Corporate

 Social  Responsibility,  Earnings  

Management,  and  Firm  Performance:  Evidence  
from  Panel  VAR  Estimation  
 

Mark  C.  Anderson  

Haskayne  School  of  Business  
University  of  Calgary  
mark.anderson@haskayne.ucalgary.ca  
 
Soonchul  Hyun  
Haskayne  School  of  Business  
University  of  Calgary  
soonchul.hyun@haskayne.ucalgary.ca  
 
Hussein  A.  Warsame  
Haskayne  School  of  Business  
University  of  Calgary  
hussein.warsame@haskayne.ucalgary.ca  
 
 
 
 
 

Electronic copy available at: http://ssrn.com/abstract=2379826

  

Corporate  Social  Responsibility,  Earnings  

Management,  and  Firm  Performance:  Evidence  
from  Panel  VAR  Estimation  
 

Abstract  

Corporate social responsibility (CSR), earnings management (EM) and firm performance
(FP) represent three important dimensions of corporate governance. Previous literature
investigates links between CSR, EM, and FP but has typically looked at pair-wise relations
(CSR-EM, CSR-FP, and EM-FP) for one-way effects without considering endogeneity among
the variables. We examine these relations recognizing endogeneity and possible two-way effects
and also consider how features of corporate governance (CG) and management compensation
(MC) influence interrelations between firms’ FP, EM and CSR. To examine the complex
relationships among these endogenous variables (CSR, EM, PF, CG, and MC) under different
eras in management oversight, we divide our complete sample period from 1992 to 2009 into a
pre-SOX (Sarbanes-Oxley) period (from 1992 to 2001) and a post-SOX period (from 2002 to
2009), and innovatively employ a rigorous panel vector autoregressive (PVAR) approach. We
find three main results: (1) CSR had a positive influence on EM in the pre-SOX period but CSR
had no impact on EM post-Sox, consistent with opportunistic use of CSR pre-SOX. (2) There is
no relation between CSR and FP pre-SOX, but there are bi-directional relations between them
during the post-SOX period: a positive influence of CSR on FP and a negative influence of FP
on CSR, suggesting more effective and less opportunistic use of CSR post-SOX. (3) FP
positively leads EM in both pre- and post-SOX periods, consistent with managers using EM to
meet expectations. We also observe interesting relations between CG and FP post-SOX and
between MC and EM pre-SOX that should be investigated further. Our application of PVAR to
this setting may engender new insights about relations between various aspects of corporate
governance.  

 
Electronic copy available at: http://ssrn.com/abstract=2379826
  

1.  Introduction  
Since Friedman (1970) first defined corporate social responsibility (CSR), researchers

have been interested in how CSR issues affect and are dealt with by managers. Firms want to

fulfill corporate social responsibility because this has become a publicized issue and there is a

common interest as to the need for it. Thus, firms may try to balance corporate growth and social

commitment in order to optimize their financial and social performance. Previous literature

suggests that the reasons for implementing CSR initiatives could be based on practical purposes

related to a firm’s performance as well as social pressure or ethical motivations.

Many researchers have investigated the relation between CSR and firm performance (FP),

but the results are as yet inconclusive. A positive relation between CSR and firm performance

has been shown to prevail in some studies (Margolis and Walsh, 2003; Orlitzky et al., 2003) but

results remain mixed (McWilliams and Siegel, 2000). In the accounting discipline, CSR is

considered in relation to earnings management (EM), often measured by discretionary accruals.

Previous literature shows inconsistent empirical evidence on the relationship between CSR and

earnings management. Kim, Park, and Wier (2012) examine whether firms that pursue high

standards of CSR behave in a responsible way to constrain earnings management, thereby

providing more transparent and reliable financial information along the lines of an ethical theory

of CSR. While Kim et al. (2012) find a negative relation between CSR and discretionary accruals,

other researchers show a positive relation between EM and CSR. In this context, a positive

relation is consistent with managers making opportunistic investments in CSR initiatives

(Petrovits, 2006; Prior, Surroca, and Tribo, 2008; Chih, Shen, and Kang, 2008). Due to the

mixed findings and implications from the literature, there is a need for further research to provide

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Electronic copy available at: http://ssrn.com/abstract=2379826

  

a comprehensive understanding of the relationship between CSR and managers’ financial

reporting behavior.

On another dimension, research on relations between EM and FP has been conducted.

While some critics and scholars insist that managers’ accruals choices are opportunistic,

resulting in low-quality reported earnings, others believe that managers exercise their discretion

to improve the informational value of accounting numbers (Watts and Zimmerman, 1986; Healy

and Palepu, 1993). Subramanyam (1996) finds that discretionary accruals are associated with

contemporaneous stock prices and future earnings and cash flows, and concludes that managers

choose accruals to enhance the informativeness of accounting earnings. From the opportunistic

earnings management perspective, Healy (1985) documents that CEOs manipulate earnings

downwards when their bonuses are at their maximum because net income exceeds the bonus

ceiling.

