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2.1 Introduction

This chapter presents theoretical framework in relation to corporate social responsibility and financial performance. It further describes the relationship between corporate social responsibility and financial performance, prior empirical researches on corporate social responsibility and financial performance as well as the Sri Lankan context in relation to corporate social responsibility. This chapter helps to get a clear understanding of the theoretical background lies behind the research topic.


Corporate Social Responsibility

Corporate social responsibility is not as simple as it sounds. The world business council for sustainable development in its publication (2001) making good business sense by Lord Hlme and Richerd Wattes used the following definition, CSR is the continuing commitment by business to behave ethically and contribute to economic development while improving the quality of life of the workforce and their families as well as of the local community and society at large. The same report gave some evidence of different perceptions of what this should mean from a number of societies across the world. There is no universally accepted definition for CSR. Selected definitions by CSR organizations and actors include, "CSR is about how companies manage the business processes to produce an overall positive impact on society, Mallen Baker (2007)."CSR is a companys commitment to operating in an economically, socially and environmentally sustainable manner whilst balancing the interests of diverse stakeholders", CSR Asia (2007).

"Corporate social responsibility is the commitment of businesses to contribute to sustainable economic development by working with employees, their families, the local community and society at large to improve their lives in ways that are good for business and for development," International Finance Corporation (2008). The corporate social responsibility is a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis," The European Commission (2001). Definitions vary from being defined as CSR is about capacity building for sustainable livelihoods. It respects cultural differences and funds the business opportunities in building the skills of employees, the community and the government from Ghana, through to CSR is about business giving back to society from the Philippines. In the United States, CSR has been defined traditionally much more in terms of a philanthropic model. Companies make profits unhindered except by fulfilling their duty to pay taxes. Then they donate a certain share of the profits to charitable causes. It is seen as tainting the act for the company to receive any benefit from the giving. The European model is much more focussed on operating the core business in a socially responsible way, complimented by investment in communities for solid business case reasons. Therefore, corporate social responsibility (CSR) is a concept which encourages organizations to consider the interests of society by taking responsibility for the impact of the organization's activities on customers, employees, shareholders, communities and the environment in all aspects of its operations. This obligation is seen to extend beyond the statutory obligation to comply with legislation and sees organizations voluntarily taking further steps to improve the quality of life for employees and their families as well as for the local community and society at large.


Evolution of Social Responsibility

In the United States, the idea of corporate social responsibility appeared in the early part of the twentieth century, amid growing concerns about large corporations and their power. The ideas of charity and stewardship helped to shape the early thinking about CSR in the United States. Some of the wealthier business leaders became great philanthropists who gave much of their wealth to educational and charitable institutions and developed paternalistic programs to support the recreational and health needs of their employees. These business leaders believed that business had a responsibility to society that went beyond or worked in parallel with their efforts to make profits. The term CSR itself came in to common use in the early 1970s although it was seldom abbreviated. The term stakeholder, meaning those impacted by an organization's activities, was used to describe corporate owners beyond shareholders from around 1989. As a result of the early ideas about businesss expanded role in society, two broad principles emerged. They are charity principle and stewardship principle. These principles have shaped business thinking about social responsibility during the twentieth century. They are the historical foundation stones for the modern idea of corporate social responsibility.


The charity principle

The idea that the wealthier members of society should be charitable towards those less fortunate is a very ancient notion. Royalty through the age have been expected to provide for the poor. The same is true of those with vast holding of property, from the feudal times to present time. When wealthy business leaders endowed public libraries, supported settlement houses for poor, gave money to educational institutions, and contributed fund to many other community organizations, they were continuing this long tradition of being my brothers keeper.

This kind of private aid to the needy members of society was especially important in the early decades of this century. When wealthy industrialists reached out to help others in these ways. They were accepting some measures of responsibility for improving the conditions of life in their communities. In doing so, their actions helped counteract the critics who claimed that business leaders were uncaring and interested only in profits.


