Earnings Management and Corporate Social Responsibility: International Evidence

Transcription

1 Earnings Management and Corporate Social Responsibility: International Evidence Jinhua Cui*, Hoje Jo**, and Joonghyuk Kim* October 21, 2015 Abstract This study examines whether corporate social responsibility is associated with firms earnings management in an international setting. Using a large sample of international firms, we find a significantly negative association between corporate social responsibility and firms earnings management. This negative relation holds after we account for potential endogeneity. Our results also suggest that the inverse CSR-earnings management association is more pronounced in countries with low individualism scores, high uncertainty avoidance scores, common law regime, high investor protection, and high human development. Furthermore, our component analysis suggests that the inverse CSR-earnings management association is more prominent in firms with stronger stakeholder governance, higher awareness on environmental issues, and more stakeholder capital. Overall, our results are supportive of the ethical financial transparency hypothesis, the individualistic culture hypothesis, and the uncertainty avoidance culture hypothesis, but not the opportunistic incentive hypothesis. Keywords Earnings management; Corporate social responsibility; Individualistic culture; Uncertainty avoidance; Investor protection ** Jo (corresponding author) is the Gerald and Bonita Wilkinson Professor of Finance, Leavey School of Business, Santa Clara University, 500 El Camino Real, Santa Clara, CA , U.S.A. (408) , (408) (fax), hjo@scu.edu. Jo appreciates the sabbatical support of Santa Clara University and partial financial assistance of the Asian Institute of Corporate Governance at Korea University. This paper is conducted in part while Jo was visiting Korea University Business School during his sabbatical period. * Cui is a Ph.D. candidate of Finance in the Korea University Business School, Korea. (010) , kiki4u@korea.ac.kr. * Kim is an Associate Professor of Finance in the Korea University Business School, Korea , j-kim@korea.ac.kr. 1

2 Earnings Management and Corporate Social Responsibility: International Evidence Introduction There has been divergence of views regarding whether earnings management reflects proper or improver activities. Advocates of earnings management maintain that earnings management is taking advantage of the flexibility in the choice of financial treatment to signal managers valuable private information on future cash flows (Healy and Whalen 1998; Beneish 2001). Opponents argue that earnings management is the practice of using manipulative devices to misrepresent or obscure transparency of the financial reports (Ronen & Varda 2008, p.25). The middle of the road views earnings management as choosing an accounting treatment that is either opportunistic (maximizing the utility of management only) or economically efficient. Recent corporate social responsibility (CSR) studies have found evidence that CSR is beneficial to the firm, as evidenced by lower cost of equity (Dhaliwal, et al. 2011), higher analyst following (Hong and Kacperczyk 2009), more favorable analysts recommendation (Ioannou and Serafeim 2014), higher analyst forecast accuracy (Dhaliwal, et al. 2012), and more effective corporate governance and higher firm value (Waddock and Graves 1997; Blazovich and Smith 2011; Jo and Harjoto 2011, 2012). Others focus on the cost side of CSR engagement. For instance, Sprinkle and Maines (2010) provide recent anecdotal evidence for the costs of CSR such as immediate cash outflows and opportunity cost of spending on CSR. Similar to Friedman (1970), Barnea and Rubin (2010) maintain that if CSR initiatives do not maximize firm value, such initiatives are a waste of valuable resources. Mahapatra (1984) also lends support to the argument that investors do not view CSR as efficient. 2

3 In this study, we examine whether CSR activities across nations is an attempt to decrease their earnings management by enhancing information transparency. Prior literature has drawn attention to the association between earnings management and CSR in an attempt to understand the drivers of financial reporting quality, proxied by earnings management practices because corporate decision making is largely influenced by financial reporting quality (Kim et al. 2012). Empirical evidence, however, provides inconclusive results regarding the direction of this association (Chih et al. 2008; Prior et al. 2008; Lev et al. 2010). To resolve these issues, we take a comprehensive approach of the relation between CSR and financial reporting behavior of international firms by examining cultural, legal, investor protection, and development level differences. In addition, we examine a broad set of financial reporting characteristics that include overall accruals management, positive and negative accruals management along with each component of international CSR dimensions including strategic governance, human capital, environment, and stakeholder capital. Furthermore, despite the important implications of CSR on earnings management, direct evidence of empirical association between CSR and earnings management mitigating endogeneity remains largely understudied. To test the relation between earnings management and CSR, we examine how earnings management is associated with firms CSR activities in an international setting. Our earnings management measure is based on the absolute value, positive value, and absolute negative value of discretionary accruals, where discretionary accruals estimated by modified Jones model following Kothari et al. (2005). While the discretionary accruals data are provided by the Worldscope, the data for CSR construction is assembled from MSCI Environmental, Social, and Governance (ESG) Intangible Value Assessment (IVA) Database. To the best of our knowledge, this study is the first to examine the relationship between CSR activities and earnings management mitigating endogeneity in an international 3

