Abstract
Drawing on the cognitive dissonance theory and the behavioral consistency theory, this study examines whether hypocrisy, proxied by the ethical dissonance between corporate philanthropy and environmental misconducts, triggers auditors to issue modified audit opinions (MAOs), and further investigates the moderating effect of hypocrisy on the relation between financial reporting quality (proxied by discretionary accruals) and MAOs. Using a sample of 20,852 firm-year observations from the Chinese stock market over 2005–2019, our findings reveal that the likelihood of receiving MAOs is significantly higher for hypocritical firms than for their counterparts, suggesting that hypocrisy provides negative soft information about top managers' myopia, immorality and lack of integrity, elicits the perceived distrust from auditors, motivates auditors to have a higher extent of professional skepticism, and eventually triggers MAOs. Moreover, hypocrisy reinforces the negative (positive) relation between financial reporting quality (discretionary accruals) and MAOs. Furthermore, above findings are robust to a variety of sensitivity tests using alternative proxies for modified audit opinions and hypocrisy, as well as different sample compositions, and further our conclusions are still valid after using the propensity score matching approach and two-stage treatment effect regression procedures to control for the endogeneity issue. Lastly, the effect of hypocrisy on MAOs is more pronounced for remedial (ex post) hypocrisy than for preventive (ex ante) hypocrisy.
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Data availability
Data will be made available on request.
Notes
“Focal firms” refer to the subject firms that arouse the negative emotions from auditors and other stakeholders.
Zijin Mining Group, a famous firm that has been listed on both the Hong Kong Stock Exchange and the Shanghai Stock Exchange, made substantial donations during the 2008 Wenchuan earthquake, but it was found to be a severe environmental destroyer. Nevertheless, Zijin Mining Group did not receive modified audit opinions in 2008. Fushun Special Steel Co., Ltd. (600399) carried out corporate philanthropy in 2016 and 2017, but was administratively punished due to atmospheric pollution. Auditors issued an unqualified opinion with explanatory notes and a disclaimer of opinion in 2016 and 2017, respectively. In 2017, Hubei Yihua Chemical industry Co., Ltd (000422) donated 430 thousand RMB (59 thousand dollars). However, due to “illegally discharge and recidivism” in previous years, the company was administratively punished for several times, and thus received an unqualified opinion with explanatory notes in 2017 (http://hb.sina.com.cn/news/j/2016-12-18/detail-ifxytqax6461811.shtml).
Hypocrisy means the divergence between statements and observed behaviors or the inconsistencies between different CSR dimensions (Scheidler et al., 2019; Wagner et al., 2009), but “window-dressing” means that CSR is carried out for appearance (rather than for promoting structural change; Lin, 2010). In terms of the motivations, window-dressing aims to repair the legitimacy urgently (Cai et al., 2012; Chen et al., 2008; Jo and Na, 2012), overshadow wrongdoings (Du, 2015b), and distract the attention from the truths or underlying problems (Connors et al., 2017; Koehn and Ueng, 2010). As a comparison, hypocrisy can be also used as an important conduit for maintaining the societal legitimacy (Brunsson, 2007), but it is often employed for the conformity to social pressure (Antonetti et al., 2020) and to manage conflicting stakeholder demands (Cho et al., 2015; Nickell and Roberts, 2014). To sum up, window-dressing is related to crisis management tactic (Du, 2015b; Wu et al., 2021), but hypocrisy is more likely to be related to a firm’s routine behaviors rather than occasional activities. Given that the auditor's primary task is to discover and disclose the potential flaws in financial statements (DeAngelo, 1981), routine and on-going hypocrisy are more likely to be related to client integrity.
During the devastating earthquake of Wenchuan in 2008, 368 Chinese firms bestowed the donation of RMB 1.6 billion (about $ 0.24 billion) within 3 days (May 12–14, 2008; http://money.163.com/special/00252MT8/earthquake. html) after the earthquake. In the massive flooding of Henan province in 2021, Alibaba, Tencent and many enterprises quickly responded to the unexpected disaster and donated 100 million RMB (about $ 14.9 million) for the flood, respectively (https://new.qq.com/rain/a/20210721A052JO00). The bandwagon effect of corporate philanthropy exists during sudden and extreme disasters, so firms refer to rivals to adjust their philanthropic decisions.
By 2020, only 3% of Chinese listed firms launch charitable foundations (https://baijiahao.baidu.com/s?id=1741279823513251029&wfr=spider&for=pc), which provides strategic support for long-term and routine donations.
For Hypothesis 1 (H1), we discuss two types of associations between hypocrisy and audit opinions. For Hypothesis 2 (H2), we focus on the second type of association.