We investigate the empirical associations among CSR, EM, and FP jointly because

previous literature has looked at pair-wise relations (CSR-EM, CSR-FP, and EM-FP) separately.

Our model accommodates interactions among these three factors and two other endogenous

factors, corporate governance (CG) and management compensation (MC), that may influence

firms’ FP, EM and CSR. Previous empirical studies document that CG and MC influence

managers’ propensity to engage in firms’ earnings management and on CSR. Thus, it is

important to consider the influence of these relationships jointly. No previous study that we are

aware of has taken into account endogenous relationships between these five considered factors.

The Sarbanes-Oxley Act (SOX) of 2002 is the most important legislative change

influencing corporate financial reporting enacted in the United Sates since the 1930s. (Li, Pincus,

and Rego, 2008). SOX forced firms to enhance the accuracy and reliability of financial reporting

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by strengthening corporate accountability and professional responsibility, which led to higher

quality earnings (DeFond and Francis, 2005). Cohen, Dey, and Lys (2008) found that the period

before the passage of SOX was characterized by an increasing trend in accrual-based earnings

management and that the passage of SOX brought about a decline in earnings management. In

addition, Lobo and Zhou (2006) examine the change in managerial discretion over reporting

financial information following SOX and find that firms reported lower discretionary accruals

after SOX than in the period prior to SOX. Since managers’ earnings management activities as

well as corporate governance have changed between pre- and post-SOX periods, the interactions

among the considered factors may also have changed between pre- and post-SOX periods. For

this reason, it is important to separately consider these different periods when estimating the

empirical model.

Thus, the research purpose of this study is to examine the relations between FP, CSR and

EM while taking into consideration CG and MC in the contexts of pre- and post-SOX periods.

To execute this study, we innovatively employ rigorous panel vector auto regression (PVAR)

procedures. The panel vector autoregressive (PVAR) method is used to capture the dynamic

interactions between pairs of considered variables while acknowledging the probable existence

of endogeneity using panel data. PVAR allows all of the key variables (CSR, EM, CG, MC, and

FP) to be jointly endogenous and enables us to investigate causal directions between all pairs of

the considered variables. This estimation procedure enables observation of the dynamic

relationships between all the variables due to lagged effects within and across time series.

The remainder of the study is organized as follows. Section 2 discusses the related

previous studies and hypothesis development. Section 3 provides the empirical methodology.

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Section 4 describes data, sample selection, and the measurement of variables. The empirical

results are presented and discussed in Section 5. Finally, Section 6 concludes.

2.  Literature  Review  and  Hypothesis  Development  

2.1  The  Implementation  of  Sarbanes-­‐Oxley  Act  

Following the accounting scandals at Enron, WorldCom, and Xerox, the issue of

reporting more reliable and transparent financial information become crucial, leading to the

passage of the Sarbanes-Oxley Act (SOX) in July of 2002. SOX was enacted to improve

corporate governance and increase the public’s trust and confidence in firms’ financial

information by prohibiting auditors from conducting non-audit services, increasing the

responsibility of management for accounting fraud and for the assessment of their firms’ internal

controls (Section 404), and requiring companies to disclose their financial information in more

detailed and timely fashions.

Complying with SOX has proven costly to companies and many executives believe the

costs outweigh the benefits (Protiviti 2012). Because SOX exposes CEOs to greater litigation

risks and penalties for accounting fraud, CEOs might avoid taking value-increasing risky actions.

Wallison (2003) argues that the change in managers’ strategic decisions about investment may

negatively affect firm values and economic growth. Since the economy in the United States has

been in a long-term slump since 2001, it is possible that CEOs’ effort spent on enhancing

corporate governance and improving accounting transparency via SOX, rather than on future

investment plans, could deliver bad news to investors.

After the passage of SOX, researchers examined how the changes in managers’ financial

reporting behaviors and corporate governance due to SOX affected earnings management, firm

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performance, and executive compensation. Zhang (2007) examined the market reaction to the

legislative event and found that there were negative abnormal stock returns around the event.

Cohen, Dey, and Lys (2008) found that the period before the passage of SOX was characterized

by an increase over time in accrual-based earnings management and that the passage of SOX

brought about a decline in earnings management after controlling for equity-based compensation

(because earnings management is likely to be linked with equity-based incentives).

We conjecture that if managers’ earnings management activities and corporate

governance changed between the pre- and post-SOX periods, the interactions among the

considered factors might have changed between the pre- and post-SOX periods. Therefore, we

divide the complete sample period from 1992 to 2009 into a pre-SOX period (from 1992 to 2001)

and a post-SOX period (from 2002 to 2009) and analyze relations between the variables for the

two periods. We also note that it is not possible to predict the causal and bi-directional relations1

among the considered variables based on previous literature because the literature has not

addressed the endogeneity and two-way relations that can be assessed through the PVAR

approach applied in this study.