4 setting, both being distinct and understudied phenomena in academic literature. Our study attempts to fill that void by investigating CSR-earnings management nexus across nations along with cultural, legal, investor protection, and development level differences. In addition, to mitigate the endogeneity issue, we further use dynamic system generalized methods of moment (GMM) following Blundell and Bond (1998) and Wintoki et al. (2012) as well as the simultaneous equation approach. By using various econometric methods, including ordinary least square (OLS) and fixed-effect regressions (unreported), we empirically find that CSR is significantly and negatively associated with accruals management proxies after controlling for firm characteristics. To mitigate the endogeneity issue, we use the simultaneous equation approach and dynamic system generalized methods of moment (GMM) and further find that our main finding of a negative association between CSR engagement and earnings management remains robust. Although evidence of the CSR-earnings management relation in the prior literature generally remains inconclusive (Chih et al. 2008; Prior et al. 2008; Lev et al. 2010), our study suggests a robust inverse association between CSR and earnings management proxies across nations even after mitigating endogeneity, considering reverse causality, and controlling cultural, legal, investor protection, and human development degree differences. In the cross-country analysis, we find evidence of significant and positive (negative) impact of individualism scores (uncertainty avoidance scores) on earnings management proxies, suggesting that firms in individualistic cultures tend to engage in more earnings management while firms in uncertainty avoiding cultures are less likely to engage in earnings management. This evidence is consistent with the findings of Han et al. (2010) who study the relation between earnings management and cultures. They, however, do not address CSR issues. In the interaction analysis, we further find evidence of significant and positive (negative) impact of individualism scores interacted with CSR scores (uncertainty avoidance scores interacted 4

5 with CSR scores) factor on earnings management. Moreover, our results suggest that the inverse CSR-earnings management association is more pronounced in countries with low individualism culture, high uncertainty avoidance culture, common law, high investor protection, and high human development index scores. Furthermore, our component analysis suggests that the inverse CSR-earnings management association is more prominent in firms with stronger stakeholder governance, high awareness on environmental issues, and more stakeholder capital. The remainder of this paper is organized as follows. First, we briefly describe the literature on which we base our hypothesis development. We then discuss the sampling and measurement of CSR practices and earnings management. Following this discussion, we present the empirical results. In the final sections, we discuss the significance and limitations of this study and state our overall conclusions. Literature and Hypotheses Related Literature While the literature on the association between CSR and financial performance is abundant, studies that examine CSR and earnings management are relatively limited, and the results are mixed. A few studies that examine the relation between CSR and financial reporting behavior primarily focus on the opportunistic incentive of CSR within an agency theoretic framework. Lev et al. (2005) discuss the possibility of manipulating earnings through accounting estimates and suggest that this potentially manipulated information does not provide useful information. Thus there could be managers opportunistic incentive both in strategic CSR and earnings management. Prior et al. (2008) investigate whether firms use CSR strategically to disguise earnings management. They find a positive association between 5

6 earnings management and CSR for regulated firms, but this result is not statistically significant for unregulated firms. As regulated firms typically have less discretion in accounting choices, insignificant results reported for unregulated firms, comprising more than 80 percent of the sample, make their evidence less persuasive. In addition, Kim and Venkatachalam (2011) find that sin firms (i.e., firms in the gaming, tobacco, and alcohol industries) exhibit superior financial reporting quality relative to a control group. Since reporting incentives may be different depending on whether socially responsible activities are discretionary, their results are less pertinent to our research objective, as inclusion in a sin industry is not a discretionary activity. Different from prior studies that highlight managerial opportunism in explaining the CSR - financial reporting linkage, Kim et al (2012) focus on ethical concerns as an alternative motivation for CSR that drives corporate financial reporting. Unlike Prior et al. (2008) and Kim and Venkatachalam (2011), Kim et al (2012) use unregulated firms and such discretionary CSR activities as charitable giving, environmental policies, and diversity hiring, thus providing more general evidence on the relation between CSR and financial reporting practice. Their study, however, is limited only for the U.S. Using multinational data, Chih et al. (2008) examine CSR and earnings management and provide inconsistent results across different earnings management proxies. They also use only a limited set of proxies for earnings management. They show that CSR firms are more aggressive in accruals management but are less likely to engage in earnings smoothing and earnings loss avoidance. Note that different countries have different cultural differences, different levels of investor protection, different accounting standards, and different legality of CSR (Reinhardt et al. 2008), and earnings management practices also vary across countries (Leuz et al. 2003). Thus, the results in Chih et al. (2008) could be driven by these country and cultural differences rather than differences in CSR activities. Given the inconsistent evidence 6