The stewardship principle

Many of todays corporate executives see themselves as stewards or trustees who act in the general publics interest. Although their companies are privately owned and they try to make profits for the stockholders, the company is managed and directed by professional managers who believe they have an obligation to see that everyone benefits from the companys actions. According to this view, corporate managers have placed in a position of public trust. They control vast resources whose use can affect people in fundamental ways. Because they exercise this kind of crucial influence, they incur a responsibility to use those resources in ways that are good not just for the stockholders alone but for society generally. In this way, they have becomes stewards or trustees for society. As such, they are expected to act with a special degree of social responsibility in making business decisions. 2.3.3 Modern forms of CSR

The two principles of the charity and the stewardship established the original meaning of corporate social responsibility. Corporate philanthropy is the modern expression of the charity principle. The stewardship principle is given meaning today when corporate managers recognise that business and society are intertwined and interdependent.


This mutuality of interests places a responsibility on business to exercise care and social concern in formulating policies and conducting business operations. The following table 2.1 shows how these two principles have coalesced to form the modern idea of corporate social responsibility. Table 2.1 Modern form of CSR Charity principle Stewardship principle Definition Business should give voluntary Business should act as a public aid to societys needy persons trustee and consider the interests of and group. Modern Expression Voluntary actions to promote good the social Corporate philanthropy all who are affected by business decisions and policies. Acknowledge business and society interdependence Balancing the interests and needs of many groups in society

Source: Adopted from W.C.Fredrick, J.E.Post, K.Davis, Business and Society, 7th Edition.


Responsibilities of a Business Firm

What are the responsibilities of a business firm and how of them must be fulfilled. Milton Friedman and Archie Carroll offer two contrasting views of the responsibilities of business firms to society.


Friedmans traditional view of business responsibility

A business person who acts responsibility by cutting the price of the firms product to prevent inflation or by making expenditures to reduce pollution, or by hiring the hard-core unemployed, according to Friedman, is spending the shareholders money for a general social interest. Even if the business person has shareholder permission or encouragement to do so, he or she still acting from motives other than economic and may harm the very society the firm is trying to help in the long run.


By taking on the burden of these social costs, the business becomes less efficienteither price goes up to pay for the increased costs or investment in new activities.These results negatively affect-perhaps fatally- the long-term efficiency of a business. Friedman thus referred to the social responsibility of business as a fundamentally subversive doctrine and stated that: There is one and only one social responsibility of business to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.


The Carroll model of social responsibility

Archie Carroll (1979) proposes that the managers of business organizations have four responsibilities. Carrolls pyramid of social responsibility model is outlined below.

Philanthropic Ethical Legal Economic

Source: Adopted from A.B Carroll, A Three Dimensional Conceptual Model of Corporate Performance, Academy of Management Review, October 1979.

1. Economic responsibility is fundamental to the firm, as the overriding need is to be profitable and to protect the longevity and success of the firm. However this does not preclude the firm from behaving in an ethical manner. Economic responsibilities of a business organizations management are to produce goods and services of value to society so that the firm can repay its creditors and shareholders.


Economic components, It is important to perform in a manner consistent with maximum earning per share. It is important to be committed to being as profitable as possible. It is important to maintain a strong competitive position. It is important to maintain a high level of operational efficiency. It is important that a successful firm be defined as one that is consistently profitable. 2. Legal responsibilities, the need is for the firm to be a law-abiding entity. Carroll argues, the law offers society a codification of a set of standards to which firms and individuals are bond. The firm should respect both the letter and sprit of the law. For example, in Sri Lanka the government has banned polythyine bags under 20 microns. Legal components, It is important to perform in a manner consistent with expectations of government and the law. It is important to comply with various national and supra-national laws and regulations. It is important to be law abiding corporate citizen. It is important that a successful firm be defined as one that fulfils its legal obligations. It is important to provide goods and services that at least meet the minimal legal requirement. 3. Ethical responsibilities of an organizations management are to follow the generally held beliefs about behaviour in a society. The onus on the firm behaves and acts in an ethical manner and to avoid harm in its actions.


