Heterogeneity in CSR activities: is CSR investment monotonically associated with earnings quality?

ABSTRACT

Extant studies have investigated the relation between corporate social responsibility (CSR) endeavours and earnings quality based on monotonic models, showing mixed and inconclusive empirical evidence. By identifying heterogeneity in CSR investments, we extend prior literature to explore the potentially nonmonotonic nature of this relation. Specifically, we classify firms into two sub-groups, entities underinvesting and overinvesting in CSR activities, in which the levels of CSR investments are lower and higher than the theoretically optimal point respectively. Our empirical results show that the level of CSR underinvestment is positively associated with the magnitude of both accrual-based earnings management (AEM) and real earnings management (REM) and, hence, negatively related to earnings quality. For firms overinvesting in CSR activities, we do not find a significant relation between CSR overinvestment and AEM. The empirical analyses for real activities manipulation exhibit inconsistent results throughout our four REM proxies. However, the mixed evidence for firms with CSR overinvestment cannot fully exclude the possibility that overinvesting in CSR activities has a significant impact on future financial reporting quality. Varying incentives for CSR overinvestment in different firms could drive the inconsistent results. The positive effect of CSR overinvestment by some firms may offset the negative effect brought about by other entities, making the overall effect minor and unnoticeable. Our empirical results, together with some other CSR-related research, emphasise the need for more transparent reporting regarding the detailed nature, aim, and strategy of relevant CSR investments to help investing communities and other constituents better understand the incentives behind CSR activities.

KEYWORDS:

• CSR investment
• earnings quality
• AEM
• REM

Acknowledgements

We would like to thank the editor (Professor Carol Tilt) and two anonymous reviewers for their constructive comments on this paper. Furthermore, we appreciate the useful feedback from Professor Yue Li and Dr Guanming He, as well as the nonnegligible guidance from an anonymous angel at the early stage of this project. All errors are a result of our own unassisted work.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Correction Statement

This article has been corrected with minor changes. These changes do not impact the academic content of the article.

Notes

1 As indicated in prior literature (Al-Tuwaijri et al., 2004; Li et al., 1997; Wang et al., 2018), it is noteworthy that CSR investment and CSR disclosure are two completely different concepts, as firms with greater CSR investments may not necessarily make sufficient disclosures on such activities, and vice versa. This study keeps an eye on financial reporting behaviour in light of CSR investment.

2 This argument is based on the assumption that directors make rational investment decisions, i.e. the “output” is proportional to the “input”. The assumption is sensible, especially within the optimal CSR investment level, where the financial objectives are coordinated with the social goals. Admittedly, one could argue that some CSR investments might not lead to either good social or financial performance. The occurrence rate of such disproportionate investments could be acceptably low under the rational investment assumption.

3 Prior studies also contend that some directors and investors are willing to appropriate some portions of funds for social investments simply due to their personal belief and ethical triggers. Bénabou and Tirole (2010) argue that firms may make charitable contributions through approved social investments. The philanthropic incentive indicates that some corporate social investments may not enhance firm value but aim at achieving social goals. One could argue that such charitable CSR investments may not stem from opportunistic incentives but have little impact on future financial performance and earnings quality. Even if the philanthropically motivated CSR investments may also have some financial effects, these are usually manifested by means of the aforementioned paths. In other words, some CSR expenditures could be incentivised by multiple factors. For example, some philanthropic directors may make charitable investments when they possess private information on desirable financial performance in future.

4 The “Environmental” pillar covers 3 categories: (1) resource use, (2) emissions, and (3) innovation. The “Social” pillar covers 4 categories: (1) workforce, (2) human rights, (3) community, and (4) product responsibility. The “Governance” pillar covers 3 categories: (1) management, (2) shareholders, and (3) CSR strategy.

5 For details on the Asset4 ESG scoring methodology, refer to “Thomson Reuters ESG Scores (May 2018)” (available at: http://zeerovery.nl/blogfiles/esg-scores-methodology.pdf).

6 Given the considerable impact of the 2008 global financial crisis on financial reporting quality (Altamuro & Beatty, 2010; Krishnan & Zhang, 2014), our sample period starts from 2010, when the effect of the financial crisis was gradually fading.

7 Our sample for the subsequent regression analyses will be further reduced because of the introduction of lag variables. The number of firm-year observations available for each regression model differs, due to the variation in data availability of different AEM and REM proxies.

8 Thomson Reuters Eikon has updated the ESG score calculation methodology since 2018. The CSR related data (with the sample period between 2010 and 2019) used in this study are all based on the new scoring methodology introduced in 2018 (10 categories within 3 pillars). This is different from the data (with the sample period from 2002 to 2010) used in Lys et al. (2015), which are based on the old version of the ESG scoring methodology in Asset4 (18 categories within 4 pillars). We measure CSR investment level as the weighted average of social and environmental pillar scores produced by Asset4. The weights of social and environmental pillar scores (0.355:0.340) are consistent with the weights used in the new methodology of overall ESG score calculation (Thomson Reuters, 2018).

9 The magnitude of our aggregated REM measure increases as firms engage more in real activities manipulations, consistent with the combined REM proxy defined by Cohen et al. (2008) but opposite to the one used by Kim et al. (2012).

10 Some supporters of the extreme optimisation view insist that directors do not make suboptimal strategic decisions, and any abnormal CSR investments might be attributable to measurement errors or insufficient statistical controls (Ittner & Larcker, 2001). This perspective, however, fails to identify the fact that sometimes it is difficult to react to the swift changes in the market or institutional environment, and the motives of certain CSR activities are essentially not free from managerial opportunism. Directors are in the process of dynamic learning. Hence, a large dataset without sample selection bias will include observations distributed around the optimal level of CSR investments (Hanlon et al., 2003; Ittner & Larcker, 2001).

11 Other variables without illustrations here have the same meaning as the identical ones in model (1).

12 Following the similar logic to financial performance controls in model (1), we decompose return on assets into profit margin and asset turnover due to their potentially different persistence (Nissim & Penman, 2001).

13 For instance, the UK Companies Act (2013) requires that all firms listed in the main market of the London Stock Exchange make relevant disclosures about social and community issues, gender diversity, human rights, and greenhouse gas emissions in their strategic report and directors’ report. Nevertheless, the regulation follows a “comply or explain” approach. Firms may decide whether to make relevant disclosures or provide sound reasons why they do not disclose such information. There is still a lack of detailed and consistent guidance regarding the disclosure of CSR activities in terms of the nature, aim, strategy, etc.