7 from prior research with mixed implications on the relation between CSR and earnings management, it is difficult to draw definite conclusions about the nature of the relationship. Although Han et al. (2010) do not focus on CSR, they examine whether the degree to which managers exercise earnings management to their cultural and legal environment of their country. They suggest that both the uncertainty avoidance and individualism dimensions of national culture explain managers earnings management across countries, and that this association varies with the strength of investor protection. Hypothesis Development While the definition of CSR is not universally accepted, the definition offered by Carroll (1979) is most widely accepted: The social responsibility of business encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time. Carroll s (1979) description of a firm s social responsibilities suggests that CSR firms should strive to make a profit, obey the law, be ethical, and, further, be a good corporate citizen by financially supporting worthy social causes. Focusing on four main aspects of social reality, economics, politics, social integration, and ethics, Garriga and Mele (2004) classify CSR theories into four groups: (1) ethical theories, (2) political theories, (3) integrative theories, and (4) instrumental theories. Earnings Management and Corporate Social Responsibility Ethical theorists (e.g., Carroll 1979; Jones 1995; Donaldson and Preston 1995; Phillips et al. 2003) suggest that a firm must accept social responsibility as an ethical obligation. Such theories are based on principles such as the right thing to do or the 7

8 doing what is ethically correct, requiring a CSR firm to give simultaneous attention to the legitimate interests of all stakeholders in reference to some guiding moral principle. 1 Ethical theories of CSR suggest that managers have an incentive to be honest, trustworthy, and ethical in their business processes, and thus tend to adhere to a high standard of behavior. Numerous studies on the ethical view of CSR (e.g., Carroll 1979; Donaldson and Preston 1995; Jones 1995; Phillips et al. 2003; Kim et al. 2012) argue that there is a moral imperative for managers to do the right thing. For instance, Jones (1995) and Kim et al. (2012) concludes that CSR firms have an incentive to be honest, trustworthy, and ethical because such behavior is beneficial to the firm. In Carroll s (1979) model, ethical responsibilities embrace those activities and practices that are expected by society. Hence, if managers engage in CSR in the context of a moral obligation, then we predict that they are more likely to constrain earnings management and to make responsible operating decisions, thereby maintaining transparency in financial reporting. Therefore, we expect a negative association between CSR and earnings management. We propose the following hypothesis: Hypothesis 1(a): Under the ethical financial transparency hypothesis, a CSR firm is less likely to engage in earnings management. While ethical obligation and financial transparency hypothesis predict a negative association between CSR and earnings management, some studies relying on opportunistic use of CSR suggest a positive relation. That is, managers might engage in CSR practices for 1 By focusing on the responsible use of business power in the political arena, political theories consider a firm s relationship with society and its concomitant responsibility to that society (Donaldson and Dunfee 1994; Matten and Crane 2005). Political theories suggest that a firm needs to take into account the community where it is operating and seek ways of formalizing the firm s willingness to improve the community. Integrative theory argues that business needs to integrate social demands into their business because its success is dependent on society. A number of prior studies (Carroll 1979; Wood 1991; Swanson 1995; Agle and Mitchell 1999) rely on this view. On the other hand, instrumental theories (e.g., Friedman 1970) consider economic objectives and view CSR as a mere means to wealth creation for shareholders. Under this theory, any proposed social activity is accepted if and only if it is consistent with wealth creation (e.g., McWilliams and Siegel 2001; Mackey et al. 2007). 8

9 personal benefit rather than for the interest of the firm and its stakeholders (Barnea and Rubin 2010). Prior theoretical studies (e.g., Jensen and Meckling 1976; Carroll 1979) suggest that CSR can potentially be linked to the pursuit of managers self-interest. From an agency cost perspective, McWilliams et al. (2006) argue that CSR is a managerial perquisite, in the sense that managers use CSR to advance their personal agendas. Focusing on managers opportunistic behavior within an agency theoretic framework, Petrovits (2006) and Prior et al. (2008) find evidence consistent with this view. Prior studies (e.g., Fritzche 1991) suggest that ethical codes can become windowdressing when they pertain to the pursuit of self-interest or economic egoism of the organization. Hemingway and Maclagan (2004) argue that firms adopt CSR to cover up the impact of some corporate misconduct. Thus, firms may engage in CSR as a form of reputation insurance, which then gives them a social license to operate with respect to earnings management. This motivation indicates that decisions to participate in CSR activities may be made to give stakeholders the impression that the firm is transparent, when, in fact, the firm hides behind the appearance of transparency while engaging in earnings management. This motive is somewhat consistent with evidence in Jo and Kim (2007) in that firms increase sudden disclosure frequency to make information opaque while they manage earnings around seasoned equity offering (SEO). Barnea and Rubin (2010) argue that top management tends to engage in CSR activities to build their own personal benefits and reputation as good global citizen. Together, if managers opportunistic incentives deriving from self-interest and/or reputation insurance prevail, then we would observe a positive relation between CSR and earnings management because managers of these firms are more likely to attempt to mislead stakeholders as to the value of the firm and financial performance. This discussion leads to a competing hypothesis on the relation between CSR and earnings management. 9