2.2  CSR  and  Earnings  Management  

Many researchers have been interested in CSR topics, and have conducted studies on

various aspects of it in a number of disciplines. According to the definition of CSR proposed by

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.” McWilliams and
                                                                                                                       
1
 For example, Brown and Caylar (2006) describe: “we identify a link between Tobin’s Q and various firm-specific
corporate governance measures, but we have been silent on the questions of whether better governance enhances
firm valuation or whether more highly valued firms opt for better governance”.  

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Siegel (2001) define CSR as actions that appear to further some social good beyond the firm’s

interests and practices that are required by law. Based on agency theory (Jensen and Meckling,

1976), McWilliams and Siegel (2006) suggest a managerial opportunism perspective of CSR in

which managers engage in CSR initiatives to develop their careers or other personal interests,

and Hemingway and Maclagan (2004) suggest that companies invest in CSR activities to cover

up some corporate misconduct. Neu, Warsame, and Pedwell (1998) suggest that organizations’

disclosure of environmental information in annual reports and other environmental disclosures

provide them with an effective method of managing public impressions.

Recent accounting literature has addressed the question of whether corporate social

responsibility (CSR) is associated with earnings management. Prior, Surroca, and Tribo (2008)

argue 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. Chih, Shen, and Kang (2008) examined whether CSR-related features

of firms had a positive or negative relation to the quality of financial information during the

1993–2002 period. They found that when firms had a greater commitment to CSR, the extent of

earnings smoothing was lower, avoidance of earnings losses and decreases was less evident, but

the extent of earnings aggressiveness was greater. Based on the ethical theory of CSR, Kim, Park,

and Wier (2012) investigate whether 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.

Based on the contrasting opinions and perspectives on the relation between CSR and

earnings management as measured by discretionary accruals, we infer that both CSR and EM

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have opportunistic elements as well as ethical or informative elements. This mixture of

opportunistic and ethical CSR and opportunistic and informative EM makes it necessary to

consider alternative hypotheses about the relations between CSR and EM. We describe four

possibilities below.

Opportunistic CSR and opportunistic EM: This combination leads to the opportunistic

hypothesis (Prior, Surroca and Tribo, 2008) with a prediction that CSR and EM would be

positively related.

Ethical CSR and opportunistic EM: This combination leads to the ethical hypothesis

(Kim, Park and Wier, 2012) with a prediction that CSR and EM would be negatively related. The

notion here is that ethical CSR provides a signal about management type (ethical versus

opportunistic) and that ethical managers would engage in less earnings management.

Opportunistic CSR and informative EM: This combination has not been considered

directly in previous literature because the emphasis has been on opportunistic EM. It is unlikely

that opportunistic CSR would lead to informative EM or that informative EM would lead to

opportunistic CSR.

Ethical CSR and informative EM: This combination has also not been considered in

previous literature. Informative EM is not necessarily associated with ethical behavior by

managers because EM reflects a desire to communicate information about the value of the firm

and is not directly tied to managerial character. However, it is plausible that informative EM is

more credible when managers have a reputation for higher ethical standards, suggesting the

possibility of a positive association between ethical CSR and informative EM. We make the

following hypothesis, consistent with opportunistic CSR and opportunistic EM and possibly with

ethical CSR and informative EM.

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H1: CSR and EM are positively related.

The pre-SOX period was characterized by managerial opportunism. According to former

SEC head Arthur Levitt (1998), managers’ widespread use of earnings management techniques

to meet analysts’ earnings expectations had caused growing concerns about erosion in earnings’

quality. DeGeorge, Patel, and Zeckhauser (1999)   introduced behavioral thresholds for earnings

management and found that earnings were managed to exceed each of three thresholds: report

positive profit, sustain recent performance, and meet analysts’ expectations. Petrovits (2006)

examined firms’ corporate philanthropy programs from 1989 to 2000 and found that firms

reporting small earnings increases tended to make income-increasing discretionary charitable

foundation-funding choices. In addition, Barnard (1997) presented evidence that managers made

contributions of corporate resources to attain a higher social status, to obtain board committees’

favor by contributing to their favorite causes or to promote their own ideological preferences.

Other researchers suggested that managers and board members exert considerable influence over

corporate giving (Boatsman and Gupta, 1996; and Brown, Helland, and Smith, 2006)

Cohen, Dey, and Lys (2005) found that managers’ opportunistic behavior, which was

related to the fraction of compensation derived from options, was significantly associated with

earnings management in the pre-SOX period. According to Cohen, Dey, and Lys (2008),

accrual-based earnings management declined significantly after SOX, consistent with less

opportunistic earnings management. Therefore, discretionary accruals after SOX are likely to on

average be less opportunistic and more informative. In addition, there has been greater scrutiny

of CSR activities by investors and boards of directors post-SOX meaning that CSR activities

may have become more purposeful and disciplined after SOX. Thus, based on the high

propensity of managers to engage in opportunistic behavior during the pre-SOX period, we

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observe that a positive relation between CSR and EM in the pre-SOX period is more likely to be

associated with managerial opportunism than a positive relation between CSR and EM in the

post-SOX period. We do not have a strong basis for making directional predictions about

whether CSR leads EM or EM leads CSR.

