Corporate social responsibility and earnings management in U.S. banks

Highlights

•	Reverse causality between EM and CSR is explored in the U.S. banking sector.

•	Banks actively engaged in EM practices are found to be deeply involved in CSR.

•	CSR seen as part of legitimation strategies aimed at deflecting attention from EM.

•	Bank's engagement in CSR activities is found to have no significant impact on EM.

•	Extreme caution should be exhibited when factoring CSR commitment in firm analyses.

Abstract

Business decision making depends on financial reporting quality. In identifying the drivers of financial reporting quality, proxied by earnings management (EM), prior literature has drawn attention to the association between corporate EM practices and commitment to corporate social responsibility (CSR). Empirical evidence, however, provides inconclusive results regarding the direction of this association. Using simultaneous equations, we examine the bi-directional CSR–EM relationship in U.S. commercial banks. We demonstrate that, although banks that engage in EM practices are also actively involved in CSR, the reverse relationship is not significant. We provide implications for investors, analysts, business participants and regulators.

Keywords:

• Ethics
• Corporate social responsibility
• Earnings management
• Banking institutions

Acknowledgements

We acknowledge helpful comments by the Editor (Glen Lehman), three anonymous reviewers, and also George Balabanis, Constantinos Caramanis, Sandra Cohen, Claude Francoeur, Geoffrey Heal, Leire San-Jose, George Moschis, Paul Palmer, Simone Pettigrew, Vangelis Souitaris, Roger Steare, Josef Antonio Tribo and Pauline Weetman. The paper has also benefited from the comments of the participants at the 35th European Accounting Association Slovenia 2012. This scientific paper was realized within the context of the project entitled “International Hellenic University (Operation – Development)”, which is part of the Operational Programme “Education and Lifelong Learning” of the Ministry of Education, Lifelong Learning and Religious affairs and is funded by the European Commission (European Social Fund – ESF) and from national resources. This project has also received funding from the European Union, Seventh Framework Programme (FP7-REGPOT-2012-2013-1) under Grant Agreement No. 316167.

Notes

4 A number of studies have, however, underscored that the Fortune magazine's Most Admired survey and other CSR ranking lists, such as the Newsweek environmental reputation list, may suffer from a financial halo effect which posits that broader CSR perceptions are possibly influenced by corporate financial performance (Brown and Perry, 1994; Fryxell and Wang, 1994; Guidry and Patten, 2010; Rozenzweig, 2009).

5 Healy and Wahlen (1999, p. 368) define earnings management (EM) as occurring “when managers use judgment in financial reporting and in structuring transactions to alter financial reports either to mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

6 Membership of the DJSI is acclaimed as an indication of leadership in terms of corporate sustainability. The DJSI uses the “best-in-class” approach by selecting the top 30 percent of companies in a specific industry based on sustainability criteria.

7 Launched in 2003, the Equator Principles constitute a credit risk management framework for determining, assessing and managing environmental and social risk in project finance transactions (http://www.equator-principles.com/index.php/about; accessed on November 16, 2012).

8 These groups may not be directly affected but are nevertheless able to advance arguments that could weaken the firm's social legitimacy.

9 We collect data up until 2007 for three reasons. First, the KLD database only has rich data on ratings of corporate social responsibility for the period 2003–2007. Second, the KLD database has few banks after 2007 so to include observations for the years subsequent to 2007 would drastically reduce the sample size. Third, to include observations for the years subsequent to 2007 may contaminate our results because of potential effects from the financial crisis which started in the U.S. in December 2007 (see Cornett, McNutt, & Tehranian, 2009, p. 413).

10 KLD Research & Analysis, Inc. was taken over by the RiskMetrics Group (RMG) in 2010.

11 For example, during the financial crisis, accounting for LLPs under U.S. GAAP was based on an incurred loss model (Barth and Landsman, 2010), whereby a bank provides for loan loss only if there is objective evidence to suggest that a loan has been impaired. As a consequence, a bank would not necessarily provide for loan loss based on external factors such as the bursting of the real estate bubble. Though such an event suggests that many homeowners might default on their loans (indicating a loss in the value of the loans), a bank would still not make any loan loss provisioning.

