Firms Earnings Smoothing, Corporate Social Responsibilities, and - PDF document

Firms’ Earnings Smoothing, Corporate Social Responsibilities, and Valuation Lei Gao lgao@memphis.edu Fogelman College of Business and Economics The University of Memphis Memphis, TN 38152 Joseph H. Zhang jzhang5@memphis.edu Fogelman College of Business and Economics The University of Memphis Memphis, TN 38152 Preliminary Draft Comments are welcome. February 15 th , 2013

Firms’ Earnings Smoothing, Corporate Social Responsibilities, and Valuation ABSTRACT Income smoothing via accounting discretion could improve or garble actual earnings information. Although managers prefer a less volatile earnings path and perceive lower risk for income smoothness, prior studies show that there is no discernible relation between smoothness and firm valuation. Recent literature documents that socially responsible firms behave differently from other firms in their earnings management and financial reporting. We conjecture that the reported earnings of smoothers that are socially responsible deviate less from their permanent earnings, thus their reported earnings are more value relevant. Our empirical tests show income- smoothing firms with higher corporate social responsibility (CSR) experience higher contemporaneous earnings-return relationship, greater Tobin’s Q, and stronger current return- future earnings relationship. The results show that CSR is proved desirable as it adds a unique “quality dimension” to the smoothed earning and is useful for firm valuation. Key Words: Earnings Smoothness, Corporate Social Responsibility, Earning and Return Relations, Firm Valuation 2

Firms’ Earnings Smoothing, Corporate Social Responsibilities, and Valuation 1. Introduction E arnings smoothing is at the forefront of executives’ thinking. In the Graham, Harvey and Rajgopal (2005) ’s survey of CFOs, several argue that “…you have to start with the premise that every company manages earnings” and the survey notes that an “overwhelming 96.9% of the respondents indicate that they prefer a smooth earnings path” . Even though anecdotal evidence shows that business enterprises prevalently engage earnings smoothing and managers prefer smoothed earnings over time, the relationship between smoothed earnings and firm valuation remains questionable: On the one hand, smoothed earnings by managing reported earnings do not accurately represent economic earnings at every point of time (e.g., Goel and Thakor 2003; Jayaraman 2008). On the other hand, smoothing is associated with firm valuation because mangers ’ use of accounting discretion is to reveal more private information about firm’s future earnings and cash flows (e.g., Chaney and Lewis 1995; Tucker and Zarowin 2006). Recent studies have found that corporate socially responsible (CSR) firms behave differently from other firms in financial reporting and provide more value-relevant information. For instance, CSR disclosure improves analyst forecast accuracy (Dhaliwal, Radhakrishnan, Tsang, and Yang 2012); Firms that exhibit higher CSR score behave in a responsible manner to constrain earnings management, thereby delivering more transparent and reliable financial information to investors (Kim, Park, and Wier 2012); Firms with better CSR score exhibit cheaper equity financing (Ghoul, Guedhami, Kowk, and Mishra 2011), suggesting that firms with socially responsible practices have higher valuation and lower risk. Nevertheless, some argue that engagement in socially responsible activities, if costs exceed the benefits, would reduce the present value of a firm’s cash flows (e.g., McWilliams and Siegel 2000; Mackey, Mackey, and Barney 2007; Renneboog, Ter Horst, and Zhang 2008), even though it is difficult to 3

estimate costs and benefits when relying on information that is voluntarily disclosed by firms (Sprinkle and Maines 2010). Despite that corporate executives prefer less volatile earnings path, 1 income-smoothing firms are not associated with realized cost of capitals (McInnis 2010) or equity value (Rountree, Weston, and Allayannis 2008). A potential explanation of inconsistent market performance of smoothness is partially the reason that earnings smoothing is both informative and opportunistic. The lack of results in these two recent papers intrigues us to explore whether earnings smoothing is associated with value relevance when more quality information from different dimensions are otherwise available. Firms with higher social responsibility are more ethical in their reporting behaviors with less accounting manipulation, hence, we conjecture that smoothed earnings from high-CSR firms deviate less than real “ undistorted ” earnings thus their smoothed earnings are more value relevant and leads to higher firm valuation. Our estimates of earnings smoothness use smoothing via total accruals and smoothing via discretionary accruals. Both measures emphasize that smoothness represents earnings management when it is measured relative to inherent or fundamental smoothness of the firm’s operations. Operating cash flow smoothness is used to control for inherent smoothness. 2 We use information on corporate performance from Kinder, Lydenberg and Domini & Co. (hereafter as KLD), a social choice investment advisory firm), to assess social performance, along dimensions such as corporate governance, community, diversity, employee relations, environment, and 1 Smoothing could be due to managers’ personal incentives (e.g., their job security and compensations). Moreover, managers have incentives to smooth earnings to affect market perceptions of earnings volatility, and hence, the firm’s stock price s (e.g., Levitt 1988; Goel and Thakor 2003). 2 Empirical investigations are hampered by the difficulty associated with separating reported earnings into pre- smoothed earnings and the accrual component used to moderate reported earnings. While models of nondiscretionary accruals can be used to estimate earnings before those accruals, concerns have been raised that estimates of nondiscretionary accruals are associated with considerable measurement errors (e.g., Dechow et al. 1995; Thomas and Zhang 2000). Also, not all discretionary accruals are designed to smooth the reported earnings. 4

product. The KLD data has gained validity to become a widely accepted set of CSR measures, as it meets Carroll (1979) ’s proposed model that delineates a firm’s social obligations, including economic, legal, ethical, and discretionary responsibilities. 3 To test differential effects of earnings smoothing and CSR on firm valuation, we employ the following major tests: 1) using Tobin’s Q, we examine firm performance for firms with smoothness attribute and/or higher CSR. 2) We conduct the long-window value relevance test of earning smoothness from CSR firms, i.e., smoothness and CSR are two moderators in the earnings-return relationship tests. 3) We conduct the short-window earning response coefficients (ERC) test for market perception around earnings announcement. 4) We also employ the future earnings response coefficients-based regression method, the FERC model initiated by Collins et al. (1994) and used by Tucker and Zarowin (2006). Complementarily, we disaggregate CSR score to test different components of CSR for their individual effects on firm valuation when interacting with earnings smoothing. Using a sample of 2,022 firms and 10,755 firm-year observations over the period 1993- 2010, we find a negative correlation between CSR score and earnings smoothness, suggesting that CSR firms appear to reduce or avoid earnings manipulation through discretionary smoothing. In addition, we find a positive correlation between CSR score and Tobin’ s Q, implying that CSR firms appear to be higher firm performance as compared to non-CSR firms. Empirical results further indicate that CSR score significantly increase the value relevance of current earnings when investigated separately, and that smoothing alone moderately increases the value relevance of current earnings. In joint tests with smoothing, CSR score, and their interaction in the model, we find that smoothing is positive and significant when interacted with 3 The KLD database takes a comprehensive approach that examines six dimensions related to social performance, namely, community, diversity, employee relations, the environment, human rights, and product characteristics, as well as controversial business issues. 5