2.3  CSR  and  Firm  Performance  

Many studies have investigated the relationship between CSR and firm performance, but

the results are mixed (Margolis and Walsh, 2003; Vogel, 2005). CSR activities may be positively

associated with firm performance because CSR contributes to firm reputation and innovation (i.e.,

R&D expenditures for products and services innovation linked to social issues), which increases

long-term firm value (Orlitzky, Schmidt, and Rynes, 2003; Maignan, Ferrell, and Ferrell, 2005;

Mackey, Mackey, and Barney, 2007; Husted and Allen, 2007).

Wright and Ferris (1997) claim that noneconomic pressures may influence managerial

strategies rather than value-enhancement goals and find significant negative excess rate of

returns around the announcement of the divestments of South African operations. But Teoh,

Welch, and Wazzan (1999) found no relationship between CSR and financial performance when

examining divestitures from South Africa. CSR might be considered an important

communication strategy aimed at enhancing firm reputation and public image. Ihlen, Barrlett and

May (2011) expressed concern that the public has become cynical about corporate

‘greenwashing’ exercises that were “window dressing to divert attention from poor corporate

behaviors.”

McWillams and Siegel (2000) state that “Researchers have reported a positive, negative,

and neutral impact of CSR on financial performance. This inconsistency may be due to flawed

empirical analysis because it does not control for investment in R&D. When the model is
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properly specified, we find that CSR has a neutral impact on financial performance”. In addition,

Elsayed and Paton (2004) argue that the reason that previous studies have shown mixed results is

that many of these papers suffer from model misspecification and/or limited data without

controlling for firm heterogeneity and dynamic effects. They investigate the influence of

environmental performance on firms’ financial performance using dynamic panel data analysis

and find environmental performance has a neutral impact on firm performance based on the

theoretical concept that firms invest in environmental initiatives until the marginal cost of

environmental initiatives equals the marginal benefit.

Thus, previous studies have not developed a consensus with regard to the relationship

between CSR and firm performance. Tuwaijri, Christensen, and Hughes (2004) assert that the

prior literature’s mixed results about relations between environmental disclosure, environmental

performance, and firm performance may be attributable to the fact that they were not treated as

endogenous variables. They examine interrelations among these variables using a simultaneous

equations approach. However, no studies have jointly examined the direct influence of CSR on

FP and the reverse relation of FP on CSR. Therefore, there is a need for further research to

examine the relations between CSR and firm performance. We make the following observations.

Opportunistic CSR and FP: Opportunistic CSR would not lead to higher firm

performance and it is unlikely that higher firm performance would lead to opportunistic CSR.

Ethical CSR and FP: It is plausible that ethical CSR would lead to higher firm

performance if such CSR reduces long-term exposure to risks such as environmental risk,

encourages innovative investment, or enhances stakeholder satisfaction in ways that improve

productivity or investment value. It is unclear how higher firm performance would influence

ethical CSR. On the one hand, managers of high-performing firms would have more resources

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to invest in CSR. On the other hand, managers of high-performing firms who are economically

motivated may avoid discretionary investments in CSR that were not value-adding.

We make the following hypothesis to test for positive relations between CSR and firm

performance.

H2: CSR is positively related to firm performance.

Together with the passage of SOX in 2002, the social atmosphere increasingly places

emphasis on the trust, transparency, and social responsibility of firms. CSR has also moved from

ideology to reality, and many consider it necessary for organizations to define their roles in

society and apply social and ethical standards to their businesses (Lichtenstein, Drumwright, and

Braig, 2004). Companies increasingly employ CSR activities to position their corporate brands in

the eyes of consumers and other stakeholders by voluntarily disclosing their CSR activities using

annual reports (Sweeney and Coughlan 2008) and websites (Maignan and Ralston 2002;

Wanderley, Lucian, and Farache 2008).

The activities associated with CSR investments and the amounts of CSR spending have

increased compared to the early stages of CSR, and companies’ voluntary reporting of CSR

activities has also increased. Clarkson, Li, Richardson, and Vasvari (2008) investigate the

relationship between environmental performance and the level of voluntary environmental

disclosure by testing competing predictions from economics-based and socio-political theories of

voluntary disclosure. They find a positive association between environmental performance and

voluntary environmental disclosure. Therefore, CSR initiatives can provide an opportunity for

investors to regard high CSR firms as having a relative competitive advantage over competing

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firms. Porter and Kramer (Harvard Business Review, 2006)2 observed that “corporations would

discover that CSR can be much more than a cost, a constraint, or a charitable deed—it can be a

source of opportunity, innovation, and competitive advantage.” Thus, we expect that after SOX,

the likelihood or intensity of a positive influence of CSR on firm performance would be greater

than that of CSR before SOX.  