10 Hypothesis 1(b): Under opportunistic incentive hypothesis, a CSR firm is more likely to engage in earnings management. International Cultural Differences The international setting of our study provides an opportunity to investigate whether and how the relation between CSR engagement and earnings management varies across countries. We first investigate whether cultural differences across countries affect the relation between CSR and earnings management. We focus on the difference between individualistic and collectivistic cultures, which is one of the most important dimensions in cultural variation. Hofstede (1980) defines individualism as a preference for a loosely-knit social framework in which individuals are expected to take care of only themselves and their immediate families. In contrast, collectivism stands for a preference for a tightly knit social framework in which individuals can expect their relatives, clan, or other in-group to look after them in exchange for unquestioning loyalty. We expect managers in individualistic cultures to care more about how they have discretion in financial reporting, compared to people in collectivistic cultures who are more likely to emphasize company group goals above individual or managerial needs or desires. We postulate that earnings management is more profound in individualistic cultures relative to collectivistic cultures, and the relation between CSR engagement and earnings management is less pronounced in individualistic cultures relative to collectivistic cultures, suggesting that managers in societies with high individualism place more importance on their discretion and personal benefits when they choose financial reporting, leading to a lesser impact of CSR on earnings management. Therefore we expect the following; 10

11 Hypothesis 2(a): Under the individualistic culture hypothesis, the impact of CSR engagement on earnings management would be stronger in societies with low individualism or high collectivism relative to societies with high individualism or low collectivism. As indicated before, Han et al. (2010) suggest that both individualism and uncertainty avoidance dimensions of national culture explain managers earnings management across countries, and that this association varies with the strength of investor protection. In fact, uncertainty avoidance is one of the five cultural dimensions presented by Hofstede (1980). Uncertainty is defined as a state wherein outcomes and conditions are unknown or unpredictable. Some people are more comfortable with uncertainty than others, and the degree to which individuals participate in certain behaviors to stay in comfortable situations is called uncertainty avoidance. In cross-cultural psychology, uncertainty avoidance is a society's tolerance for uncertainty and ambiguity. It reflects the extent to which members of a society attempt to cope with anxiety by minimizing uncertainty. The uncertainty avoidance dimension expresses the degree to which a typical person in a society feels uncomfortable with a sense of uncertainty and ambiguity. 2 Along with Hofstede's conceptualization of uncertainty avoidance, he developed an index, the Uncertainty Avoidance Index. This index measures levels of uncertainty avoidance so that countries could be compared to one another. A low score on the uncertainty avoidance index indicates that the people in the country are more comfortable with ambiguity, more entrepreneurial, more likely to take risks, and less dependent on structure rules. Countries 2 According to Hofstede (1980), the fundamental issue is how a society deals with the fact that the future can never be known: should we try to control the future or just let it happen? Countries exhibiting strong uncertainty avoidance index (UAI) maintain rigid codes of belief and behavior and are intolerant of unorthodox behavior and ideas. Weak UAI societies maintain a more relaxed attitude in which practice counts more than principles. For instance, people in cultures with high uncertainty avoidance tend to be more emotional. They try to minimize the occurrence of unknown and unusual circumstances and to proceed with careful changes step by step by planning and by implementing rules, laws and regulations. In contrast, low uncertainty avoidance cultures accept and feel comfortable in unstructured situations or changeable environments and try to have as few rules as possible. People in these cultures tend to be more pragmatic, they are more tolerant of change. 11

12 with high uncertainty avoidance scores desire more stability, more structured rules and social norms, and are less comfortable taking risks. We expect managers in high uncertainty avoidance cultures to consider more about how they have discretion in financial reporting, compared to managers in low uncertainty avoidance cultures who are more likely to more comfortable with ambiguity, more likely to take risks, and less dependent on financial reporting rules. We postulate that earnings management is more profound in high uncertainty avoidance cultures relative to low uncertainty avoidance cultures, and the relation between CSR engagement and earnings management is more pronounced in high uncertainty avoidance cultures relative to low uncertainty avoidance cultures, suggesting that managers in societies with high uncertainty avoidance place more importance on financial reporting, leading to a greater impact of CSR on earnings management. Therefore we expect the following; Hypothesis 2(b): Under the uncertainty avoidance culture hypothesis, the impact of CSR engagement on earnings management would be stronger in societies with high uncertainty avoidance relative to societies with low uncertainty avoidance. Other International Differences We next examine whether the impact of CSR on earnings management is affected by a country s labor regulation and law regime. La Porta Lopez-de-Silanes, Shleifer, and Vishny (LLSV hereafter, 1997, 1999), and La Porta et al. (1998), in their series of seminal papers, show that the legality of a specific country including civil versus common law systems are important for economic development in a country. Clearly, there is a marked difference in the legal protection of investors between the two most influential legal systems, namely, English common law and French civil law. Botero et al. (2004) examine the regulation of labor through three bodies of law: employment law, collective relations law, and social security laws in eighty-five countries. They find that common-law countries have significantly lower 12