12 Banks use available-for-sale investment securities to make net income less volatile or to affect regulatory capital through the timing of the realization of fair value gains or losses. This is more often true for the common stock component of those securities classified as available-for-sale securities, and not so often for the held-to-maturity component.

13 Our categorization of the loans differs from Beatty et al. (2002) and Cornett et al. (2009) since these studies employ data derived from the Chicago Federal Reserve Bank and Sheshenoff databases. We rely on Datastream where loans are categorized into real estate, commercial and industrial, and consumer and installment loans.

14 As in prior studies (e.g., Benson and Davidson, 2010; Ghoul et al., 2011), we exclude KLD's category of corporate governance since this aspect of banks is highly regulated, especially following the passage of the Sarbanes-Oxley Act of 2002 and, as such, there might not be any systematic difference among the sample banks.

15 The inclusion of either variable in Eq. (6)(6) ${\text{CSR}}_{ij}={\beta }_0+{\beta }_1\text{FT}\_{\text{EM}}_{ij}+{\beta }_2{\text{EBIT}}_{ij}+{\beta }_3{\text{SIZE}}_{ij}+{\beta }_4{\text{MB}}_{ij}+{\beta }_5{\text{LEV}}_{ij}+{\beta }_6{\text{CAP}}_{ij}+{\beta }_7{\text{INTA}}_{ij}+{\beta }_8{\text{CONS}}_{ij}+{\beta }_9{\text{REAL}}_{ij}+{\beta }_{10}{\text{COM}}_{ij}+u_{ij}$(6) yields qualitatively similar findings. Hence, for brevity purposes, we report only the findings based on the model in which we include the COM variable.

Additional information

Notes on contributors

Vassiliki Grougiou

Dr Vassiliki Grougiou is a faculty member at International Hellenic University of Thessaloniki, Greece. She holds an MSc from Stirling University and a PhD from Strathclyde University, Glasgow. Prior to joining IHU, Grougiou was employed in marketing positions in the services sector. Her research focuses on consumer behavior, services, corporate social responsibility, and social marketing. Grougiou's research work has appeared in the Journal of Service Research and Journal of Marketing Management among others. She has twice received the Best Paper Award at the Academy of Marketing Conference, in 2009 and 2012, for the Consumer Behavior and Social Marketing Track, respectively.

Stergios Leventis

Dr Stergios Leventis is a senior lecturer in accounting at the International Hellenic University. He is also a senior research fellow at Aston Business School (UK). Before joining IHU, he worked as an accounting consultant. He gained an MSc from Heriot-Watt University, Edinburgh, and a PhD from the University of Strathclyde, Glasgow. His research focus is on accounting disclosure and quality, auditing, banking and corporate social responsibility. He has published work in a number of international scientific journals. He serves on the editorial boards of international journals such as Accounting and Business Research and Corporate Governance: An International Review.

Emmanouil Dedoulis

Emmanouil Dedoulis is a lecturer in accounting at the Department of Business Administration, Athens University of Economics and Business. His research interests include the development of the institution of accounting, current developments in accounting and auditing standards and corporate social responsibility. He has published a number of articles in reputable journals such as International Review of Financial Analysis, Critical Perspectives on Accounting and Accounting Forum. He is a member of the Institute of Certified Auditors in Greece and of the Greek Ministry of Economy's Committee of Accounting Books.

Stephen Owusu-Ansah

Stephen Owusu-Ansah, PhD, CIA, CBM, is a Professor of Accounting and the Dean of the School of Business at Dominion University College, Accra, Ghana. His research interests are in the areas of corporate financial reporting, corporate social and environmental reporting, fraud detection, corporate governance, risk management, control and compliance. Some of his recent scholarly publications have appeared in Accounting Forum, Abacus, Accounting and Business Research, Corporate Governance: An International Review, European Accounting Review, International Journal of Accounting, and Journal of International Financial Management and Accounting. He was an Associate Professor of Accounting at the University of Illinois Springfield, USA at the time the paper was submitted.