2.4  Earnings  Management  and  Firm  Performance  

There has been a debate over whether discretionary accounting accruals enhance or take

away from the information provided by earnings. While some critics and scholars insist that

managers’ accruals choices are opportunistic, resulting in low-transparency earnings, others

believe that managers exercise their discretion to improve the informational value of accounting

numbers (Watts and Zimmerman, 1986; Healy and Palepu, 1993). Subramanyam (1996)

investigates whether the stock market prices discretionary accruals and finds that discretionary

accruals have incremental information content and improve earnings’ ability to explain returns.

He concludes that managers choose accruals to enhance the informativeness of accounting

earnings.

Following the opportunistic earnings management perspective, Healy (1985) finds

evidence that CEOs manipulate earnings downwards when their bonuses are at their maximum

due to a bonus ceiling. Dechow and Sloan (1991) find that executives are likely to decrease

expenditures on R&D in their final employment years to increase earnings. In our analysis, EM

is measured as the absolute value of discretionary accruals as opposed to a directional measure

and should therefore be interpreted as a measure of the extent to which earnings are managed in

                                                                                                                       
2
http://hbr.org/2006/12/strategy-and-society-the-link-between-competitive-advantage-and-corporate-social-
responsibility/ar/1

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a period. Opportunistic EM does not convey information about the value of the firm so it would

not be positively associated with firm value.

Opportunistic EM and FP: If earnings management were primarily opportunistic, there

would not, on average, be a positive relationship between discretionary accruals and a firm’s

performance value.

We measure FP using Tobin’s Q which provides information about the market value of

the firm’s assets relative to their book value. Tobin’s Q may be interpreted as a measure of

unrecognized intangible asset value or expected future abnormal earnings (Ohlson (1995) and

Feltham and Ohlson (1995) expressed a firm's market value as book value plus the present value

of expected abnormal earnings). Thus, a positive relation between EM and Tobin’s Q would

indicate the use of discretionary accruals to signal long-term firm value. Jiraporn, Miller, Yoon,

and Kim (2008) find a positive relationship between earnings management and firm value

measured by Tobin’s Q.

Informative EM and FP: EM would, on average, be positively related to FP if earnings

management were primarily informative.

We specify the following hypothesis to test for the presence of informative EM.

H3: Firm performance is positively related to the use of earnings management.

Cohen, Dey, and Lys (2005) found that EM was positively related to the fraction of

compensation derived from options in the pre-SOX period, consistent with opportunistic EM.

Cohen, Dey, and Lys (2008) found that accrual-based earnings management declined

significantly after SOX, consistent with less opportunistic earnings management in the post-SOX

era. If informative EM increased relative to opportunistic EM increased after SOX, the

likelihood or intensity of a positive relation between EM and FP would also be stronger after

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SOX. However, Cohen, Dey, and Lys (2005) present evidence that the informativeness of

earnings increased steadily over time, but found that there was no significant change in earnings

informativeness following the passage of SOX.

Hand (1989) observes that managers may smooth earnings to meet expectations within

the market and even to increase the persistence of earnings. That is, last year’s market value

(market expectation) may affect current earnings management if managers want to meet the

expectations. In this case, FP would be positively related to EM and FP would lead EM.

2.5  The  Other  Two  Endogenous  Factors  (MC  and  CG)  

Prior studies on the relationship between management compensation and earnings

management (i.e., Bergstresser and Philippon, 2005; Burns and Kedia, 2003; Cheng and

Warfield, 2005) show that managers who have equity incentives are more likely to manipulate

reported earnings [the relation between EM and MC]. Also, Kane (2002) determines that longer-

term compensation based on market valuation tends to motivate executives’ considerations of

CSR [the relation between MC and CSR]. Deckop, Merriman, and Gupta (2006) investigate

whether CEO pay is properly structured to provide incentives to CEOs to improve firm CSP

(corporate social performance). They find that a short-term CEO pay focus was negatively

related to CSR, whereas a long-term focus was positively related to CSR [the relation between

MC and CSR].

Many researchers (Peasnell, Pope, and Young, 1999; Klein, 2002; Beasley, 1996)

investigate the relationship between corporate governance and earnings management. Based on

various proxies (audit committees and board characteristics, such as independence) of good

corporate governance, their findings indicate that the better the proxy, the smaller the connection

between the proxy and earnings management [the relation between CG and EM]. On the other
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hand, Ho (2005) provides evidence that higher commitments to CSR are strongly and positively

related to the qualifications and terms of directors, boards’ exercise of strong stewardship and

strategic leadership roles, and the management of capital market pressures and that these various

attributes combined constitute the hallmarks of good CG [the relation between CG and CSR].

As highlighted in the above-mentioned literature, the three factors of interest (CSR, EM

and FP) are interrelated and also related to CG and MC, but previous studies have not considered

the endogeneity problem and causality issues when investigating the relationships between

subsets of these factors.

3.  Methodology  
We employ a panel vector autoregressive (PVAR) approach to examine the dynamic

relationships between CSR, EM, FP, CG and MC. The PVAR method incorporates a traditional

vector autoregressive (VAR) approach with panel data. The VAR method is quite flexible and

powerful, accounting for many biases such as endogeneity, omitted variables, and reversed

causality (Luo, 2009). Because previous literature  shows that CSR, EM and FP are interrelated,

and two other factors, CG and MC, influence management’s propensity to engage in EM or CSR,

and influence FP, it is important to examine the interactions between the five variables jointly as

endogenous variables.

