further, codes of ethics play a greater role in reducing earnings management for firms in countries with weaker investor protection mechanisms. Our results suggest that corporate codes of ethics can be a viable alternative to country-level investor protection mechanisms in curbing aggressive reporting behaviors.

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Notes

  1. 1.

    For example, in their review of empirical studies examining the effectiveness of business codes, Kaptein and Schwartz (2008) find that 35 % of the studies found a strong positive relationship, 16 % reported a weak positive relationship, 33 % found no significant relationship, 14 % reported mixed results, and one study found evidence of a negative relationship.

  2. 2.

    For example, Choi and Pae (2011) are based on an ethical commitment survey conducted for 252 Korean firms in 2004.

  3. 3.

    See “Business Codes of the Global 200” (KPMG 2008).

  4. 4.

    The authors identify eight basic governing principles: fiduciary, property, reliability, transparency, dignity, fairness, citizenship, and responsiveness.

  5. 5.

    Further information on EIRIS can be obtained at their website: http://www.eiris.org.

  6. 6.

    The area related to the firm’s communication of its code of ethics cannot be used in our study because EIRIS dropped the questionnaire inquiring about this issue in 2006.

  7. 7.

    While it is not clear how such bias affects our inference, to the extent the biases/errors are randomly distributed across firms, they will bias against documenting our findings.

  8. 8.

    EIRIS refers to this variable as “governance.” We label it as “corruption” as the former is a bit too broad of a concept and the latter is more descriptive of what the variable measures.

  9. 9.

    The data are no longer available to replicate the fifth measure illustrated by Scholtens and Dam (2007), Communication of the code of ethics (whether the company has adopted a code of ethics or business principles by which it communicates to all employees). The answer was either no evidence of, has adopted, or clearly communicates. For this measure (whatID = 224 in the access file), the data are only available until 2006. We cannot find this question in the “Guide to EIRIS Research” handbook published in the summer of 2013.

  10. 10.

    The results are unchanged when Human Rights is included in the principal component analysis.

  11. 11.

    The results are qualitatively similar when unweighted OLS is estimated. The ethics variables have the predicted sign, although the significance levels are slightly lower (p < 0.10), presumably due to the econometric issues discussed above.

  12. 12.

    For comparison, Scholtens and Dam (2007), which also use the EIRIS data, have 24 countries represented in their sample. We have a slightly lower number of countries represented because we require extensive firm-level control variables which were not required in Scholtens and Dam (2007).

  13. 13.

    We obtain 163 country-year medians of the regression variables under this procedure. The EthicalSystem variable remains negative and significant at p < 0.10.

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Acknowledgments

We thank seminar participants at the 2013 European Accounting Association Annual Congress and 2013 American Accounting Association Annual Meeting

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Corresponding author

Correspondence to Tony Kang.

Additional information

Data Availability

Data used in this study are available from public sources identified in the study. We thank EIRIS for providing data on corporate ethics policy.

Appendix: Variable Definitions

Appendix: Variable Definitions

Test variables (from EIRIS):

  1. 1.

    Code of Ethics Systems The first question about the firm’s code of ethics is whether the company has a code of ethics and, if so, how comprehensive is it. The answer is either no, limited, basic, intermediate, or advanced.

  2. 2.

    Code of Ethics Implementation The second question is whether the company has a system for implementing a code of ethics and, if so, how comprehensive is it. The answer is either no, limited, basic, intermediate, or advanced.

  3. 3.

    Corruption Does the company have policies and procedures on bribery and corruption? Here, the firm can have a clear policy and procedures, an adopted policy, or no policy disclosed.

  4. 4.

    Human Rights Policy and System Overall Rating What is the extent of policy addressing human rights issues? The answer is either no evidence of, has adopted, or clearly communicates.

Culture-related variables from Hofstede (2001)

  • PDI: Power distance score

  • IDV: Individualism score

  • MAS: Masculinity score

  • UAI: Uncertainty avoidance score

Country-level control variables

INFLATION: Measured by the annual growth rate of the GDP implicit deflator, showing the rate of price change in the economy as a whole. The GDP implicit deflator is the ratio of GDP in current local currency to GDP in constant local currency from the World Bank.

GDP_GROWTH: Growth of gross domestic product, measured as the annual percentage growth rate of GDP at market prices based on constant local currency also from the World Bank

Firm-level control variables

CORPORATE GOVERNANCE: We measure Corporate Governance with a score from zero to three based on the survey question “Does the Company: (1) separate the roles of chairman and chief executive (2) have a board comprising more than 33 % independent directors, (3) have an audit committee comprising a majority of independent directors, and (4) disclose director remuneration. Companies’ answers could be “none,” “one,” “some,” or “all.” Therefore, the range of this measure is 0-3.

ROA: Return on Assets, measured as net income deflated by the beginning of the year total assets.

LNSIZE: Natural logarithm of market value of equity

BM: Book-to-market ratio

LEV: Leverage ratio, measured by debt to total assets

ISSUE: 1 if shareholders’ equity increases by more than 10 %; 0 otherwise

LOSS: 1 if the firm reported a loss during the year; 0 otherwise

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Chen, C., Gotti, G., Kang, T. et al. Corporate Codes of Ethics, National Culture, and Earnings Discretion: International Evidence. J Bus Ethics 151, 141–163 (2018). https://doi.org/10.1007/s10551-016-3210-y

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Keywords

  • Corporate ethics policy
  • Code of ethics
  • Business ethics
  • Earnings discretion
  • Accruals

JEL Classifications

  • G300
  • L210
  • M140
  • M410