13 level of labor regulation than non-common-law countries. We thus investigate whether the relation between CSR and earnings management is more pronounced in common law countries or in non-common law countries. On the one hand, more labor regulation can ensure that companies implement high quality financial reporting practices, rather than engaging in programs for executives own private benefits. If this is the case, we expect CSR engagement to have a greater effect on earnings management in non-common law countries than in common law countries. On the other hand, company-initiated high quality financial reporting programs may be more important for earnings management when other means of labor protections, such as government s regulation of labor, is weak. Under this scenario, we expect CSR to have a greater impact on earnings management in common law countries than in non-common law countries. In addition, we examine whether the impact of CSR on earnings management is affected by a country s investor protection level. LLSV (1997) suggests that investor protection is, in fact, crucial because, in many countries, expropriation of minority shareholders and creditors by insiders, i.e., the controlling shareholders or managers is widespread. When outside investors finance firms, they face a risk, and the returns on their investments will surely never materialize because the insiders simply keep them, although investment protection literally refers to any form of guarantee or insurance that investments made will not be lost through fraud or manipulation. 3 LLSV (1997) also document that countries with strong investor protection tend to have more valuable stock markets than countries with weak protection. Weak investor protection can also be a contributing factor to sharp market declines during a financial crisis. Leuz et al. (2003) maintain that firms are likely to manage their earnings less in countries with stronger investor protection. Thus we 3 Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against possible expropriation or manipulation by the insiders. 13

14 suspect that investor protection is inversely related to earnings management to the extent that managers engage in CSR in the context of a moral cause. In that context, moral managers are more likely to restrain earnings management and tend to maintain transparency in financial reporting. Moreover, we speculate that the CSR-earnings management association is more pronounced in firms of countries with higher investor protection than firms of countries with lower investor protection Furthermore, we investigate whether this relation differs between more developed countries and less developed countries. CSR engagement might have a greater impact on earnings management in more developed countries relative to less developed countries for two reasons. First, human development might be more crucial to a firm s success in more developed countries relative to less developed countries, because other traditional sources of competitive advantage, such as production technology, access to capital, and economies of scale, are more readily available to companies in more developed countries. Second, various stakeholders in more developed countries are likely to have greater expectations and place more importance in high quality financial reporting programs than stakeholders in less developed countries. One contributing factor to this difference is the role played by nongovernmental organizations (NGOs) and other civil society in promoting stakeholder value, including social responsibility and financial transparency. While these organizations have a long history and substantial influence on corporate governance in more developed countries, there is relatively less advancement of NGOs in less developed countries. As a result, stakeholders such as customers, employees, and investors in more developed countries are more likely to prefer firms with higher reporting quality, causing a CSR firm to have a greater impact on earnings management relative to less developed countries. On the other hand, one might argue that the effect of CSR activities on earnings management can be greater in less developed countries because many of the traditional 14

15 sources of competitive advantage such as access to capital are lacking in these countries, leaving human development the primary factor that determines a firm s competiveness and success. Under this scenario, we would expect CSR engagement to have a greater impact on earnings management in less developed countries than in more developed countries. Data and Measurement We obtain individual firm level Corporate Social Responsibility (CSR) index information from MSCI Environmental, Social, and Governance, Intangible Value Assessment Database (IVA Database) over periods. The IVA Database provides CSR index information for around 2,000 companies from 36 different countries: Top 1,500 companies in the MSCI World Index, Top 25 companies in the MSCI Emerging Market Index, Top 275 companies in the FTSE 100 and the FTSE 250 by market capitalization, excluding investment trusts, and ASX 200 companies. We drop 6 countries out of those 36 countries that do not have enough observations for our estimation of earnings management measure. 4 Thirty countries we focus in this study include Australia, Austria, Belgium, Brazil, Canada, Chile, Denmark, Finland, France, Germany, Greece, Hong Kong, India, Italy, Japan, South Korea, Malaysia, Mexico, Netherlands, New Zealand, Norway, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, Thailand, United Kingdom, and the United States. All other required firm level accounting and stock return information are obtained from Worldscope Database, Compustat Global (Non-US firms) and Coumpust North America (US firms)(compustat). In addition, country level information such as investor protection scores (from La Porta et al. 1998), cultural factors (from the Hofsted centre) and Gross Domestic Product (GDP) (from World Bank) are included. The initial CSR index from IVA 4 In our estimation of earnings management measure, we require at least 10 observations each year from each country. The detailed discussion of the data requirement and estimation procedure is provided in the next section. 15