Ethical components, It is important to perform in a manner that is consistent with the expectations of societal mores and ethical norms. It is important to recognize and respect new or evolving ethical, moral norms adopted by society. It is important to prevent ethical norms from being compromised in order to achieve corporate goals. It is important to recognise that corporate integrity and ethical behaviour go beyond mere compliance with laws and regulations. 4. Philanthropic responsibilities are the purely voluntary obligations a company assumes. The firm should behave as a good corporate citizen and make a contribution to the community in which it operates. Philanthropic components, It is important to perform in a manner consistent with the philanthropic and charitable expectations of society. It is important to assists the fine and performing arts. It is important to that manager and employees participate in voluntary and charitable activities within their local communities. It is important to provide assistance to educational institutions. It is important to assist voluntarily those projects that enhance a communitys quality of life. Carroll lists these four responsibilities in order of priority. A business firm first make a profit to satisfy its economic responsibilities. To continue in existence, the firm must follow the laws, thus fulfilling its legal responsibilities. According to Carroll, having satisfied the two responsibilities, the firm should look to fulfilling its social responsibilities. Therefore, Social responsibility includes both ethical and Philanthropic responsibilities, not economic and legal responsibilities.


A firm can fulfill its ethical responsibilities by taking actions that society tends to value but has not yet put into law. When ethical responsibilities are satisfied, a firm can focus on Philanthropic responsibilities-purely voluntary actions that society has not yet decided are important. Carroll suggests that business corporations fail to acknowledge philanthropic or ethical responsibilities, society, through government, will act, making them as legal responsibilities. Government may do this, moreover, without regard to an organisations economic responsibilities. As a result, the organization may have greater difficulty in earning a profit than it would have had if it had voluntarily assumed some ethical and philanthropic responsibilities. Both Friedman and Carroll argue their positions based on the impacts of socially responsible actions on a firms profits. Friedman says that socially responsible actions hurt a firms efficiency. Carroll proposes that a lack of social responsibility results in increased government regulations, which reduce a firms efficiency.


Corporate Social Responsibility and Stakeholders

CSR is essentially a concept, whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis. This means not only fulfilling legal expectations, but also going beyond compliance and investing in human capital, the environment and relations with stakeholders. Stakeholders are people who are affected by and/or are able to influence the behaviour of business organisations. The original stakeholders are the owners of the business. They have a financial stake in, and seek profit from, the organisation. Traditional capitalist ideology stresses that business are run in the interest of the owners. Today, most people accept that there are other groups of people with a stake in the business and whose interests should not be ignored. These non-proprietorial 15

stakeholders include employees who invest their time and efforts in a business. From the new perspective, the employees have a right to be considered when decisions are made. However, it does not stop there the term stakeholder extends to anyone who feels the impact of the organisation. For convenience, the distinguishen between internal stakeholders- who are directly involved with the firm and external stakeholderslocated outside the firm. A socially responsible firm will honour its responsibilities to its internal stakeholders, but will also accept the need to act responsibly towards external stakeholders. This means acting in a fair way towards customers, financiers and suppliers- promptly paying bills, making quality products, dealing in an honest way and being reliable. Socially responsible behaviour clearly requires obedience to the law and payment of taxes, but it also means operating in an ethical way, having concern for the environment and undertaking philanthropic activities on behalf of the disadvantaged and aid the cultural life of the community. The development of CSR reflects the growing expectations of the community and stakeholders about the evolving role of companies in society and the response of companies to growing environmental, social and economic pressures. Through voluntary commitment to CSR, companies are hoping to send a positive signal of their various stakeholders and in so doing make an investment in their future and help to increase profitability.


Driving forces for CSR

Many driving forces are fostering the evolution of corporate social responsibility such as: New concerns and expectations from citizens, consumers, public authorities and investors in the context of globalization and large scale industrial change.


Social criteria are increasingly influencing the investment decisions of individuals and institutions, both as consumers and investors. Increased concern about the damage caused by economic activity to the environment. Transparency of business activities brought about by the media and modern information and communication technologies.

CSR at present is mainly driven by large or multinational companies that rely extensively on their public reputation for continued viability. The systematic implementation of CSR involves the use of the following features: 1. Adoption of strong organizational values and norms justifying as to which behaviours are appropriate towards a variety of stakeholders. 2. Continuous generation of intelligence about stakeholder issues, along with positive response to the issues.


