Introduction
According to the article of Ian Chipman (2016), “the overall health of capital markets depends, in large part, on the quality and transparency of financial reporting. Trustworthy information inspires investor confidence, which in turn leads to financial stability and efficiency”. In his article he mentions a few big scandals as a result of trust, which provided incentives for managers to cheat. Ian Chipman namely states that credibility will lead to manipulation from dishonest managers. One of the companies who was involved with a big scandal was “WorldCom”. WorldCom was an American telecommunication company who went bankrupt in 2002. Eventually, it was declared as one of the largest bankruptcy in U.S. history. WorldCom used fraudulent accounting methods to maintain the price of WorldCom’s stock. As Ian Chipman mentions in his article, credibility provides incentives for managers to cheat and WorldCom abused the market’s trust by manipulating their financial statements to obtain an unjust advantage. After research, the Securities and Exchange Commission estimated that the total assets of WorldCom had been inflated by about 11 billion. Therefore this scandal has been made one of the largest accounting frauds in U.S. history. Since the many scandals are based on the disclosure of false information, many professionals emphasize the importance of high quality financial reporting. High quality information is vital for a good communication between the corporation and the investing community (Jans et al, 2005). Since the critical role of financial disclosure, the International Federation of Accountants claims that it is imperative that efforts are made to examine ways to improve the quality of disclosure. Therefore I investigate the quality of disclosure, more specifically the effects of CSR-related executive compensation on the quality of disclosure. Since CSR is related to behave ethically and compensation is to create goal congruence, CSR-related compensation is more likely to improve the quality of disclosure (Holme and Watts, 1999; Bebchuk and Fried, 2003). This results in the following research question;
What are the effects of CSR-related executive compensation on the quality of disclosure?
Scientific contribution
This study contributes to the CSR, compensation and the earnings management literature. Many researchers studied the relationship between CSR and earnings management; whether “socially responsible firms behave differently from other firms in their financial reporting”. (Kim et al, 2012; Chih et al, 2008). According to the study of Kim, Park and Wier (2012), CSR firms behave in a responsible manner to constrain earnings management, thereby delivering more transparent and reliable financial information to investors as compared to firms that do not meet the same social criteria. They find that CSR firms are less likely to be associated with earnings management. Prior, Surroca and Tribo (2008) found evidence that executives with incentives to manage earnings will be very proactive in boosting their public exposure through CSR activities, particularly in firms with high visibility. Alternatively, firms with low levels of earnings management have fewer incentives to seek public exposure by promoting socially responsible activities. So, the relationship between CSR and earnings management is addressed by different angles. This study will complement the CSR as well as the earnings management literature by adding executive compensation; if CSR-related executive compensation is associated with earnings management. According to Bebchuk and Fried (2003), executive compensation can be seen as a (partial) remedy to the agency problem. Laux and Laux (2009) found evidence that accounting-based compensation schemes encourage the CEO to manipulate earnings, whereas Kim, Park and Wier (2012) found evidence that CSR constrains earnings management. Therefore this study contributes to the literature by combining CSR and compensation to study the effect on disclosure quality, which is measured by earnings management.
Theoretical framework
Quality of disclosure
Disclosure term, in the widest sense, is meant to provide information. In accounting, the term is used in a more limited way and is meant just presentation of financial information of the company in financial or annual reports (Khoram and Hassan, 2013). High quality information is vital for a good communication between the corporation and the investing community. Companies can communicate their information by means of disclosure (Jans et al, 2005). According to Arab and Mohammed (2007), investors and credit providers are considered the two fundamental user groups, as far as financial information is concerned, and to provide them with this information is one of the accounting missions. Providing high quality financial reporting information is important because it will positively influence investors and credit providers in making investment, credit, and similar resource allocation decisions enhancing overall market efficiency (IASB, 2008). Quality of disclosure can be defined in a variety of ways. Diamond and Verrecchia (1991) define disclosure quality in terms of the precision of an investor’s beliefs about security value after receiving the disclosure. King (1996) defines disclosure quality as the degree of self-interested bias in the disclosure. Sinqavi and Desai (2012) argue that quality of disclosure refers to the completeness, accuracy or precision, and reliability features. Quality disclosure performs two crucial functions: 1) informing and 2) influencing individuals to whom the information is addressed. The term “informing” underlies the effort of the issuer in transferring information about a specific fact so that receiver has access to it. The term “influencing” means the willingness to change values and behaviours of receivers (Antonella Pisano). Many researchers measure the quality of disclosure indirectly by focusing on attributes that are believed to influence quality of financial reports, such as earnings management, financial restatements, and timeliness (e.g. Barth et al., 2008; Schipper & Vincent, 2003). In this article we will focus on earnings management as a measure of disclosure quality. Lobo and Zhou found namely evidence that when managers engage more in earnings management, the information quality of the earnings is lower. Besides, constraint on earnings management leads to a perception of higher quality financial reporting and this enhances the credibility of the earnings forecasts. (Chen et al, 2015). According to Healy and Wahlen (1999), ‘‘Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting practices.’” In this article we address the question whether CSR-related compensation is associated with the quality of disclosure.