16 Database is merged with the data from Worldscope Database and Compustat at the firm level, and then combined with the various country level variables. After merging all databases used in this study, we are left with the final sample of 6,146 firm year observations from 2006 to Measurement of Earnings Management Following the literatures on earnings management such as Jones (1991), Defond et al. (1998), Kothari et al. (2005) and Jo and Kim (2007), we use the discretionary component of accruals as proxy for earnings management. More specifically, we adopt the model from Kothari (2005) to estimate discretionary component of accruals. We then take the absolute value of discretionary accruals (ABS_DA) and use it as a measure for earnings management following prior studies (e.g. Warfield et al. 1995; Klein 2002; Kim, et al. 2012). In addition, we divide the sample into two groups: one with positive discretionary accruals (incomeincreasing accruals) and the other with negative discretionary accruals (income-decreasing accruals). The absolute values of positive discretionary accruals (PDA) and negative discretionary accruals (NDA) are used for our sub-analyses. Consistent with prior studies (e.g., Teoh et al. 1998; Chan et al. 2008), we run a separate cross-sectional OLS model as in equation (1) within each industry (with the same 2 digit SIC code), for each country, for a given calendar year to estimate discretionary accruals. (1) where TAC i, t is total accruals for firm i at year t, defined as the difference between net income and operating cash flows (Pincus et. al. 2007; Fan & Yu 2013), ΔREV i,t is the change in revenues for firm i between year t-1 and t, PPE i,t is the gross property plant and equipment 5 In the later section, the sample size varies across different analyses due to the data availability of each variable. 16

17 for firm i at year t, ROA i,t is the return on the total assets for firm i at year t, defined as net income divided by total asset. Each variable is deflated by TA i,t-1, total assets for firm i at the beginning of year t. The residuals obtained from regression equation (1) are defined as a measure for discretionary accruals. In order to obtain meaningful regression estimates, we require that the number of firms in an industry of each country for a given year should be at least 10. If the number of firms is less than 10, then we use one digit SIC code to define the same industry. If the number of firms is still less than 10 even when one digit SIC code is used, we replace the coefficients with the coefficients based on a separate regression that uses all firms in that country for that year. Measurement of Corporate Social Responsibility IVA Database defines the key ESG issues affecting each industry. These key issues can be broadly categorized into four groups: Strategic governance, Human capital, Stakeholder capital, and the Environment. We construct the measure of CSR index (CSRIDX) by calculating the mean score of all 29-IVA sub-ratings of Strategic Governance, Human capital, Stakeholder capital, and the Environment (See Appendix 1 for the description of the 29-IVA sub- dimensions). Measurement of Firm Characteristics Following prior studies on the effect of CSR on earnings management such as Kim et al. (2012), Dhaliwal et al. (2012), Harjoto and Jo (2015), we include several firm characteristics as control variables in our analyses. They are firm size, measured by the natural logarithm of total market value of equity in millions of U.S. dollars (LOG_MVE), market to book ratio, measured by market value of equity divided by book value of equity 17

18 (MBR), research and development expenses divided by total sales (RNDR), return on total asset (ROA) measured by net income divided by total assets, debt structure, measured by long-term debt divided by total assets (DEBTR). In addition to the aforementioned firm characteristics, prior studies such as Ahmed et al. (2013) and Christensen et al. (2015) show that IFRS adoption affects the earnings management behavior by a firm. Following those studies, we also include an indicator variable (IFRS) that receives the value of one if a firm adopts IFRS rule in a given year and zero, otherwise. Measurement of Country Level Variables We also include country level variables that are known to affect individual firms earning management level. For instance, Leuz et al. (2003) suggests that in countries with stronger investor protection, firms tend to manage their earnings less. Thus, we include the investor protection measure for each country from La Porta et al. (1998). Based on prior studies (e.g. La Porta et al. 1998; Leuz et al. 2003), the degree of investor protection is measured by the arithmetic average score across the following five legal variables: the efficiency of the judicial systems, the rule of law, the corruption, the risk of expropriation, and the risk of contract reputation. In addition, previous researches find that cultural factors have influence on accounting practices in different countries (Gray 1988; Doupnik and Tsakumis 2004). In particular, Han et al. (2010) show that using Hofstede s cultural indices, national culture as well as legal environment can explain the differences in manager s earnings management behaviors across different countries. They find that on average, firms in countries with high uncertainty avoidance index and low individualism index exhibit higher level of earnings management. Thus, we include two of national culture dimensions obtained from Hofstede (2011, 2012) in our analyses that are expected to have influence on earnings management in different 18

19 countries. They are individualism (IND) and uncertainty avoidance (UAI) dimensions. In addition, the GDP per capita is closely related to the government s regulation, economic policies according to Leuz et al (2003). The GDP per capita information is obtained from World Bank in a given year. Research Design To examine how the CSR activities affect the earnings management behaviors, we first regress the aforementioned three CSR indices on the earnings management levels, along with firm and country level variables. Specifically, the following equation (2) is the baseline OLS regression model we estimate. ABS_DA(PDA or NDA) t = CSRIDX t-1 2 LOGMVE t-1 3 MBR t-1 4 DEBTR t-1 + 5ROA t-1 6 RNDR t-1 7 IFRS t-1 8 LOGGDP 9 ID 10U I 11 LTO+ + t 12LLS 13IDV*CSRIDX+ 14UAI*CSRIDX+ 15Industry dummy 16 Year dummy (2) In order to mitigate the potential endogeneity problem between the CSR measure and earning management, following Jo and Harjoto (2012), we also estimate a simultaneous equations model with the following two equations (3) and (4). ABS_DA(PDA or NDA) t = CSRIDX t-1 2 F rm on rol var ables 3 Na obal Factor 4Industru dummy 5 Year dummy + t (3) CSRIDX t = ABS_DA (PDA or NDA) t-1 2 F rm on rol var ables 3 Na onal Fac ors 4Indus ry dummy 5 Year dummy + t (4) For additional robustness check, we perform a dynamic panel system generalized method of moment (GMM) model that is commonly used to deal with the remaining 19