Core areas of CSR

There are six core areas in which corporate social objectives may found. They are, The environment- This covers pollution control, preventing or repairing damage to the environment resulting from processing of natural resources. Energy- This covers conservation of energy and increasing energy efficiency in business operations. Fair business practises- This concerns fairness in dealing with employees, suppliers and customers. Human resources- This means giving thought to the impact of organizational activities on human resource of the organisation. Community involvement- Business organisations are involved in community, education, art and health related projects. 17

Product-Socially responsible firms make products of quality in terms of user safety, serviceability and durability. These products provide customer satisfaction and honestly advertised. 2.5.3 Principles of CSR policies

A comprehensive social responsibility policy involves acceptance of five principles: As society accords privileges to business organisations, they owe society a debt that is discharged by adopting socially responsible policies; The basic rule for firms to do things with integrity, openness and honest cooperation; Activities are to the evaluated on social responsibility criteria along with other criteria; Social or external cost are to be seen as part of operating expenses; The firm needs to be prepared to use its resources for wider social purposes. 2.5.4 Arguments against CSR

Deciding to be socially responsible may conflict with shareholders interests in several ways: 1. Restrict the free market goal of profit maximization The primary task of business is to maximize its profits by concentrating on commercial activities. Social involvement reduces the economic efficiency of the business organizations. 2. Firm may incur additional costs. Example of these extra costs includes: Paying staff more than the minimum wage set by market forces or legislation to avoid accusations of exploitation; Treating emissions and waste to reduce environmental pollutions; Increasing product and plant safety levels; Costs of monitoring compliance with social responsibility policies.


3. May reduce revenues Examples include: Charging lower prices for products to avoid being accused of exploiting the consumer; Refusing to supply particular governments; Not promoting a socially undesirable good to particular consumer groups (e.g. cigarettes or alcohol to the young). 4. Shareholder funds may be diverted to socially worthwhile projects. This relates to charitable donations by firms to the arts, relief of social need or sponsorship of national projects. This money could otherwise be divided perhaps. 5. Management and staff time may be wasted on social projects. The management and staff are paid to run the business not to indulge in social engineering.


Arguments for CSR

There are counter argument to suggest that social responsibility in business will improve shareholder returns: Essential to being a sustainable enterprise. A sustainable enterprise is one whose competitive strategy does not fundamentally conflict with the long term needs and values of society. Put simply, a non sustainable enterprise is living on borrowed time and has no long-term future. It is in the interests of shareholders that firm become sustainable if earnings are to continue into future. Attracts socially conscious investors.


Ethical investment funds will be attracted to firms with a good social responsibility score. This will cause their shares to trade at a premium price. This represents a direct rise in shareholder wealth. Attract socially conscious consumers. The consumer will pay a premium price for products they regard as sound. Examples include ethical cosmetics, organic foods, recycled papers products, and fair trade coffee. Improve relations with government and other regulatory bodies. Many firms depend on the goodwill of government bodies for the granting of production licence, planning permissions or convivial legislation. A good record in social responsibility may help convince the decision maker to use discretion in the firms favour. Reuse stress on management and staff and permits improved morale. This argument points to the fact that feelings of ethics and social responsibility are not solely external to the firm. The management and staff of the firm are members of society too and have similar values. If business decisions force managers and staff to contradict their private ethics on a daily basis, the impact will be to reduce moral and increase staff turnover. This will harm financial performance. A socially responsible firm, on the other hand, may be able to attract these staff.


Financial Performance

The purpose of analysing financial performance of a business is to determine how successfully it has carried out operating activities for enhancing its profitability. For the long term survival, growth and development of a business, it must maintain its profitability at a satisfactory level. Therefore, financial performance is primarily important to internal management as well as to external parties who are interested in maintaining a continuing relationship with a successful entity. Similarly, potential


shareholders are keen to know about the profitability of a company before they make their investment decisions. Financial statements generally provide users with essential information that heavily influences their decisions. They are an excellent model for capturing and organizing financial information. They package information in a structured fashion that permits analysis of a wide range of trends and relationships among the data. Their trends and relationships, in turn, provide considerable insight into a companys opportunities and risks, including growth and market acceptance, costs, productivity profitability, liquidity and many others (AICPA, 1994). To analyse the financial performance of a business enterprise there are various techniques used. Ratio analysis is a powerful tool to analyse the financial performance. A ratio measures the relationship between two accounting variables mathematically. Ratio is used as a benchmark for evaluating the financial position and performance of the business firm. Because, a figure reported in the financial statement does not provide any meaningful understating of the performance of the financial position of a firm. Ratios provide a systematically analyzing for financial statement.


