INSIGHTS ON CORPORATE SOCIAL RESPONSIBILITY AND FINANCIAL REPORTING QUALITY

By | March 9, 2022

Introduction

Corporate social responsibility (CSR) has come to the forefront of both academic and popular attention. Firms publicize their commitments to CSR, establish CSR governance structures, and issue CSR reports. CSR is defined as the economic, legal, moral, and philanthropic actions of firms that influence the quality of life of relevant stakeholdersSocially responsible firms promote efforts to help protect the environment, seek social equality, and improve community relations. 

There have been two opposing views of CSR in the literature – the stakeholder value maximization view and the shareholder expense view. The stakeholder value maximization view argues that focusing on the interests of other stakeholders increases their willingness to support the operations of a firm, which in turn increases shareholder wealth. This view is encapsulated by the phrase “doing well by doing good.” Ethical, political, and integrative theories of CSR suggest that managers have an incentive to be trustworthy and ethical in their business processes, and thus tend to adhere to a high standard of behavior. Thus, when managers engage in CSR in the context of a moral imperative, they are more likely to make responsible operating decisions, maintain transparency in financial reporting, and provide investors with more reliable financial information, suggesting a positive connection between CSR and financial reporting quality.

In contrast to the stakeholder value maximization view, the shareholder expense view posits that engaging in socially responsible activities helps stakeholders at the expense of shareholders. In this view, CSR activities serve as a manifestation of managerial agency problems and are linked to the pursuit of a manager’s self-interest. Furthermore, a manager may engage in CSR activities to cover up corporate misconduct. If managers engage in CSR practices based on opportunistic incentives, they are more likely to mislead stakeholders regarding a firm’s financial performance, suggesting a negative connection between CSR and financial reporting quality.

CSR is related to corporate sustainability management but has a long separate history of research that has explored its importance for shareholder wealthfirm valuefinancial performancefirm riskthe cost of leverage, and other issues. Nevertheless, prior research does not present comprehensive evidence on the relationship between CSR and financial reporting quality. Financial reporting quality is the accuracy with which financial reporting conveys information about a firm’s financial position that is complete, neutral, and free from error. The quality of financial reports is often studied in the context of earnings reporting, forecasting, and management The two opposing views of CSR imply different relationships between CSR and financial reporting quality. Some aspects of these relationships have been explored previously with inconsistent results. Our recent study aims to clarify the evidence on the link between CSR and financial reporting quality.

Data and Empirical Methods

We obtain measures of the firms’ CSR activities from the Kinder, Lydenberg, and Domini Research & Analytics (hereafter referred to as KLD) database, which assesses the social, environmental, and governance performance of large public companies in the U.S. Our study focuses on five dimensions of KLD ratings: community, diversity, employee relations, environment, and product quality. Each dimension is composed of strength and concern indicators. A firm scores one strength (concern) point for each socially good (bad) action in each dimension. We adjust the raw CSR measure by dividing a firm’s strength and concern scores by the total number of strength and concern indicators identified in each year for each dimension. We then take the difference between the adjusted total strength and concern scores to construct the CSR measure. We then construct four measures of financial reporting quality using variables obtained from the Institutional Brokers’ Estimate System (IBES) and the Center for Research in Security Prices (CRSP) databases. 

We perform regression analyses to examine the relationship between the dependent financial reporting quality variable and the independent variables of CSR scores. We include control variables such as market-to-book value of the firm, firm assets, leverage, return on assets, research and development, and institutional ownership. We also include year and firm fixed effects and cluster robust standard errors at the firm level for all the regressions.

Findings

To start with, we find that firms with higher levels of CSR measures are associated with higher accuracy of financial forecasts, fewer earnings surprises, and greater coverage by financial analysts over the period from 1991 to 2018. This finding suggests a positive relationship between CSR and financial resorting quality, supporting the shareholder value view of CSR. We further conduct several analyses to address the potential endogeneity in this relationship, such as the instrumented variables approach. Our findings remain consistent with the baseline results.

We then examine additional factors that affect the relationship between CSR and financial reporting quality. We focus on four areas and examine the impact of agency concerns, customer awareness, long-term institutional holdings, and financial constraints. 

First, well-governed firms that experience fewer agency concerns are more likely to engage in CSR activities. Our empirical results support this conclusion as the positive relationship between CSR and financial reporting quality is stronger for firms that face low agency concerns. 

Second, prior research suggests that advertising enhances the benefits of CSR and customers take into consideration firms’ CSR activities when making purchase decisions. Advertising creates awareness about firms and their activities, which enhances the impact of CSR on the value of firms by creating goodwill on the part of customers and strengthening the monitoring effect of customers. Our findings support this view and show that the relationship between CSR and reporting quality is stronger for firms with a high level of customer awareness. 

Third, long-term institutional ownership is an effective monitoring mechanism. Our results demonstrate that the contribution of CSR to a firm’s financial reporting quality is more significant when the firm has a higher level of long-term institutional ownership. 

Fourth, earlier CSR researchers argued that financial constraints are negatively correlated with CSR, suggesting that CSR is a luxury for firms. Our empirical results further contribute to this result and suggest that when firms do not face financial constraints, the link between CSR measures and financial reporting quality improves significantly. 

Finally, we focus on how firms may benefit from better financial reporting quality, and how financial reporting quality affects the information environment and firm risk for firms with different levels of CSR. We show that high CSR firms are more likely to experience a significant negative relationship between financial reporting and firm risk, and greater transparency in financial reporting decreases information asymmetry for high CSR firms. Therefore, higher CSR may be an indicator of firms that are better governed and achieve lower risk and higher transparency in financial reporting.

Contributions

Our study contributes to the literature in several ways. First, we construct a data sample covering the period from 1991 to 2018 that is larger than earlier studies. Using this dataset, we find a positive relationship between CSR and financial reporting quality measures. Second, we contribute to the ongoing debate on the value of CSR. Our results support the stakeholder value view of CSR and shed light on how CSR is associated with another aspect of corporate behavior – financial reporting quality. We confirm that this relationship is positive. Third, our results identify factors that affect the significance of this relationship. We demonstrate that firms with lower agency concerns, higher customer awareness, more long-term institutional investors, and fewer financial constraints face a more significant link between CSR and financial reporting quality.

Dmitriy Chulkov is a Professor of Economics and Management Information Systems at Indiana University Kokomo.

Xiaoqiong (Crystal) Wang is an Assistant Professor of Finance at Indiana University Kokomo.

This post is adapted from their research paper “Corporate Social Responsibility and Financial Reporting Quality” available on SSRN.

The views expressed in this post are those of the authors and do not represent the views of the Global Financial Markets Center or Duke Law.

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