20 endogeneity problem (Wintoki et al. 2012). ABS_DA(PDA or NDA) t = CSRIDX t-1 2 ABS_DA(PDA or NDA) t-1+ 3ABS_DA (PDA or NDA) t-2+ 4 F rm on rol var ables 5 Na obal Fac or 6Indus ry dummy 7 Year dummy t (5) Empirical Results Descriptive Statistics Table 2 reports summary statistics of the variables used in the study. There are 6,146 firm-year observations over year 2006 to 2011 period, although the number of sample observation varies depending upon the availability of sample for different regression models. Panel A provides an overview of main and control variables. The mean absolute value of discretionary accrual (ABS_DA) is and standard deviation is The mean absolute values of positive discretionary accrual (ABD_PDA) and negative discretionary accrual (ABD_NDA) are and , respectively. This implies that on average, firms manage their earnings more in income-increasing than in income-decreasing or incomesmoothing. These statistics are comparable to those reported in prior study (Chih et al. 2008). The average of CSR indices (CSRIDX) is This number is comparable to Jo et al. (2015) who use the same MSCI IVA database for CSR measurement. We also present the descriptive statistics for firm characteristics in our sample. The mean (standard deviation) of LOGMVE and ROA is (1.2248) and (0.0703) respectively. The summary statistics for other firm characteristics variables and country-level variables also are reported in the Panel A. All variables used in our analyses are winsorized at the bottom 1% and the top 99%. Panel B of Table 2 shows descriptive statistics for the country level variables in this study for each country. Nine countries from Asia Pacific region, fifteen countries from 20

21 European region, three countries from North American, and another three countries from other region are included in the analyses. The sample size from each region accounts for approximately 30% of total sample, except for other region that accounts for only 1.56% of total sample. About 57% (29%) of 1,883 firms from Asia Pacific region are Japanese (Australian) firms. U.K. firms account for about 38% of European companies. France contributes the next highest portion of European sample, about 14%. Not surprisingly, most samples from North American region are the U.S. firms (over 86% of 2,252 firms). On average, North American countries show the highest level of earnings management measured by ABS_DA (0.1019), mainly due to the U.S. firms. Countries in other three regions show the similar level of ABS_DA. In fact, the U.S. firms exhibit the highest level of ABS_DA, followed by Australian companies, while the firms in Chile and Japan show the lowest level of earnings management. Consistent with Han et al. (2010), there is an indication that firms in a country with relatively higher individualism (IDV) and lower uncertainty avoidance (UAI) manipulate their earnings more. For instance, the U.S. and Australian firms who exhibit the highest ABD_DA level also show relatively higher individualism (U.S.=91, Australia=90), and lower UAI (U.S.=46, Australia=51). On the other hand, Japanese firms who have the lowest ABD_DA level along with Chili firms show relatively lower individualism (IDV=46) and higher uncertainty avoidance (UAI=92). CSR index (CSRIDX) indicates that European firms more actively engage in CSR activities compared to the firms in other parts of the world. In particular, German firms show the highest level of CSR, whereas the firms in Chile, Malaysia, and Mexico exhibit the lowest level. In our unreported results, firms across different regions show similar characteristics with some variations. For instance, firms in Asian Pacific region exhibit higher sales growth (SALEG, on average about 8.5%) than firms in other regions. European companies seem to 21

22 invest more in research and development (RNDR) than those from other parts of the world. In particular, Denmark has the highest RNDR, , followed by Switzerland, Reflecting the recent fast economic growth, Indian firms show the highest profitability (ROA) and sales growth rate (SALEG). Almost 96% of all European firms adopted IFRS account standard, while only about 28% of firms from Asia Pacific region adopted it. Out of 10 countries where all firm adopt the IFRS rule, nine are European countries. U.S. is the only country where firms do not adopt the rule, and only about 0.3% of Japanese firms appear to adopt it. [Table 2 about here] Effects of CSR and Others on Earnings Management: Univariate Difference Tests Table 3 reports the univariate test results. Specifically, it presents the results on whether the level of earnings management (ABS_DA) is different depending on how actively firms engage in CSR activities. Kim et al. (2012) show that socially responsible firms are less likely to manage their earnings, using the U.S. sample. We attempt to reexamine the issue in an international setting. The sample is divided into two groups by their CSR indices: HIGH (firms with CSR indices higher than the sample median) and LOW (firms with CSR indices lower than the median). Our results show that firms with higher CSR (HIGH) manage their earnings less that those with lower CSR (LOW) with the difference (0.0192) being statistically significant at 1%, which is consistent with Kim et al. (2012) s results. Table 3 also shows how cultural factors as well as the degree of investor protection affect managers earnings management across countries. According to Han et al. (2010), firms in countries with higher individualism and lower uncertainty avoidance dimension of national culture exhibit higher level of earnings management. They also report that 22

