Corporate Social Responsibility, Corporate Governance and Earnings Quality: Evidence from Korea

• Published date: 01 September 2013
• Author: Youngkyu Park,Bo Bae Choi,Doowon Lee
• DOI: http://doi.org/10.1111/corg.12033
• Date: 01 September 2013

Corporate Social Responsibility, Corporate

Governance and Earnings Quality: Evidence

from Korea

Bo Bae Choi*, Doowon Lee, and Youngkyu Park

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: How does corporate governance affect a manager’s intention to promote corporate social

responsibility (CSR)? Is the relationship between f‌inancial transparency and CSR activities affected by the business group

aff‌iliation and ownership structure of f‌irms?

Research Findings/Insights: CSR ratings are negatively correlated with the level of earnings management when all f‌irms

are considered. However, the relationship is weaker for chaebol f‌irms and f‌irms with highly concentrated ownership, which

suggests that CSR practices can be abusively used by those f‌irms to conceal their poor earnings quality. The adverse use of

CSR is discouraged if the fraction of shares owned by institutional investors is high. However, no evidence is found for a

similar moderating effect for foreign investors.

Theoretical/Academic Implications: This study suggests that the business group aff‌iliation and the ownership structure of

a f‌irm are important factors in determining the managerial incentives to engage in CSR, which can explain the mixed results

reported in previous research. In addition, the possibility of a simultaneous relationship between CSR and other key f‌irm

characteristics, such as earnings quality, should be considered when conducting research on CSR.

Practitioner/Policy Implications: This study provides the insight to investors and other stakeholders that the managerial

incentives behind CSR activities can differ depending on a f‌irm’s characteristics. Care must be taken when assessing the

CSR activities, in particular, of f‌irms with weak corporate governance. For policy makers, it is important to ensure that

CSR-related disclosures by f‌irms are based on actual plans and are not intended to deceive stakeholders, especially when

the f‌irms are not actively monitored by external shareholders.

Keywords: Corporate Governance, Business Groups, Corporate Social Performance, Financial Disclosure, Institutional

Shareholder

INTRODUCTION

Previous studies document mixed results regarding the

association between corporate social responsibility

(CSR) and transparent f‌inancial reporting. Some research

(Chih, Shen, & Kang, 2007; Choi & Pae, 2011; Gelb &

Strawser, 2001) argues that socially responsible f‌irms are

focused not only on increasing current prof‌its but also on

fostering future relationships with stakeholders (the long-

term perspective hypothesis). Such f‌irms, therefore, should

act in a responsible manner when reporting accounting

information. In support of this view, empirical evidence

demonstrates that f‌irms that are more committed to CSR

(Gelb & Strawser, 2001) or to ethical conduct (Choi & Pae,

2011) provide more extensive f‌inancial disclosures and

engage less in earnings management (Chih et al., 2007). In

contrast, other researchers suggest that managers may stra-

tegically use CSR to disguise their opportunistic behaviors

(the managerial opportunism hypothesis). Promoting CSR

activities can help a manager secure his or her job by avoid-

ing scrutiny from stakeholder activists (Cespa & Cestone,

2007). In addition, a strong alliance with stakeholders, such

as employees, can be used as an entrenchment mechanism

by managers to defend against hostile takeovers (Pagano &

Volpin, 2005). Thus, managers who act in pursuit of private

benef‌its by distorting earnings information should be more

*Address for correspondence: Bo Bae Choi, Newcastle Business School, University of

Newcastle, University Drive, Callaghan, Newcastle, NSW 2308, Australia. Tel:

+61 2 4921 5011; Fax: +61 2 4921 7398; E-mail: bobae.choi@newcastle.edu.au

447

Corporate Governance: An International Review, 2013, 21(5): 447–467

© 2013 John Wiley & Sons Ltd

doi:10.1111/corg.12033

motivated to engage in CSR to protect their entrenchment

(Prior, Surroca, & Tribo,2008). Accordingly, Prior et al. (2008)

document a positive correlation between the level of earn-

ings management and CSR engagement. Chih et al. (2007)

also report a high extent of earnings aggressiveness in

socially responsible f‌irms.

This paper revisits the association between CSR and earn-

ings quality and discusses possible explanations for the con-

f‌licting results of previous research. CSR engagement

induced by managerial opportunism would be more promi-

nent in f‌irms with weak governance. Previous studies, such

as Harjoto and Jo (2011), provide evidence that commitment

to CSR has value-decreasing effects when a high level of

managerial entrenchment exists, thus supporting the notion

of Barnea and Rubin (2010) that corporate insiders may seek

to over-invest in CSR in pursuit of personal benef‌its. Our

paper considers agency problems in business groups and

the ownership structure of f‌irms.