Classification of ratios

Ratios can be classified into different categories depends upon the basis of classification. 1. Based on the financial statements Profit and loss accounts ratios Ratios calculated on the basis of the items of the profit and loss accounts only. Examples are gross profit ratio, stock turnover ratio etc. Balance sheet ratios Ratios calculated on the basis of the figure of balance sheet only. Examples are current ratio, debt equity ratio etc. Composite / Inter statement ratios


Ratios based on figures of profit and loss account as well as the balance sheet. Examples are fixed assets turnover ratio, profitability ratio etc.

2. Based on the various users The financial statements are intended to summarize the operating performance and provide a wealth of information to various parties such as owners, managers, creditors, government agencies, employees, union officials, perspective investors and general public. However, each group have different interests and therefore, the type of information sought for by each of the above group will depend on their specific needs. Based on the various users the broadly speaking basic ratios are follows, Profitability ratios. One of the main objectives of a business is to make a profit. Profitability is an indication of the efficiency with which the operations of the business are carried on. Profitability ratios examine the relationships between profit and sales turn over, assets and capital employed. The ratios indicating the profitability of the business are gross profit, operating profit, net profit, return on capital employed and return on assets employed. Liquidity / Solvency ratio Profitability is of course an important aspect of a companys performance and debt or gearing is another. Solvency / liquidity ratio measure the financial stability of the business, the ability of the business to pay its way both on a short term and long term basis. The key solvency / liquidity ratio are working capital / current ratio, liquidity ratio (quick ratio, acid ratio), capital gearing etc. Asset utilization ratio


Asset utilization measures how effectively management controls the current aspects of the business principally stock, debtors and creditors. The key asset utilization ratios include stock turnover, debtors collection period, creditors collection period and asset turnover ratio.

Investment ratios These are the ratios, which help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shareholders of a company. Investment ratios are used by business people and investors who intend to buy either a whole business, or holding of shares in limited companies. The ratios will help to assess the performance of the company in which they wish to invest. The key ratios are earning per share, dividend yield, earning yield, price earning ratio and dividend cover / payout ratio. 2.6.2 Measuring the operating performance

Stockholders invest in the expectation that the firm will earn profits. Profits are also required to ensure the firms long term growth and staying power. A firms profitability can be measured in several differing but interrelated dimensions. First, there is the relationship of a firms profits to sales, that is, what is the residual return to the firm per sales rupees. The second type of measure, return in relation to investment quantified as return on total assets (ROA) or return on equity (ROE), relates profits to the investment required to generate them. As a group, these ratios allow the analyst to evaluate the firms earnings with respect to a certain level of assets, sales or the owners investment. In short, Profitability ratios are two types. Those showing profitability in relation to sales, and those showing profitability in relation to investment / capital employed. Together these ratios indicate the firm efficiency of operations. Profitability in relation to sales 23

One measure of a firms profitability is the relationship between the firms costs and its sales. It measures a firms ability to control its expenses in relation to its sales. The ratio tells us the profit of the relative to sales after the deduction of the cost of producing the goods sold.

Return on sales / gross profit The rate of return on sales (also called as profit margin ratio or net profit ratio) is another widely used ratio for measuring operating performance of a firm.This ratio is measuring the percentage of each rupee of sales that result in net profit. In the other word, it indicates the percentage of each sales rupee remaining after the firm has paid all expenses and taxes. The higher the rate of return on sales, the better, and the lower the relative cost of sales and other expenses including income taxes. It is expected to remain reasonably constant. Since the ratio consists of a small number of components, a change may be traced to a change in selling price, sales mix, purchase cost and production cost. This ratio is calculated by dividing net operating profit after interest and tax by sales. Net operating profit after interest and tax Return on Sales = Sales Profitability in relation to investments Return on Equity The rate of return on equity measure the return earned on the funds contributed by the companys ordinary shareholders. Since ordinary shareholders of a company are the owners who bear the greatest degree of risks with regard to the capital they have contributed. . ROE is viewed as one of the most important financial ratios to measure the ultimate profitability of their investment. 24

It measures a firm's efficiency at generating profits from every rupee of net assets (assets minus liabilities), and shows how well a company uses investment rupees to generate (assets minus liabilities), and shows how well a company uses investment rupees to generate earnings growth.The rate of return on ordinary shareholders equity is calculated using net profit less preference share dividend.

