The level of corporate social responsibility (CSR) exhibited by a firm is connected to the informational property of smoothed earnings as perceived by the market. The authors’ findings indicate that firms with high CSR see an improved market premium.
Managers use earnings smoothing measures to portray an improved risk profile by exhibiting a less volatile earnings trend. But prior studies have not shown any significant impact on firm valuation arising from income smoothness. The authors find that there is a positive relationship in the case of firms with high corporate social responsibility (CSR) because of the perception of more transparency and accountability in reporting. Also, firms with higher CSR have a greater stock price reaction to reported earnings and a stronger relationship between current returns and future earnings. This perception of earnings quality translates into better firm valuation.
How Is This Research Useful to Practitioners?
There has been a lot of prior research that studied whether income smoothing dilutes the information content of earnings announcements for assessing future performance of the firm. Earnings smoothing can be accomplished through accounting discretion, especially in the area of balance sheet accruals. This research specifically explores whether the level of corporate social responsibility can have an impact on the prevalence and informational property of smoothed earnings. Firms with higher levels of CSR are seen to have lower levels of earnings manipulation than other firms. There is an element of managerial compensation also associated with smoothed earnings that is not covered in the research and that provides an incentive to managers to engage in these activities. Investment professionals must realize that income smoothing may lead to underestimation of firm risk, resulting in higher firm valuation.
But the perception might be different for firms with high CSR. The authors’ findings indicate that the higher the CSR, the higher the perceived quality of information. Therefore, income smoothing for such companies indicates positive information impact and leads to better firm valuations. This research provides some guidance to investment professionals in estimating future earnings and conducting firm valuation while accounting for these qualitative factors. Otherwise, earnings smoothness will carry a negative connotation of management connivance to earn better compensation by downplaying cash flow volatility, which is negatively valued by investors because it increases the perception of risk associated with a firm’s earnings.
How Did the Authors Conduct This Research?
The authors collect data on 2,022 firms from 1993 to 2010. The financial statement information is taken from the Compustat database, data on stock returns and prices are from CRSP, and consensus earnings forecasts are from I/B/E/S. The firms are public with ordinary, single-class, common stocks.
The data for deriving social responsibility measures are from KLD Research and Analytics. Six social performance–related dimensions are considered, including corporate governance, community, diversity, employee relations, environment, and product.
The authors use long and short window value relevance tests as well as concurrent Tobin’s q tests. They use Tobin’s q as a proxy for firm value to test the impact of CSR and earnings smoothing on valuation to determine whether the information provided by smoothed earnings holds value for the investment community. The tests are performed from two angles: the earnings–return relationship, which is the association test between unexpected earnings and cumulative abnormal returns over the reporting and returns period, and market valuation tests. The future earnings response coefficient is also tested, which relates current year stock returns to future earnings.
Generally, earnings smoothness is viewed as earnings manipulation to portray the firm as less risky than it actually is because earnings volatility is an indication of a level of risk associated with the firm. In the case of socially responsible firms, a trust level is established whereby the quality of financial reporting is perceived to be superior and the expected deviation between reported earnings and actual earnings as well as future earnings is considered to be less. But overall earnings smoothness should indicate a level of caution and prompt investors to investigate whether they should anticipate an impact on performance during the investment horizon.