There are several advantages of VAR compared to the traditional multiple regression

model. VAR can estimate both the direct effect and reversed effect between all pairs of

considered variables. For instance, it can estimate the effect of historical CSR initiatives on firm

performance, which is the direct effect. It can also estimate the dynamic feedback effect from

historical firm performance on CSR, which is the reversed effect. Thus, we can examine the bi-

directional relations between CSR and firm performance. As another example, we may want to
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know whether better governance enhances firm valuation or whether more highly valued firms

opt for better governance (Brown and Caylar, 2006). A second advantage of VAR is that it

captures within-effects (e.g., past CSR’s influence on its own), as well as cross-effects (e.g.,

influence of historical management compensation on earnings management). These advantages

mean that VAR can be used to assess the dynamic interrelations between the endogenous

variables (Luo, 2009): CSR, EM, FP, CG, and MC. Thus, the VAR method is used to capture the

dynamic interactions between the pairs of considered variables, while acknowledging the

probable existence of endogeneity.

The PVAR method has the advantages of VAR with a panel data approach. The use of

PVAR in this study allows for unobserved individual heterogeneity as well as time-fixed effects,

while treating all variables as endogenous (Love and Zicchino, 2006). Use of the PVAR

approach in the accounting literature is nascent while a few papers in finance, marketing, and

management information systems have employed this approach (e.g. Dekimpe and Hanssens,

1995; Stanca and Gallegati, 1999; Love and Zicchino, 2006; Villanueva, Yoo, and Hanssens,

2008; Trusov, Bucklin, and Pauwels, 2009; Dewan and Ramaprasad, 2013)

The following illustrates a first-order panel VAR model:

𝐶𝑆𝑅!" 𝛾!" γ11      γ12    γ13      γ14      γ15 𝐶𝑆𝑅!"!! 𝑓! 𝑑! 𝜀!"!"#

𝐸𝑀!" 𝛾!" γ21      γ22      γ23      γ24      γ25 𝐸𝑀!"!! 𝑓! 𝑑! 𝜀!"!"
                              𝐹𝑃!" = 𝛾!" + γ31      γ32      γ33      γ34      γ35   𝐹𝑃!"!! + 𝑓! + 𝑑! + 𝜀!"!" (1)
𝐶𝐺!" 𝛾!" γ41      γ42      γ43      γ44      γ45 𝐶𝐺!"!! 𝑓! 𝑑! 𝜀!"!"
𝑀𝐶!" 𝛾!" γ51      γ52      γ53      γ54      γ55 𝑀𝐶!"!! 𝑓! 𝑑! 𝜀!"!"

fi – Individual fixed effects

dt – Time fixed effects

where CSRit represents corporate social responsibility for firm i at year t, EMit is earnings

management for firm i at year t, FPit is firm performance for firm i at year t, CGit is corporate

16  
 
  

governance for firm i at year t, and MCit is management compensation for firm i at year t. CSRit-1,

EMit-1, FPit-1, CGit-1, and MCit-1 are one year lags and ɛits are residuals. γ!" , 𝛾!" , 𝛾!" ,  and  𝑟!"

represent direct effects of CSR on EM, FP, CG, and MC, respectively. γ!" , 𝛾!" , 𝛾!" ,  and  𝑟!" are

the reversed effects from EM, FP, CG, and MC on CSR, respectively. The within-effects are

γ!! , 𝛾!! , 𝛾!! , 𝛾!! ,  and  𝑟!! and the cross-effects between EM, FP, CG, and MC are the remaining

gamma coefficients (i.e., γ!" , 𝛾!" , 𝛾!" , 𝛾!" ,  and  so on).

In using the PVAR procedure, we allow for individual fixed effects (fi) and time-fixed

effects (dt). According to Love and Zicchino (2006), each variable in the VAR is time demeaned.

Since the individual fixed effects (fi) are correlated with the lagged independent variables, we

also use forward mean differencing, referred to as the “Helmert procedure.” This transformation

preserves the orthogonality between the transformed variables and lagged independent variables.

We can therefore apply the lagged regressors as instruments and estimate the coefficients using

the system GMM (Generalized method of moments) by Arellano and Bover (1995). The time-

fixed effects (dt) are eliminated through “time-demeaning” of the variables in the system through

subtraction of individual variables from the individual mean in every year; and calculation of the

mean in panels by the identified time frame and consequent subtraction of the mean from the

series. Individual fixed effects (fi) are removed through use of the Helmert transformation that

eliminates the forward mean3 from each individual year.

                                                                                                                       
3
 Forward mean-differencing is referred to as the ‘Helmert procedure’ (see Arellano and Bover, 1995). This
procedure removes only the forward mean, i.e. the mean of all the future observations available for each firm-year.
(Love and Zicchino, 2006).  