Untabulated results (available on request) show that hypocrisy is significantly positively related to the likelihood of financial restatements, the probability of tiny profit [ROA lies in (0, 0.01)], the likelihood of meeting and beating earnings forecasts—the difference between actual EPS and the analysts' mean annual earnings forecast lies in (0, 0.01).
These situations include: (1) individuals display stable behavioral pattern across various comparable situations; (2) managerial personality affects their personal and corporate decisions consistently; (3) firms’ policies and decisions might be a manifestation of managerial traits and preferences; and (4) the extent to which an individual exhibits a behavior in one situation is predictable from that of another situation (Cain & McKeon, 2016; Cronqvist et al., 2012; Hjelström et al., 2020; Wang & Cao, 2022).
Internal control can be used as a supportive analogy to interpret the relation between hypocrisy and modified audit opinions. Internal control is essential to financial report quality and directly affects audit opinions. On the one hand, previous literature finds that firms with weak internal control are related to lower accruals quality (Ashbaugh-Skaife et al., 2008; Chan et al., 2008; Doyle et al., 2007). On the other hand, poor internal control can degrade auditors’ trust on financial statements (regardless of the level of financial reporting quality). Jiang et al. (2010) and Goh et al. (2013) validate that internal control weaknesses increases the likelihood that auditors issue modified audit opinions or going concern opinions. Analogically, hypocrisy has similar influential channels on audit opinions.
We also constructHY2 (HY3) to cover 95% of the time interval from the time of environmental misconducts to the time of environmental penalties. Due to environmental misconducts, 60.49% of firms are punished in the same year (year t), and 28.40% of firms are punished due to environmental misconducts in the next year (year t + 1). In addition, accumulated 95% of firm-years receive environmental penalties within 3 years after environmental misconducts.
The potential channels are reported as below: (1) Auditors spend substantial time in communicating with client employees in field audits. Managers, financial staffs and employees of client firms as insiders know more about internal information about environmental misconducts that have happened in year t but may be penalized in the subsequent years. (2) Contingencies in a firm's financial statements about environmental penalties can convey relevant information (about contingent liabilities and estimated liabilities) of year t + 1 to auditors. (3) Other channels through which auditors can get the information about future environmental punishments.
The punishments on environmental misconducts of year t may be made in year t + 1. On November 2, 2015, the Environmental Protection Bureau of Beijing Shunyi conducted the supervisory detection on Advanced Technology & Materials Co., Ltd., and found that the overall nickel discharge exceeded the emission standard. After offering the "Notice of administrative punishment in advance" and undergoing corporate self-justification, the Environmental Protection Bureau of Beijing Shunyi issued the administrative punishment decision to the firm on February 29, 2016.
Compared with earnings management, financial reporting quality is a broader concept, which is also affected by information transparency, financial restatement and financial irregularities. A branch of prior literature employs the signed discretionary accruals to measure earnings management (Bédard et al., 2004; Dhaliwal et al., 2010; Xie et al., 2003), but most studies use the absolute value of the magnitude of discretionary accruals as an inverse proxy for financial report quality (Ham et al., 2017; Krishnan et al., 2011; Labelle et al., 2010). Given the reversing effect of accruals, the absolute measure captures the effect of past as well as current earnings management (Lennox et al., 2016).
The hypocritical subsample and the good-deed subsample represent the worst (hypocritical) and the best (pure) incentives for corporate philanthropy, respectively, and thus the differences in audit opinions between the hypocritical firms and those to the good-deed firms are easier to be observed. Nevertheless, we re-test H1 and H2 using alternative sample constructions: (1) the hypocritical subsample and the clean subsample; (2) the hypocritical subsample and the evil subsample. The results remain qualitatively similar to those in main tests.
Among firms with MAOs, compared with the non-HY subsample, the HY subsample has larger firm size, higher debt-to-asset ratio, lower current ratio, lower ratio of other receivables, more analyst following, higher ratio of institutional ownership, higher proportion of blockholder ownership and better regional economic development level. The time gap between corporate philanthropy and environmental punishments has a mean value of − 0.041 (year), and the average time gap from the time point when environmental violations occur to the time point when environmental violations are punished for the HY subsample among firms with MAOs is 171 days (0.30 year), suggesting that administrative punishments are later about 171 days (0.30 year) than environmental misconducts. When the number of days is converted to the number of year, it may be greater than or less than the actual interval years. If an environmental violation occurred on November 25, 2015 and environmental penalties were imposed on February 25, 2016, then the number of the lagged days is 92 days, which can be converted as the number of the lagged year as 0.252 (92/365) and is less than the actual number of the lagged year (1 year = 2016–2015). (2) If an environmental violation occurred on January 25, 2015 and environmental penalties were imposed on February 25, 2016, then the number of the lagged days is 396, which can be converted as the number of the lagged year as 1.085 (396/365) and is greater than the actual number of the lagged year (1 year = 2016–2015).