Although the ratio can be figured before income taxes, it is commonly calculated by using after tax profits as follows: Net operating profit after tax and preference dividend Return on Equity = Ordinary shareholders equity The preference share dividend is subtracted from net profit after income tax to yield the portion of profit available to the ordinary shareholders. Ordinary share holders equity is the total amount of ordinary share capital plus all reserves of the company. Return on Capital Employed The return on capital employed is the ratio which shows how efficiently a business is using its resources. ROCE can be calculated in a number of different ways. One version is the return on shareholders equity, which is more relevant for existing or perspective shareholders than management. Net operating profit before interest and tax Return on Capital Employed = Total capital employed Return on Asset The return on assets (ROA), which is popularly known as the return on investment. ROI is popularly one of the most useful measures of profitability and the operating 25

efficiency of the firm without regard to its financial structure. The return is defined as net income prior to the cost of financing and is computed by adding back the (after tax) interest cost. An indicator of how profitable a company is relative to its total assets.

ROA gives an idea as to how efficient management is at using its assets to generate earnings. This ratio is calculated by dividing a company's annual earnings by its total assets for the period. The formula used to calculate this ratio is as follows: Net operating profit before interest and tax Return on Asset = Total Assets ROA is displayed as a percentage. Some investors add back interest expense incurred on borrowed funds into net income when performing this calculation. Because they would like to reflect the fact that the efficient use of resources is not affected by the method of financing the acquisition of assets. Net profit before tax is used rather than the after tax figure, so that the firms profitability is not affected by taxation policies external to the firm. ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company's previous return on assets or the return on assets of a similar company. The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. When you really think about it, management's most important job is to make wise choices in allocating its


resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.



The relationship between ROA and ROE can be understood in terms of the firms relationship to its creditors and shareholders. The creditors and shareholders provide the capital needed by the firm to acquire the assets needed for the business. In return, they expect to be rewarded with their share in the firms profits. The ROA measure can be interpreted in two different ways. First, it is an indicator of managements operating efficiency; how well management is using the assets at its disposal to generate profits. Alternatively, it can be viewed as the total return accruing to the providers of capital, independent of the source of capital. The ROCE measure reflects return to the firms common shareholders and is calculated after deducting the paid to the creditors (interest) and other providers of equity capital (preferred shareholders).


The Relationship between CSR and Financial

Performance- Prior Empirical Research

Commentators have argued both for and against the view that corporate social responsibility is enlightened economic self-interest. Those who have theorized that a negative relation exists between social responsibility and economic performance have argued that a high investment in social responsibility results in additional costs. According to McGuire et al. (1988, p. 855) the added costs may result from actions such as making extensive charitable contributions, promoting community development plans, maintaining plants in economically depressed locations and


establishing environmental protection procedures. These costs might put a firm at an economic disadvantage compared to other less socially responsible firms. In contrast, others have argued the case for a positive association. McGuire et al. (1988) cite the argument that a firm perceived as high in social responsibility may face relatively fewer labour problems or perhaps customers may be more favourably disposed to its products. Alternatively, CSR activities might improve a firms reputation and relationship with bankers, investors and government officials. Improved relationships with them may well be translated to economic benefits. According to Spicer (1978a, b), Rosen et al. (1991), Graves and Waddock (1994) and Pava and Krausz (1996), a firms CSR behaviour seems to be a factor that in uences banks and other institutional investors investment decisions. Thus, a high CSR profile may improve a firms access to sources of capital. Modern corporate stakeholder theory (Cornell and Shapiro, 1987; Freeman, 1984; Jones, 1995; McGuire et al., 1988) can also explain part of the CSR, economic performance relationship. According to stakeholder theory the value of a firm is related to the cost of both explicit claims and implicit claims on a firms resources. Claimants include not only the legal owners of the firm but other constituencies such as lenders, employees, consumers, banks, government, etc. Stakeholders who have explicit claims on the corporation include besides its owners, lenders, employees, government, etc. In addition, there are others with whom the firm has made implicit contracts, which could include the quality of service and CSR. According to McGuire et al. (1988), if the firm does not honour these implicit contracts. Then it is argued that the parties to these contracts may attempt to transform them from implicit to explicit agreements. The latter may be more costly for the firms involved. According to Freeman (1984) and McGuire et al. (1988) the implications of the conversion of implicit to explicit contracts may have broader effects than the direct costs resulting from the forced change in its behaviour (e.g. cost of installment of gas emission control equipment). For example, socially irresponsible actions in one area (e.g. gas emissions) may spill-over and affect the corporate image in other areas as well (e.g. unregulated issues on labour relationships). This could in turn result in 28