CSR-related executive compensation based on agency theory and stakeholder theory
According to Hill and Jones (1992), the agency theory can be defined as “one in which one or more persons engages another person to perform some service on their behalf which involves delegating some decision-making authority to the agent”. An important assumption of the agency theory is that the interest of principles and agents diverge. According to the agency theory, the principal can limit divergence from the interests by establishing appropriate incentives for the agent (Hill and Jones, 1992). Bebchuk and Fried (2003) states that executive compensation can be seen as a (partial) remedy to the agency problem. They are designed to provide managers with efficient incentives to maximize shareholder value and create goal congruence (Bebchuk and Fried, 2003). Consequently, it is more likely to state that CSR goals can be established by providing CSR-related compensation to managers. According to Friedman (1970), “CSR is to conduct the business in accordance with shareholders’ desires, which generally will be to make as much money as possible while conforming to the basic rules of society, both those embodied in law and those embodied in ethical custom.” Jones (1980) defined CSR as “the notion that corporations have an obligation to constituent groups in society other than stockholders and beyond that prescribed by law or union contract, indicating that a stake may go beyond mere ownership”. This implies not only to take into account their shareholders, but also their stakeholders. This is in line with the stakeholder theory, which outlines how a company can satisfy the interests of their shareholders as well as their stakeholders (Freeman, 1984).
Agency theory and stakeholder theory
According to the agency theory, the principal can limit divergence from the interests by establishing appropriate incentives for the agent (Hill and Jones, 1992), whereas the stakeholder theory outlines how a company can satisfy the interests of their shareholders as well as their stakeholders (Freeman, 1984). Based on these two theories, CSR-related compensation should constrain earnings management. Bebchuk and Fried (2003) namely explain that executive compensation is designed to provide managers with efficient incentives to maximize shareholder value and create goal congruence (Bebchuk and Fried, 2003). If this compensation is based on CSR targets, it is more likely to state that CSR goals can be established by providing CSR-related compensation to managers. Earnings management is a tool for managers to increase their earnings. Investors are namely more likely to make bad decisions based on misleading information. In line with the stakeholder theory, this is not in the best interest of their stakeholders. According to Chih, Shen and Kang (2008), financial transparency and accountability are both important for shareholders as well as for stakeholders; they are developing into principles of CSR that could reduce the abuse of information asymmetry. Prior, Surroca and Tribo (2008) explain that “earnings management practices damage the collective interests of stakeholders and hence, managers who manipulate earnings may deal with stakeholder activism and vigilance by resorting to CSR practices. Therefore CSR-related executive compensation is negatively associated with earnings management and hence, positively associated with the quality of disclosure. Since the quality of disclosure is measured by the level of earnings smoothing and the degree of earnings aggressiveness, the following hypothesis are given;
Hypothesis 1 (H1): CSR-related executive compensation is negatively related to the level of earnings smoothing.
Hypothesis 2 (H2): CSR-related executive compensation is negatively related to the degree of earnings aggressiveness.
Research design
In this article we use earnings smoothing and earnings aggressiveness to measure earnings management. According to Muammar et al (2014) “earnings smoothing is a measure of earnings under the condition smoothly reported all the time. If the accounting profit is artificially smooth, then the profit figures fail to represent the actual performance of the economy, thus lowering the information on earnings reports which led to earnings opacity”. In line with Bhattacharya et al. (2003) earnings smoothing is equal to one minus the contemporaneous correlation between the change in accounting accruals and the change in operating cash flow. Both are scaled by lagged total assets. Earnings aggressiveness is defined as the management actions that lead to the tendency of delaying the recognition of losses and accelerating the income, and subsequently impacting the quality of earnings (Altamuro et al., 2005). In line with Bhattacharya et al. (2003), earnings aggressiveness is equal to the accruals divided by lagged total assets. By employing quantitative research, data are collected based on the annual and remuneration reports of 100 listed Dutch firms. Since I investigate the effect of CSR-related executive compensation on the quality of disclosure, I attempt to estimate the relationship with a regression analysis using SPSS.