23 institutional difference such as legal environment can explain the difference in earning management practice across countries. Consistent with their results, we also find that firms in countries with higher individualism (IDV) and low uncertainty avoidance (UAI) culture engage in more earnings management. In addition, we find that the degree of investor protection (LLSV) is positively associated with the earnings management level 6. [Table 3 about here] Bivariate Correlations Table 4 presents the bivariate correlation between various measures of earnings management, CSR indices, firm characteristics, and country-level variables. CSR index (CSRIDX) is significantly and negatively related to the measure of earning management (ABS_DA) at the 5% level or less. The correlation coefficients between ABS_DA and other variables are collectively consistent with our expectation. In particular, the national cultural factors such as IDV and UAI show the consistent relation with the results in Table 3. ABS_DA is significantly and positively correlated with leverage (DEBTR), profitability (ROA), R&D expenditure (RNDR), investor protection (LLSV), individualism (IDV), common law regime (COMMON), and GDP per capita (LOGGDP), while negatively correlated with whether a firm adopts IFRS accounting standard and uncertainty avoidance (UAI). These simple correlation results between ABS_DA and various variables, however, should be interpreted with caution since we do not control for firm characteristics yet. [Table 4 about here] 6 Han et al. (2010) reports the positive correlation between the investor protection measure and the earnings management in their correlation result (Table 1). Our multivariate analyses, however, show that the investor protection has negative effect on the earnings management, which is consistent with Leuz et al. (2003). Therefore, the univariate result reported in Table 3 should be interpreted with caution. 23

24 Baseline Multivariate Regressions Table 5 presents the multivariate analysis results using OLS. In all nine models, we find that the lagged value of CSRIDX is significantly and negatively associated with the earnings management level measured by ABS_DA as well as income-increasing accruals management (PDA) and the absolute value of income-decreasing accruals management (NDA). We use the lagged value of CSR indices to make sure that corporate social responsibility be the impact factor. To account for large variation in number of firms in each country, we use robust clustered standard errors at country level as suggested in Petersen (2009). This negative relationship implies that in general, managers from more socially responsible firms engage in less earnings management in non-u.s. countries as well as the.u.s (as reported in Kim et al. (2012)), after controlling for other firm and country level variables. In these regressions, we include year and industry dummy (based on two digits SIC code). 7 We also examine the effect of CSR and the national cultural factors (IDV and UAI) on the earnings management level (ABS_DA, PDA, and NDA) after controlling for other firm and country level variables. Firms in countries with higher individualism (IDV) and lower uncertainty avoidance (UAI) manage their earnings more as shown in Han et al. (2010). We find that the higher the investor protection (LLSV), the lower the earnings management level (ABS_DA), confirming Leuz et al. (2003) that investor protection can reduce managers incentive to manipulate their earnings. In Models (2) to (9), we examine whether the effect of CSR on the earnings management is different conditional on each national cultural factor (IDV and UAI) by including the cross product between each cultural factor and CSR indices. Specifically, we 7 Our unreported weighted least square (WLS) regression results are qualitatively identical to our baseline regression results. 24

25 examine whether the different cultural environment affects the role of CSR on earnings management differently. From Model (2), we observe the significant and positive coefficients on IDV*CRSIDX. It suggests that in countries with relatively higher individualistic culture, managers use more reporting discretion in earnings accruals as they invest more in CSR, decreasing the negative effect of CSR on earnings management to compared to that in countries with lower individualistic culture. Thus, even in those countries with higher individualism cultural dimension, we find that CSR is still effective in decreasing earnings management but in lesser degree. Combined together, these results are supportive of our individualistic culture hypothesis 2. We also find that the effect of CSR on ABS_DA is conditional on the degree of uncertainty avoidance from Model (3). The coefficients on crossproduct terms are statistically significant and negative. Thus, in those countries with higher uncertainty avoidance cultural dimension, we find that CSR is effective in decreasing earnings management but in greater degree. All other variables including three cultural factors show the same signs as in other models. We also investigate whether the main effect of CSR and the interactive role of IDV (or UAI) and CSR on earnings management vary across income-increasing or income-decreasing earnings management. Models (4) through (9) of Table 5 present the results on incomeincreasing (PDA) and income-decreasing (NDA) discretionary accruals, respectively. We find that the main effect of CSR on both types of discretionary accruals is statistically and significantly negative, suggesting that regardless of the direction of earnings management, CSR plays a role to reduce manager s usage of earnings discretion across countries. IDV is positively associated with both PDA and NDA, whereas UAI shows significant and negative relation with both PDA and NDA. 8 The sum of the coefficients between CSRIDX and IDV*CSRIDX in model (4). 25