Are Socially Responsible Managers Really Ethical? Exploring the Relationship Between Earnings Management and Corporate Social Responsibility

• DOI: http://doi.org/10.1111/j.1467-8683.2008.00678.x
• Author: Diego Prior,Jordi Surroca,Josep A. Tribó
• Date: 01 May 2008
• Published date: 01 May 2008

Are Socially Responsible Managers Really

Ethical? Exploring the Relationship Between

Earnings Management and Corporate Social

Responsibility

Diego Prior, Jordi Surroca and Josep A. Tribó*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper investigates the connection between earnings management and corporate social

responsibility (CSR). We argue that earnings management practices damage the collective interests of stakeholders; hence,

managers who manipulate earnings can deal with stakeholder activism and vigilance by resorting to CSR practices.

Research Findings/Insights: Using archivaldata from a multi-national panel sample of 593 f‌irms from 26 countries between

2002 and 2004, we f‌ind a positive impact of earnings management practices on CSR; this relationship holds for different

robustness checks. Also, we demonstrate that the combination of earnings management and CSR has a negative impact on

f‌inancial performance.

Theoretical/Academic Implications: This study draws on a generalized agency theory where managers are seen as the

agents of all stakeholders and the earnings managementliterature to highlight that CSR can be used to garner support from

stakeholders and, therefore, provides an opportunity for entrenchment to those managers that manipulate earnings. As

such, it suggests new avenues of research for both the corporate governance literature, as well as for the stakeholder

perspective.

Practitioner/Policy Implications: This study offers insights for policy makers and managers interested in enhancing CSR.

For managers, our f‌indings suggest that projecting a socially-friendly image in order to disguise earnings management

cannot be sustained over time due to the detrimental effect on f‌inancial performance. In addition, this study provides a

warning signal to policy makers that certain practices geared toward raising a f‌irm’s CSR may simply be a mechanism for

hindering other devious practices.

Keywords: Corporate social responsibility, earnings management

INTRODUCTION

Accounting earnings are one of the most frequently cited

performance statisticsthat are of major interest to exter-

nal capital providers, suppliers, employees, customers, com-

munities, and regulators. Ideally, f‌inancial reporting helps

the better-performing f‌irms to distinguish themselves from

poor performers and facilitates shareholder f‌inancial decision

making (Healy and Wahlen, 1999). However, managers can

exercise some discretion in computing earnings without

violating generally accepted accounting principles, thereby

causingreported incomes to appear either greater or less than

they are in reality. In fact, Watts and Zimmerman (1978)

def‌ine earnings management as managers exercising their

discretion over the accounting numbers. They further state

that this intervention in the external f‌inancial reporting

process maybe intended to either mislead some stakeholders

about the underlying economic performance of the company

or to inf‌luence contractualoutcomes that depend on reported

accounting numbers (Healy and Wahlen, 1999: 368).

In the absence of the potential for private benef‌its, rational

managers would not engage in earnings management. Prior

research on earnings management has identif‌ied three

sets of incentives that spur this practice–capital markets,

*Corresponding author. Universidad Carlos III de Madrid, Department of Business

Administration, Calle Madrid 126. Off‌ice 7.32b, Getafe(28903) Madrid, Spain. Tel: (34)

91-6249321; Fax: (34) 91-6249607: E-mail: joatribo@emp.uc3m.es

160 CORPORATE GOVERNANCE

Volume 16 Number 3 May 2008 © 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd

doi:10.1111/j.1467-8683.2008.00678.x

contractual arrangements, and regulatory motivations

(Healy and Wahlen, 1999). First, the evidence demonstrates

that managers try to inf‌luence short-term prices, particularly

around the time of certain types of corporate events, like

stock issues (DuCharme, Malatesta and Sefcik, 2004). Other

authors, however, have suggested that managers may use

their discretion to manage earnings in order to send private

information to f‌inancial markets over future prospects for

the f‌irm. In effect, Ronen and Sadan (1981) developed a

model in which earnings management is aimed at removing

transitory items, allowing investors to better predict the

expected earnings and cash f‌lows. Second, other researchers

have examined lending and compensation contracts, written

in terms of accounting numbers, and have suggested that

these contracts create incentives for earnings management

with a view to boosting bonus awards (e.g., Holthausen,

Larcker and Sloan, 1995), improving job security (e.g.,

DeAngelo, 1988), and mitigating the potential violation of

debt covenants (e.g., DeFond and Jiambalvo, 1994). Finally,

there are also regulatory motivations for earnings manage-

ment. Managers of f‌irms in regulated sectors suffer acute

pressure from antitrust authorities regarding price controls

and market shares. Such pressure stimulates earnings man-

agement practices as a stratagem to appear less prof‌itable

(Watts and Zimmerman, 1978). In summary, the earnings

management literature suggests that capital markets, con-

tractual arrangements, and regulatoryconsiderations induce

managers to manipulate earnings reports.

