Voluntary disclosures of sustainability information have recently received considerable attention by investors, regulators, and public companies in improving reliability and integrity of corporate reporting. We examine the association between the quantity and quality of sustainability disclosures and earnings quality in the context of corporate ethical value and culture. We posit that sustainability disclosures of environmental, social, and governance (ESG) performance reports are linked to earnings quality, because of the importance of both earnings quality and ESG sustainability disclosures to investors and trustworthiness of corporate reporting. We collect our sample of 35,110 firm-year observations between 1999 and 2015. Using both difference-in-difference tests and OLS regression, we find that sustainability disclosure quantity is positively associated with innate earnings quality and negatively correlated with discretionary earnings quality in mitigating managerial earnings manipulation and unethical opportunistic reporting behavior. Further tests illustrate that sustainability disclosure quality can strengthen the positive relation between innate earnings quality and sustainability disclosure quantity and mitigate the negative relation between discretionary earnings quality and sustainability disclosure quantity. Finally, additional tests suggest that the relation between earnings quality and sustainability disclosure quantity is moderated by corporate structure and prior-year sustainability performance. Our results provide policy, practical, and research implications as ESG sustainability reporting is being integrated into corporate culture and business models.
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The terms corporate social responsibility (CSR) and ESG sustainability have been interchangeably used in the business literature. Consistent with Ng and Rezaee (2015), Jain et al. (2016) and Khan et al. (2016), we use ESG sustainability attributes constructed from the Global Reporting Initiative (GRI) database as the proxy for sustainability quality and quantity disclosures. We attempt to address an association between ESG sustainability disclosures and earnings quality and do not claim to provide any causation evidence.
The focus of this paper is on sustainability disclosures. However, there are two aspects of business sustainability, namely sustainability performance and sustainability disclosure, and prior research (e.g., Jain et al. 2016; Ng and Rezaee 2015) argues that both sustainability performance and disclosure are correlated. Prior studies (e.g., Jain et al. 2016; Ng and Rezaee 2015) use the KLD database to construct ESG sustainability performance measures and GRI and/or Bloomberg databases to construct ESG sustainability disclosures. The GRI database used in this study provides both ESG disclosure quality and quantity.
Although MD&A contains financial information related to past earnings and future earnings forecast, it also provides investors with supplementary non-financial information related to management strategies and planning.
We use the definition of sustainability reports provided by the Global Reporting Initiatives (GRI) as reports published by entities about the economic, environmental, and social impacts caused by their everyday activities.
The GRI is a not-for-profit organization which “promotes the use of sustainability reporting as a way for organizations to become more sustainable and contribute to sustainable development”.
We limited our sample to US companies that could construct both innate and discretionary earnings quality.
DID is a more effective technique when explaining a casual relation and data of certain control variables are not available.
According to the introduction on the GRI website, “GRI's mission is to make sustainability reporting standard practice for all companies and organizations. Its Framework is a reporting system that provides metrics and methods for measuring and reporting sustainability-related impacts and performance.” GRI has already released several versions of sustainability reporting frameworks, including G1, G2, G3, G3, and G4. The G1 is the earliest version and implemented by sustainability reports released in early twenty-first century. G4 is the latest version of GRI Framework and employed by most recent sustainability reports.
Following Moon Jr. (2014), intangible assets are measured as the sum of R&D expenditures and advertisement expenditures, and missing values are set to zero.
When we test the relation between disclosure quality and earnings quality, the sample size is significantly reduced to 1180, since only sample firm-year which disclose sustainability reports contain the variables of disclosure quality.
The external assurance and accounting firm assurance data are also available in the GRI database. However, these two variables are provided by GRI since 2014. Therefore, the sample sizes are quite small when we implement the two alternative measurements of disclosure quality.
When we use these two alternative measurements of disclosure quality, we only run OLS tests and don’t conduct DID tests, because the external assurance is not an exogenous factor. In contrast, the release of G4 guideline (DIS_Q1) and the GRI guideline application level (DIS_Q2) are both exogenous factors outside the firms.
The sample sizes are reduced after merging with institutional ownership data from Thomson Reuters 13-F filings and sustainability performance data from KLD database.
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Appendix: Variable Definition
Appendix: Variable Definition
Disclose = a dummy variable equals to 1, if the firm releases a sustainability report: zero otherwise.
DIS_Q1 = a dummy variable which is equal to 1, if the firm prepare the sustainability report; zero otherwise.
DIS_Q2 = the application level of GRI framework in preparing the sustainability report.
EQ = the earnings quality measured as the standard deviation of the residuals obtained from the modified Dechow and Dichev model during the 5-year period prior to the sample year.
IEQ = the predicted value from the regression of earnings quality on inherent firm traits.
DEQ = the residual from the regression of earnings quality on inherent firm traits.
CFVOL = the standard deviation of cash flows scaled by total assets over the previous 5 year window.
SALEVOL = the standard deviation of sales scaled by total assets over the previous 5 year window.
OPCYCLE = the natural logarithm of operating cycle.
NEG = the frequency of negative earnings realizations during the previous 5 years.
INT = intangible (the sum of R&D expenditures and advertisement expenditures) scaled by total assets.
INTDUM = a dummy variable equals to 1, if research and development or advertising expenditure is the missing value; zero otherwise.
CAP = capital expenditures scaled by total assets.
NOA = a dummy variable which is equal to 1 if firm net operating assets at the beginning year scaled by beginning sales are above the median of corresponding industry’s net operating assets; zero otherwise.
Ret_Vol = the standard deviation of monthly raw return over the 60 months prior to the sample period.
Earn_Vol = the standard deviation of earnings over the 5 year prior to the sample period.
Analyst = the number of financial analysts following during the sample period.
Manager = the percentage of shares owned by executives.
Cycle = the firm operating cycle measured by the accounts receivable cycle plus inventory cycle and minus the accounts payable cycle.
SIZE = natural logarithm of firm total assets.
BTM = book-to-market ratio at the beginning period.
ROA = return on assets.
Current = current assets to total assets ratio.
LEV = total liabilities to total assets ratio.
Inst_Owner = the percentage of firm’s shares owned by the institutional investors at the period end.
ESG = The overall net scores of corporate environmental, social and governance performance from the KLD database.
ENV = the number of corporate environmental strengths minus the number of corporate environmental concerns.
CSR = the number of corporate social strengths minus the number of corporate social concerns.
CGOV = the number of corporate governance strengths minus the number of corporate governance concerns.
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Rezaee, Z., Tuo, L. Are the Quantity and Quality of Sustainability Disclosures Associated with the Innate and Discretionary Earnings Quality?. J Bus Ethics 155, 763–786 (2019). https://doi.org/10.1007/s10551-017-3546-y
- Earnings quality
- Sustainability disclosure
- Unethical and opportunistic earnings management
- Sustainability performance
- Corporate social responsibility