other implicit stakeholders (e.g. trade unions) striving to make their claims explicit. Thus, firms with an image of high CSR may find that they face both fewer and lowercost explicit claims than those with a less enlightened stance.Thus, from a theoretical perspective, arguments can and have been made both for and against a positive relationship between social responsibility and concurrent or subsequent (to CSR) economic performance. Empirical research into the effects of corporate responsibility has produced mixed results. Some studies have suggested a positive relation, whereas others have concluded that the effects are negative or inconsequential. For example, Belkaoui (1976) investigated the information content of pollution control disclosures. His results suggested a positive relationship between economic performance and social responsibility, at least in this area. Other studies produced results consistent with the notion that corporate social responsibility activities impact on the financial markets (Anderson and Frankle, 1980; Shane and Spicer, 1983; Spicer, 1978a, b). However, certain studies have replicated earlier research and found conflicting results. Frankle and Anderson (1978) rejected Belkaouis (1976) interpretation and argued that non-disclosing firms had consistently performed better in the market. In a similar manner, Chen and Metcalf (1980) disagreed with Spicers (1978a, b) conclusions, arguing that his results were driven by spurious correlations. In response Spicer (1980) stated that Chen and Metcalf (1980) misinterpreted the purpose of his study, emphasizing that association not causal relationships were being investigated.

Ingram (1978) concluded that the information content of social responsibility disclosures was conditional on the market segment with which a firm is identified. Alexander and Bulcholz (1978) and Abbott and Monsen(1979) found no significant relationship between a corporations level of social responsibility activities and stock market performance. In addition, Chugh (1978), Trotman and Bradley (1981) and Mahapatra (1984) concluded that corporate social responsibility activities may lead to increased systematic risk.

Cochran and Wood (1984) used CSR rankings developed by Moskowitz (1972) to test 29

the relationship between corporate social responsibility activities and firms performance. After controlling for industry classification and corporate age, a weak positive association between corporate social responsibility activities and economic performance was found. Mills and Gardner (1984) concluded in their analysis of the relationship between social disclosure and economic performance, that companies are more likely to disclose social responsibility expenditures when their financial statements indicate favourable economic performance. One drawback of the above empirical studies is that they failed to distinguish between past, concurrent and subsequent to CSR economic performance, and thus to CSR economic performance, and thus to make possible reliable inferences about direction of causation. In most of the previous studies, economic performance covered a (commonly five year) period surrounding the CSR performance and/or social disclosure periods. Routinely, the CSR performance and/or social disclosure periods were the mid- points of that period. However, in Mahapatra (1984) and Mills and Gardiner (1984) studies, economic performance periods were concurrent to the CSR performance period concurrent to the CSR performance period economic performance subsequent to CSR disclosure period, finding a positive association. Thus, the empirical research into the relationship between corporate social responsibility and economic performance is confusing and far from conclusive. According to Ullmann (1985) this may be attributed to the use of varying and questionable measures of CSR, differences in the research methodologies and the financial performance measures used. According to Margolis and Walsh (2002), one hundred twenty-two published studies between 1971 and 2001 empirically examined the relationship between corporate social responsibility and financial performance.The first study was published by Narver in 1971. Empirical studies of the relationship between CSR and financial performance comprise essentially two types. The first uses the event study methodology to assess the short-run financial impact (abnormal returns) when firms engage in either socially responsible or irresponsible acts. The results of these studies have been mixed. Wright and Ferris (1997) discovered a negative relationship; Posnikoff (1997) reported a positive relationship, while Welch and Wazzan (1999) found no relationship between CSR and financial performance. Other studies, discussed in McWilliams and Siegel 30