17  
 
  

4.  Data,  Sample  selection  and  Measurement  

4.1  Data  and  Sample  selection

We collected yearly firm-level data (1992-2009) to estimate discretionary accruals and

Tobins’ Q from the COMPUSTAT database, on CEO compensation from the ExecuComp

database, and on CSR ratings from ESG STATS4 by MSCI ESG. The latter provides corporate

social responsibility ratings for publicly listed companies in the United States.

We merge the KLD, Compustat, and Execucomp data as follows. KLD STATS includes

19 years of historical data (1991-2009); the Execucomp database began in 1992. Thus, we set

our research period at 1992-2009. We merge estimated discretionary accruals as a proxy for EM

and Tobin’s Q as our measure of FP (based on Compustat data) with CSR ratings (from KLD

STATS) to obtain 22,488 firm-year observations. This data is then merged with CEO

compensation data (from Execucomp) to obtain 15,334 firm-year observations. We exclude

1,018 financial institutions (SIC codes between 6000 and 6999) and 1,640 utilities (SIC codes

between 4400 and 5000) because managers in these regulated industries have different incentives

to manage earnings (Cheng and Warfield, 2005; Burgstahler and Eames, 2003). Thus, our final

sample consists of 1,813 firms and 12,676 firm-year observations for the 1992 through 2009

period. We divide the whole period into the pre-SOX sample period (1992-2001) and the post-

SOX sample period (2002-2009). The pre-SOX sample consists of 766 firms and 3,974 firm-year

observations, and the post-SOX sample contains 1,645 firms and 8,702 firm-year observations.

4.2  Measurement  of  Variables  

CSR  Ratings  

                                                                                                                       
4
 This used to be called KLD STATS. We use interchangeably ESG STATS and KLD STATS.  

18  
 
  

The MSCI ESG STATS (Statistical Tool for Analyzing Trends in Social and

Environmental Performance)5 is an annual data set of environmental, social, and governance

(ESG) ratings for publicly traded companies conducted by MSCI ESG Research. The MSCI ESG

STATS ratings model includes over 50 ESG indicators in seven ESG categories for the three

topic areas:

Seven ESG categories

• Environment
• Social:
o Community
o Human Rights
o Employee Relations
o Diversity
o Customers
• Governance6

The spread of companies covered by STATS in 2010 is the largest 3,000 United States

companies as defined by market capitalization. The STATS product incorporates a binary

representation of ESG ratings: “if a company does satisfy the criteria established for a rating, this

is indicated with a ‘1.’ If a company does not meet the criteria established for a rating, this is

indicated with a ‘0.’ If an ESG indicator has not been researched for a particular company, this is

indicated by ‘NR’ (Not rated).”7 Each of the seven ESG categories has “strength” and “concern”

variables; when a company meets the criteria for “concern” variables this is transformed into a “-

1.” For analysis in this study we aggregate the ratings into total strengths and sum the concerns

over the seven ESG categories. We follow common practice in the academic literature, of adding

                                                                                                                       
5
MSCI ESG Research builds on the expertise and achievements of sustainability pioneers KLD, Innovest, and
IRRC acquired via MSCI’s acquisition of RiskMetrics.
6
 We remove out this corporate governance scores in the KLD data because we analyze corporate governance as an
endogenous variable, one of the key factors we are considering, in the model.   We use this KLD rating of
governance as a proxy for corporate governance variable in our model.
7
We excerpt the description of the rating system from MSCI ESG STATS User Guide & ESG Ratings Definition,
MSCI ESG Research (2011).

19  
 
  

the concerns to the strengths in order to arrive at a single net total score (i.e., Kim, Park, and

Wier, 2012; Griffin and Mahon, 1997; Johnson and Greening, 1999; Waddock and Graves,

1997).

Discretionary  Accruals  

We estimate discretionary accruals as earnings management proxy variables by utilizing

the annual cross-sectional industry regression with the modified Jones model based on DeFond

and Subramanyam (1998) and Kothari, Leone, and Wasley (2005). The equation to measure

discretionary accruals is as follows:

!"!" ! ∆!"!!" !∆!"!!" !!!!" !"#!!"!!

!!"!!
= 𝑏! +   𝑏! !!"!!
+ 𝑏!   !!"!!
+ 𝑏! ! + 𝑏! !!"!!
+ 𝜀!" , (2)
!"!!

where TAit is total accruals for a firm i at year t, ∆REVit is the change in net revenues for firm i at

year t, ∆RECit is the change in net receivables for firm i at year t, PPEit is gross property, plant,

and equipment for firm i at year t, IBEIit is income before extraordinary items for firm i at year t,

and Ait-1 is total assets for firm i at year t-1. Total accurals (TAit) are calculated by deducting cash

flow from operating activities (CFOit) from income before extraordinary items (IBEITit). We

obtain all items in the equations from the Compustat database. The residuals from the modified

Jones model above are then used as estimates of firms’ discretionary accruals. We employ the

absolute value of residuals as a proxy for discretionary accruals. This is because managers can

manipulate their earnings in either an income-increasing or an income-decreasing way (Warfield,

Wild, and Wild, 1995).