Business groups are a common organizational form found

around the world. In particular, business groups in conti-

nental Europe and East Asia are economically inf‌luential in

size and are commonly controlled by a powerful controlling

family(Claessens, Djankov, & Lang, 2000). Thus,in countries

with weak shareholder protection, minority shareholders of

business groups are often exposed to high agency problems

(La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2000). A

typical manifestation of agency problems is the expropria-

tion of resources by the controlling partyfrom member f‌irms

(commonly known as tunneling) to maximize the family’s

personal wealth (Bae, Kang, & Kim, 2002; Bertrand, Mehta,

& Mullainathan, 2002; Chang & Hong, 2000; Johnson, La

Porta, Lopez-de-Silanes, & Shleifer, 2000). Studies in China,

India, and Korea report that weak internal corporate gover-

nance of business groups leads to worse f‌irm performance

for group-aff‌iliated f‌irms compared with unaff‌iliated f‌irms

(Campbell & Keys, 2002; Singh & Gaur, 2009). Although

extensive research regarding the corporate governance and

f‌inancial performance of business groups exists, their CSR

activities and the motivations behind such policies remain

relatively unexplored. If the manager’s intention to promote

CSR is affected by the corporate governance as reported by

previous studies, it will be important to take into consider-

ation the inf‌luence of business groups, especially for studies

in developing and emerging markets where minority share-

holder protections are relatively weak.

This paper focuses on the business groups in Korea called

chaebol, which are multinational conglomerates of public

and private companies from a broad range of industries.

These f‌irms are largelycontrolled by wealthy founding fami-

lies who have substantial discretionary power to transfer

capital and managerial resources among the member f‌irms.1

Using data froma single country enables us to conduct com-

prehensive analyses on the impact of f‌irms’ ownership and

governance structures on CSR activities.

Manipulative use of CSR driven by managerial opportun-

ism is expected to be more prominent in chaebol f‌irms com-

pared with non-chaebol f‌irms for several reasons. Earnings

management practices in chaebol f‌irms are often used to

support expropriation activities by owner families (Bae &

Jeong, 2007; Kim & Yi, 2006). The owners/managers of

chaebol f‌irms who manage earnings for expropriatingactivi-

ties should be motivated to disguise such behaviors. Because

of the close business ties and f‌inancial interdependence

within the group, unfavorable news about one member f‌irm

tends to adversely affect the value of the entire group. More-

over, chaebol f‌irms face a higher level of regulatory restric-

tions on f‌irm operations than do non-chaebol f‌irms. Thus,

owners of chaebol f‌irms should have strong incentives to

maintain good relationships with stakeholders, including

regulatory bodies, and hide their opportunistic behaviors

using methods such as CSR commitments. The substantial

power given to the controlling family should make it easier

for the controlling party to allocate even more resources to

CSR, if necessary, to maximize the family’s personal benef‌its

(Barnea & Rubin, 2010).

A f‌irm’s ownership structure also signif‌icantly inf‌luences

the motivation to promote CSR activities. A highly concen-

trated ownership allows the controlling party to exercise

stronger discretionary control over a f‌irm’s resources. Thus,

the incentive to use CSR to support entrenchment of the

controlling owner/manager should be greater in f‌irms with

concentrated ownership. However, if there is an effective

system in place for monitoring management decisions, the

controlling party will not be able to mask its opportunistic

behaviors using CSR. Previous studies suggest that large

external shareholders, such as institutions and foreign

investors, can serve as active monitors (Chung, Firth, & Kim,

2002; Ferreira & Matos, 2008; Jiraporn & Gleason, 2007; Jung

& Kwon, 2002; Yeo, Tan, Ho, & Chen, 2002). Institutions and

foreign investors with large stakes have strong incentives to

prevent managers or controlling owners frompursuing their

self-interest at the expense of other shareholders. Thus,man-

agers will be discouraged from investing in CSR activities

that are driven by managerial opportunism.

To capture CSR activities by Korean f‌irms, we use the

index published by the Korea Economic Justice Institute

(KEJI), which has been widely used in previous studies con-

ducted in the Korean context (see, e.g., Choi, Kwak, & Choe,

2010; Oh, Chang, & Martynov, 2011). We use the index

developed in Korea because CSR can be conceived differ-

ently in various countries representing localized issues and

cultural values (Welford, 2005; Witt& Redding, 2012). One of

the unique features in Korea regarding f‌irms’ CSR practices

is that the notion of contributing to society is closely linked

to national development (Kim, Amaeshi, Harris, & Suh,

2012; Kim, Park, & Lee, 2009; Witt & Redding, 2012). Accord-

ing to executive surveys conducted by Witt and Redding

(2012) in f‌ive countries, including Germany, Hong Kong,

Japan, Korea and the US, the importance of contributing to

the national economy as part of f‌irms’ CSR policies is

observed only in Korea. Kim et al. (2012) also argue that

employment issues at a national level, such as health and

welfare systems, are embedded into the CSR framework of

Korean f‌irms. This situation can be compared with the case

of the UK, in which such matters are addressed by the gov-

ernment system but remain separate from CSR policies at

the f‌irm level. The KEJI Index adequately ref‌lects those

views concerning economic development and employment

matters in its evaluation measures. According to the KEJI,

socially responsible f‌irms are def‌ined as those that “invest in

human capital, promote the welfare of their employees,”

“improve productivity,” and “contribute to national devel-

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Volume 21 Number 5 September 2013 © 2013 John Wiley & Sons Ltd