(1997), are similarly inconsistent concerning the relationship between CSR and short run financial returns. The second type of study examines the relationship between some measure of corporate social performance (CSP) and measures of long term financial performance, by using accounting or financial measures of profitability. The studies that explore the relationship between social responsibility and accounting-based performance measures have also produced mixed results. Cochran and Wood (1984) located a positive correlation between social responsibility and accounting performance after controlling for the age of assets. Aupperle, Carroll, and Hatfield (1985) detected no significant relation between CSP and a firms risk adjusted return on assets. In contrast, Waddock and Graves (1997) found significant positive relationships between an index of CSP and performance measures, such as ROA in the following year. Studies using measures of return based on the stock market also indicate diverse results. Vance (1975) refutes previous research by Moskowitz by extending the time period for analysis from 6 months to 3 years, thereby producing results which contradict Moskowitz and which indicate a negative CSP/CFP relationship. However, Alexander and Buchholz (1978) improved on Vances analysis by evaluating stock market performance of an identical group of stocks on a risk adjusted basis, yielding an inconclusive result.


CSR Practice in Sri Lanka

Sri Lanka has a long history of corporate philanthropy, which has been led by individual conviction rather than formal public relations or social responsibility policies. Over the past few years, in keeping with global trends, such activities have been re-conceptualized as corporate social responsibility (CSR). CSR remains a diversely understood term, however, and it is unclear how most companies implement their CSR activities. Without statutory compliance, one cannot be certain that the CSR activities claimed by companies actually take place in a meaningful way, or to the extent reported. Likewise, the relative insignificance in Sri Lanka of socially responsible investment and ethical consumption in the mass market mean that there is 31

not much pressure on companies to adopt CSR policies, activities and monitoring mechanisms (International Alert, 2005). Many businesses and business organizations in Sri Lanka practice some form of social activity, usually through charitable giving to religious or educational institutions. This is a positive base for future work and demonstrates the willingness of business to support social needs. Most businesses in metropolitan area have a broad understanding of CSR and are involved in initiatives, but without having an overall policy. In an opinion survey carried out in 2004, directions of social initiatives of the business were identified among Sri Lankan business leaders. According to the survey, 32 percent of business leaders vote to the supporting developmental activities in poverty alleviation or social services. Further 22 percent identified providing employment or job training as their leading role of the society where as 17.7 percent voted for funding religious activities been their leading role. Study Conducted by International Alert (2005), have measured the level of CSR within the business community in Sri Lanka. They reviewed attitude towards CSR and their past, present and future practices in social and economic environment. They focused mainly on contribution of private sector to peace as part of their CSR process. The study indicates that most Sri Lankans do not have a clear understanding of the role they wish businesses to play in society. The public is unclear whether businesses should only focus on profits or also engage in social issues. While a slight majority feels that business should do more for the social good, they are mistrustful of companies ability to handle this task and express fears that the private sector exploits consumers and destroys cultural values. From the business point of view, most organizations feel they have a strong role to play in addressing social needs but, while there is a long history of charitable giving, most do not have a strategy or policy for doing so. Nor do they have a clear direction on how or what to contribute towards society, or the benefits of doing so. They


concluded that most organizations have only a limited understanding of the outputs of CSR. The study reveals that businesses view their CSR practices as genuine gestures of giving, though the public views them as self-interested and only designed to win publicity for commercial motives. They are of the view that a more cooperative approach is needed to strengthen CSR practices in Sri Lanka.



Corporate social responsibility means that a corporation should be held accountable for any of its actions that affect people, their communities, and their environment. It implies that the negative business impacts on people and society should be acknowledged and corrected if at all possible. It may require a company to forgo some profits if its social impacts are seriously harmful to some of the corporations stakeholders or if its funds can be used to promote a positive social good. However, being socially responsible does not mean that a company must abandon its primary economic mission. Nor does not mean that socially responsible firms cannot be as profitable as other less responsible. Social responsibility requires companies to balance the benefits to be gained against the costs of achieving those benefits. Many people believe that both business and society gain when business firms actively strive to be socially responsible. Others are doubtful, saying that businesss competitive strength is weakened by taking on social tasks.