Corporate Social Responsibility and Earnings Management : Two sides of the relationship

Abstract: Sustainability is becoming a more important topic, not just in terms of the environment but also through social and governmental aspects. There are different views on what responsibility firms should take and what their incentives might be. Companies get more pressure from society to perform activities related to Corporate Social Responsibility (CSR) and not just focus on maximizing wealth for their shareholders. Thus, creates incentives to manipulate their earnings, either by managing their accruals (AEM) or by performing real activity earnings management (REM), to please all parties. On the other hand, firms who already manipulate their earnings have motives to increase their participation in CSR activities as a cover to hide their performance of Earnings Management (EM). There are plenty of previous studies investigating the relationships between CSR and EM, but with contradicting results. Some have tested a one-way relationship while others have evaluated a bi-directional relationship. This thesis has provided evidence that there exists a relationship between CSR and EM, where AEM (REM) has a negative (positive) effect on CSR while CSR has a negative (positive) effect on AEM (REM). Also, there is a significant difference between their effects in both directions of the relationship. Thereby, the proposed research question is answered: ‘’What are the relationships between Corporate Social Responsibility and Earnings Management?’’. Firms who are highly engaged in CSR care about all of their stakeholders and they are ethical, therefore they manipulate their accruals less. But they can also have increased agency issues and therefore they perform more real activity earnings management. From the other perspective, firms who engage in accrual-based earnings management are likely to have an overconfident CEO who wants to send out the right signals but does not feel the need to hide their actions behind CSR activities. Moreover, the managers that execute real activity earnings management might feel the need to not get detected and therefore they hide their manipulations behind CSR activities. These findings are both aligned and contradicting several theories depending on what direction of the relationship one is looking at. However, the legitimacy theory has been found to have a large impact in both directions of the relationship, all companies feel the urge to either be legitimate, or appear as it. This is a quantitative cross-sectional study including 5.026 observations from European companies. The authors are aligned with the positivist paradigm and the study takes a deductive approach. The statistically significant results from OLS regression with fixed effects are backed up and compared to theories and previous studies within the area.