This study examines the impact of mandatory Corporate Social Responsibility (CSR) reporting on firms’ financial reporting quality using a quasi-natural experiment in China that mandates a subset of firms to report their CSR activities starting in 2008. We find that mandatory CSR disclosure firms constrain earnings management after the policy. The result is robust to a battery of sensitivity tests and more prominent for firms with lower analyst coverage. Further analyses reveal that upward earnings management by mandatory disclosure firms is more likely to be caught after the policy. The findings suggest that mandatory CSR disclosure mitigates information asymmetry by improving financial reporting quality.
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We also use both non-mandatory CSR reporting firms and non-disclosure firms as control group in the robustness test.
From 2008 to 2012, a total of 454 listed firms were mandated to disclose CSR reports. We exclude the mandatory reporting firms in the financial sector and classify a firm as a mandatory CSR reporting firm if the firm is mandated to submit a CSR report every year from 2008 to 2012. We also require that the firms have available information to calculate earnings management proxies and control variables. As a result, we have 296 firms as mandatory CSR reporting firms in our sample.
On October 27, 2005, the Chinese Government adopted Articles 5 and 17 under “Company Law of the People’s Republic of China” in the 18th session of the Standing Committee of the 10th National People’s Congress of the People’s Republic of China.
Notice on Strengthening Listed Companies’ Social Responsibility (Shanghai CSR Notice) and Guidelines on Listed Companies’ Environmental Information Disclosure (Shanghai Environmental Disclosure Guidelines) were issued in May 2008.
The SHSE Corporate Governance Section Index (CGSI) includes 199 SHSE listed firms that were selected by SHSE for their well-established corporate governance in December 19, 2007. As the launching of CGSI coincides with the issuance of the Notice, and as cross-listed firms may be subject to stricter regulation, we exclude those SHSE listed firms in the robustness test and our main findings remain valid.
Burns and Kedia (2006), Bergstresser and Philippon (2006), and Efendi et al. (2007) conclude that managers manage earnings to boost their compensation by shifting earnings to raise stock prices during or before stock option exercising periods. Beneish and Vargus (2002) and Bergstresser and Philippon (2006) show that managers sell more stocks when firms have abnormally high accruals. DeFond and Park (1997), Ahmed and Lobo (2006), and Mergenthaler et al. (2009) find that managers’ job security is an incentive for earnings management. DeFond and Jiambalvo (1994) and Sweeney (1994) show that managers have incentives to manage earnings to avoid violating debt covenants and gain accounting flexibility. Watts and Zimmerman (1978) and Bushman and Piotroski (2006) report that political costs serve as one factor in managers’ earnings-management decisions. See Fudenberg and Tirole (1995) and Hermalin and Weisbach (2007) for theoretical perspectives on these issues.
Currently, there are two classes of shares issued by Chinese firms that are listed and traded on the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE): A- and B-shares. A-shares are domestic shares that are restricted to domestic investors and Qualified Foreign Institutional Investors (QFII). B-shares are foreign shares that until February 2001 were only available to foreign investors.
The 2008 Notice mandates 454 listed firms to disclose CSR reports. We exclude the mandatory reporting firms from the financial sector and classify a firm as non-mandatory CSR reporting firm if the firm is mandated to disclose CSR report in 2008 but not in the subsequent years. As a result, we classify 296 firms as mandatory CSR reporting firms with available information to calculate earnings management and control variables.
Also, we run the baseline regression using the two subsamples of SHSE and SZSE, respectively. The results show that mandatory CSR firms in both SHSE and SZSE tend to reduce earnings management after they are mandated to disclose CSR report. The results are not reported for brevity and are available upon request.
In an unreported test, we examine the impact of mandatory CSR policy on earnings management for state-owned enterprises (SOEs) and private-owned enterprises (POEs) separately and find that both mandated-disclosure SOEs and mandated-disclosure POEs reduce earnings management activities after 2008.
Chen et al (2011) indicate that SOEs have fewer incentives to engage in earnings management. Hung et al. (2013) find that larger firms have smaller information asymmetry. Since mandatory disclosure firms tend to be larger firms and larger firms tend to have smaller earnings management, there is a valid concern that the negative relation between mandatory disclosure and earning management might be due to firms’ size effect. We try to alleviate this concern in several ways. First, we run difference-in-differences (DiD) test to examine the same firm's earnings management changes before and after the mandatory CSR policy. That is, we examine whether or not the same firm reduces earnings management surrounding the policy. Such a difference-in-differences test can largely remove the size effect. Second, we run firm fixed-effect test to address the concern of omitted firm characteristics bias including firm size bias. Third, we generate a propensity-score-matching sample as the control firms to make sure that the control firms have similar firm characteristics as the treatment firms. As we can see from the Panel B of Table 3, firm size no longer affects the magnitude of earnings management when we employ the propensity-score-matching approach to construct the control group. Our findings remain valid in the above three tests.
We obtain similar results when we require the difference to be <0.01 or 0.025 times standard deviation of the propensity scores.
There might be another competing argument that our results are due to the 2008 crisis effect, which might affect the calculation of discretionary accruals. In order to rule out this argument, we examine the mandatory firms’ earnings management behavior surrounding the Asian financial crisis in 1997. Specifically, we define 1993–1997 as the precrisis period and 1998–2002 as the postcrisis period and rerun the baseline regression. The unreported results show that financial crisis in 1997 does not affect the earnings management activities for the mandated CSR firms. This suggests that economic crisis is least likely the cause of the reduction in mandatory firms’ absolute discretionary accruals surrounding 2008.
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We thank workshop participants at Dongnan University for their helpful suggestions. This study is supported by the National Natural Science Foundation of China (Project Nos.: 71132004 and 71302157) and China Ministry of Finance (Project No.: 2015KJA009).
Appendix: Estimation of the Magnitude of Earnings Management
Appendix: Estimation of the Magnitude of Earnings Management
Performance-Adjusted Discretionary Accrual Measure
where TA i,t denotes the total accruals calculated as earnings less cash flows from operations for company i at year t; A i,t−1 is the total assets of company i at year t − 1; ∆REV i,t is the change in sales revenue; ∆REC i,t is the change in accounting receivables; PPE i,t represents property, plant, and equipment; ROA i,t is net income divided by the total assets at year t − 1; and ε i,t denotes the residual term. The model (A1) is estimated cross-sectionally by each industry-year group. We require each industry-year group to have at least 10 observations to ensure reliable estimation. The fitted values from Model (A1) are the normal accruals (or nondiscretionary accruals) that arise from companies’ normal operating activities, and the residual term (DA1) denotes the performance-adjusted discretionary accruals that are assumed to be opportunistically chosen by management.
Performance- and Growth-Adjusted Discretionary Accrual Measure
We first estimate the following model for each year-industry group (Raman and Shahrur 2008):
where BM i,t is the ratio of book value to market value of equity. Other variables are defined as in Model (A1). The residual term (DA2) denotes the performance- and growth-adjusted discretionary accruals that are assumed to be opportunistically chosen by management.
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Wang, X., Cao, F. & Ye, K. Mandatory Corporate Social Responsibility (CSR) Reporting and Financial Reporting Quality: Evidence from a Quasi-Natural Experiment. J Bus Ethics 152, 253–274 (2018). https://doi.org/10.1007/s10551-016-3296-2
- Corporate Social Responsibility
- Earnings management
- Information asymmetry