These deliberate managerial actions, contrived to disguise

the real value of a f‌irm’s assets, transactions, or f‌inancial

position, have negative consequences for shareholders,

employees, the communities in which f‌irms work, society at

large, and managers’ reputations, job security, and careers

(Zahra, Priem and Rasheed, 2005). One of the most far-

reaching consequences of actions like the manipulation of

earnings is that the f‌irm loses the support of stakeholders,

which may lead to increased activism and vigilance from

shareholders and other affected stakeholder groups (Zahra

et al., 2005: 818). The consequence is that the manager is

under the threat of rogue behavior by employees, misunder-

standing from customers, pressure from investors, defection

from partners, legal action from regulators, boycotts from

activists, illegitimacy from the community, and exposure

from the media. Ultimately, these threats may destroy the

f‌irm’s reputation capital (Fombrun, Gardberg and Barnett,

2000).

As a defence against stakeholder activism and vigi-

lance, which could cost a manager his job and damage the

f‌irm’s reputation, managers have incentives to compensate

stakeholders through corporate social responsibility (CSR)

practices. CSR is related to ethical and moral issues concern-

ing corporate decision-making and behavior and, as such,

addresses complex issues like environmental protection,

human resources management, health and safety at work,

local community relations, and relationships with suppliers

and customers (Castelo and Lima, 2006). Engaging in

socially responsible activities not only improves stakeholder

satisfaction, but also has a positive effect on corporate repu-

tation. Disclosure of information about corporate behavior

and outcomes regarding social responsibility may help

build a positive image among stakeholders (Orlitzky,

Schmidt and Rynes, 2003). This positive image may help

f‌irms to establish community ties and build reputation

capital; hence improving their ability to negotiate more

attractive contracts with suppliers and governments, to

charge premium prices for goods and services, and to

reduce their cost of capital (Fombrun et al., 2000). Therefore,

by resorting to CSR practices, the f‌irm is able to gain support

from its various stakeholder groups. Also, by the same

token, the f‌irm can obtain more favorable regulatory treat-

ment, endorsements from activist groups, legitimacy from

the community, and favorable coverage from the media

(Castelo and Lima, 2006), so as to avoid the potentially det-

rimental impact of government actions.

Our basic conjecture is that an executive who manipu-

lates earnings has an incentive to project a socially-friendly

image, given that CSR activities are a powerful tool for

obtaining support from stakeholders. With this tactic, the

manager will reduce the likelihood of being f‌ired due to

pressure from discontented shareholders or other stake-

holders whose interests have been damaged by the imple-

mentation of earnings management practices. Under such a

scheme, CSR is used as an entrenchment mechanism (Cespa

and Cestone, 2007) in the context of earnings manipulation.

We provide support for our contention using an interna-

tional database, composed of 593 f‌irms from 26 nations,

for the period 2002 to 2004. This result highlights the

perverse effects of combining CSR with earnings manage-

ment, calling into question some social demands on better-

performing f‌irms to devote part of their f‌inancial resources

to improve their CSR. Accordingly, if these improvements

are connected with earnings management practices, they

may damage f‌irms’ long-term wealth.

The remainder of the article is structured as follows: the

second section summarizes the most relevant literature

related to the objectives of this work and develops the

hypotheses; and third section is methodological, describing

the sample, variables,and empirical models to be tested; and

the fourth section presents the empirical results obtained.

The f‌inal section of the article illustrates the main conclu-

sions of this research and a discussion of the signif‌icance of

the results.

THEORETICAL FRAMEWORK

AND HYPOTHESES

Earnings management and CSR

Previous research (e.g., Davidson III, Jiraporn, Kim and

Nemec, 2004) has established a relationship between earn-

ings management and agency theory. These studies adopt, as

their starting point, the traditional view that the separation

of ownership and control in modern corporations, together

with the existence of information asymmetries within f‌irms,

spawn the possibility of opportunistic actions by the agent

(the manager) who may have different objectives from those

of the principal (the owner), and thus pursue self-serving

goals (the agency problem). In this context, earnings man-

agement is considered a type of agency cost because man-

agers look after their own interests by releasing f‌inancial

reports that do not present an accurate economic picture of

ARE SOCIALLY RESPONSIBLE MANAGERS REALLY ETHICAL? 161

Volume 16 Number 3 May 2008© 2008 TheAuthors

Journal compilation © 2008 BlackwellPublishing Ltd