Corporate Social Responsibility as a Strategic Shield Against Costs of Earnings Management Practices

Abstract

We highlight how Corporate Social Responsibility (CSR) can be strategically used against the negative perception from earnings management (EM). Using international data, we analyse the effect of CSR and EM on the cost of capital and corporate reputation. Results confirm that CSR strategy is positively valued by investors and other stakeholders. Contrary to EM, CSR has a positive effect on corporate reputation and lowers the cost of capital. In addition, we also find that the favourable effect of CSR on cost of capital is consistently more intense in firms that show signs of EM indicating that the market does not identify when CSR practices are used as a strategy to mask EM. We also demonstrate how institutional factors influence the above relationship.

Appendices

Appendix 1: Measuring Earnings Management with Discretionary Accruals

Jones’ Standard Model

Following Jones (1991) and Dechow et al. (1995), total accrual adjustments (TAA) are defined as

$$TAA_{it} = \left[ {\left( {\Delta CA_{it} } \right) - \left( {\Delta CASH_{it} } \right)} \right] - \left[ {\left( {\Delta CL_{it} } \right) - \left( { \Delta RLTP_{it} } \right)} \right] - DA_{it} ,$$

(6)

where $\Delta CA_{it}$ represents the change in current assets; $\Delta CASH_{it}$ reflects the change in cash held and in short-term financial investments; $\Delta CL_{it}$ is the change in current liabilities; $\Delta RLTP_{it}$ is the change in reclassified long-term obligations; $DA_{it}$ is the depreciation and amortization; i represents the company and t represents the year.

On the basis of Eq. (6), accruals are calculated using an explanatory model. The difference between actual and expected accrual adjustments (taking into account growth, company assets and the accounting result) represents the discretionary or unexplained component of accrual adjustments (DAA). It acts as a measurement of management discretion in the reporting of results.

The standard Jones model uses the following procedure to separate the discretionary component and the non-discretionary one

$$\frac{{TAA_{it} }}{{A_{i,t - 1} }} = \alpha_{1,t} \left( {\frac{1}{{A_{i,t - 1} }}} \right) + \alpha_{2,t} \left( {\frac{{\varDelta Sales_{it} }}{{A_{i,t - 1} }}} \right) + \alpha_{3,t} \left( {\frac{{PPE_{it} }}{{A_{i,t - 1} }}} \right) + \varepsilon_{t} ,$$

(7)

where $\frac{{TAA_{it} }}{{A_{i,t - 1} }}$ are the total accrual adjustments; A _i,t−1 represents the total assets of firm i in period t − 1 (this is used as a deflator to correct possible problems of heteroscedasticity); PPE _it represents the property, plant and equipment of firm i in period t and $\varDelta Sales_{it}$ is the change in sales for firm i in period t.

The non-discretionary accrual adjustments (NDAA) are $\alpha_{1,t} \left( {\frac{1}{{A_{i,t - 1} }}} \right) + \alpha_{2,t} \left( {\frac{{\varDelta Sales_{it} }}{{A_{i,t - 1} }}} \right) + \alpha_{3,t} \left( {\frac{{PPE_{it} }}{{A_{i,t - 1} }}} \right)$, and ɛ _t represents the discretionary accrual adjustments (DAA) for firm i in year t. NDAA are calculated by replacing the coefficients in Eq. (7) with the values obtained by Ordinary Least Squares. DAA are the residuals of this calculation.

Modified Jones Model (Dechow et al. 1995)

In the modified Jones model (Dechow et al. 1995, Eq. 8), the TAA use the variation in sales minus accounts receivable (used to measure the company’s growth, because its working capital is closely linked to sales) and minus the item property, plant and equipment (used to measure the depreciation costs of the discretionary adjustments). It is assumed that not all sales are necessarily non-discretionary, and that this will depend on the item to be received.

$$\frac{{TAA_{it} }}{{A_{i,t - 1} }} = \alpha_{1,t} \left( {\frac{1}{{A_{i,t - 1} }}} \right) + \alpha_{2,t} \left( {\frac{{\varDelta \left( {Sales - A*R} \right)_{it} }}{{A_{i,t - 1} }}} \right) + \alpha_{3,t} \left( {\frac{{PPE_{it} }}{{A_{i,t - 1} }}} \right) + \varepsilon_{t}$$

(8)

where A*R represents accounts receivable, and the other variables are defined as in Eq. (7).

Please note that coefficients in this model are calculated using the original Jones model (1991), and the modification is only applied when calculating non-discretionary adjustments.

Appendix 2: Corporate Social Responsibility

Table 7 represents the composition of the CSR index, and analyzes several areas (environment, human rights, the relationships with stakeholders and board of directors).

Table 7 CSR practices