The potential reasons lie in that: (1) The information about environmental misconducts began to be disclosed in 2005, so hypocrisy may be underestimated in the first two years of our research sample period (i.e., 2005 and 2006). (2) For 2019, a relatively lower number of hypocritical firms may be caused by the insufficient time interval from the time point when environmental violations occur to the time point when environmental violations are punished (penalty announcement)—environmental punishments may be not disclosed (when we hand-collect the data).
H1 states that hypocrisy can increase the auditor’s likelihood of issuing a going concern opinion under the context of a risk of going concern in the firm. In response, we further examine whether hypocrisy induces a higher probability of going concern opinions when an actual risk of going concern exists in a given firm. Referring to Guan et al. (2016), financial conditions are proxied by Altman’s Z-score, measured as "0.517 − 0.460 × (total liabilities/total assets) + 9.320 × (net profits/average total assets) + 0.388 × (working capital/total assets) + 1.158 × (retained earnings/total assets)". If Z-score is greater (less) than 0.9 (0.5), then a firm is classified as being financial healthy (distressed). Untabulated results show that HY has a significantly positive (insignificant) coefficient for financial distressed (healthy) firms, suggesting that hypocrisy exerts a more prominent effect on firms that has fallen into a risky environment.
Firms headquartered in provinces with more national nature reserves (RES) are less likely to be hypocritical for two reasons. (1) The national nature reserves need to be approved by the Ministry of Environmental Protection in China, so the authority department has mandatory requirements that the cities should have relatively high responsibility in environmental protections, the local government and people attach the importance to environmental responsibilities, and firms commit to environmental protection and avoid environmental misconducts to obtain the legitimacy from the community and the public (Suchman, 1995). (2) To maintain the qualification of the national nature reserves, environmental regulations in regions with more national nature reserves are persistent. Thus, regions with more national nature reserves have sufficient incentives to mitigate corporate opportunistic behaviors in environmental conservation (i.e., to cover up the negative impact of environmental misconducts by corporate philanthropy).
Due to the fuzzy impact of the year when the CEPL comes into effect, we delete observations in the year of 2015.
In our research sample, 8825 firm-year observations (42.32%) belong to SSE, covering 1287 unique firms. As a comparison, 12,027 firm-year observations (57.68%) belong to SZSE, covering 1,926 unique firms. Above results suggest that firm-year observations from Shanghai and Shenzhen Stock Exchanges are roughly balanced. Untabulated results show that H1 and H2 are empirically supported for both the SSE subsample and the SZSE subsample.
Also, we construct CONSEC_4 (CONSEC_5)—equaling 1 if a firm carries out philanthropic giving for four (five) consecutive years or more around environmental misconducts and 0 if a firm only carries out philanthropic giving in the year of environmental misconducts. Untabulated results show similar findings.
There is no mandatory requirement or regulation on corporate philanthropy in China. In some cases, the regulation may be caused by illegal activities in corporate philanthropy. For example, Youngor Group (600177.SH) received Regulatory Work Letter from SSE due to 1.36 billion RMB donation plan on May 18, 2022 (the donation was strong opposed by minority shareholders). Thus, SSE decided to investigate the directors, supervisors and senior managers of Youngor Group (https://baijiahao.baidu.com/s?id=1733307569777597473&wfr=spider&for=pc). Thus, Chinese firms can independently make the decisions about philanthropic giving as long as shareholders, directors, and management come to an agreement with that. As such, it is difficult to discern the real motivation of corporate philanthropy.
For example, specific contract-level data is needed to construct hypocrisy on the basis of corporate philanthropy and employee welfare, the obligation to suppliers and consumers (see Darendeli et al., 2022).
As a result, it should be very cautious for researchers to generalize our findings to other contexts. Especially, it is better to seek for an exogenous shock in which researchers can apply the difference-in-difference (DID) approach to identify the causal relation between hypocrisy and corporate behaviors.
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Acknowledgements
We appreciate constructive comments and valuable suggestions from Prof. Steven Dellaportas (the Section Editor), four anonymous reviewers, Rui Yu, Ying Zhang, Qiao Lin, Liang Xiao, Yuhui Xie, Xinshu Zhang, Jing Hong, Ruining Li, and participants of our presentations at Xiamen University and Xiamen National Accounting Institute. Prof. Xingqiang Du acknowledges financial support from the National Social Science Foundation of China ( 20&ZD111).
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We acknowledge the financial support from the National Social Science Foundation of China (Approval Numbers: 22VRC130).
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Du, X., Zhang, Y., Lai, S. et al. How Do Auditors Value Hypocrisy? Evidence from China. J Bus Ethics 191, 501–533 (2024). https://doi.org/10.1007/s10551-023-05465-2
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DOI: https://doi.org/10.1007/s10551-023-05465-2