Tobin’s  Q

We employ Tobin’s Q as a proxy for firm performance. Tobin’s Q is measured as follow

(Gompers, Ishii, and Metrick, 2003; Bebchuk and Cohen, 2005; Brown and Caylar, 2006).
20  
 
  

𝐴𝑇 + 𝑀𝑉𝐸 − 𝐵𝑉𝐸 − 𝐷𝑇
                                                                                       Tobin! s  Q =   ,                                                                                                      (3)  
𝐴𝑇

where AT is total assets, MVE is market value of equity calculated by multiplying common

shares outstanding and stock price (fiscal year close), BVE is book value of equity, and DT is

deferred taxes. We obtain all items of the equations from the Compustat database. We winsorize

the top and bottom 1% of Tobin’s Q at its distribution following Brown and Caylar (2006).

Equity-­‐based  Compensation  

We measure CEOs’ equity-based compensation as the proportion of restricted stock grant

and stock options granted to total compensation. This is measured using the valuation

methodology from the ExecuComp database. The calculation of equity-based compensation is as

follows:

restricted  stock + stock  options  granted

                         Equity_based  compensation =                              (4)
total  compensation

However, in 2006 the valuation of restricted stock and stock options granted was changed

from Standard & Poor’s Black-Scholes methodology to the grant-date fair value. This was

detailed in FAS 123R. The definitions of items shown in the table below reflect these valuations

before and after the change of reporting format was done in the ExecuComp database.

Definitions of compensation items8

From 1992 to 2005 From 2006 to 2009
Salary, bonus, non-equity incentive
Salary, bonus, other annual, restricted plan compensation, fair value of
Total stock grants, stock options granted option awards, fair value of stock
compensation (using Black-Scholes), long-term awards, deferred compensation
incentive payouts, and all other totals. earnings reported as compensation,
and other compensation.

                                                                                                                       
8
 The definitions are from ExecuComp database.  

21  
 
  

Fair value of all stock awards based

Restricted Restricted stock granted during the
on grant-date fair value as detailed in
stock grant year applied to 1992 reporting format.
FAS 123R.
The aggregate value of stock options Fair value of all options awarded
Stock options
granted as valued using Standard & based on the grant-date fair value as
granted
Poor's Black-Scholes methodology. detailed in FAS 123R.

We calculate equity-based compensation as a proxy for management compensation by

equation (4).  

Corporate  governance  

We use the KLD rating of governance as the measure of corporate governance variable in

our model. KLD STATS has two strength criteria and four concern criteria to assess firms’

governance.

   

22  
 
  

5.  Empirical  tests  and  results  

5.1  Descriptive  statistics

Table 1 provides summary statistics of the full sample in Panel A, the pre-SOX period

sample in Panel B, and the post-SOX period sample in Panel C.

Table 1
Descriptive Statistics
25th 75th Standard
N Percentile Mean Median Percentile Deviation
Panel A: Full Sample, 1992-2009 (n = 12,676)
DA 12,649 -0.037 -0.004 0.001 0.037 0.097
Positive_DA 6,442 0.0166 0.052 0.036 0.066 0.068
Negative_DA 6,248 -0.073 -0.061 -0.038 -0.016 0.087
Abs_DA 12,649 0.017 0.057 0.037 0.069 0.078
Tobin’s Q 11,549 1.268 2.076 1.665 2.419 1.272
CSR ratings 12,676 -1.000 0.041 0.000 1.000 2.394
GOV ratings 12,676 -1.000 -0.355 0.000 0.000 0.703
Equity_incen 12,334 0.212 0.430 0.460 0.651 0.281

Panel B: Pre-SOX Sample, 1992-2001 (n= 3,974)

DA 3,970 -0.036 -0.003 0.001 0.036 0.096
Positive_DA 2,009 0.016 0.050 0.036 0.064 0.064
Negative_DA 1,965 -0.069 -0.058 -0.036 -0.016 0.093
Abs_DA 3,970 0.016 0.054 0.036 0.067 0.080
Tobin’s Q 3,512 1.284 2.214 1.688 2.557 1.458
CSR ratings 3,974 -1.000 0.495 0.000 2.000 2.496
GOV ratings 3,974 -1.000 -0.251 0.000 0.000 0.601
Equity_incen 3,919 0.189 0.415 0.414 0.650 0.289

Panel C: Post-SOX Sample, 2002-2009 (n = 8,702)

DA 8,679 -0.038 -0.004 0.001 0.038 0.097
Positive_DA 4,433 0.017 0.053 0.036 0.067 0.069
Negative_DA 4,283 -0.076 -0.063 -0.038 -0.016 0.084
Abs_DA 8,679 0.017 0.058 0.038 0.071 0.077
Tobin’s Q 8,037 1.262 2.016 1.653 2.364 1.177
CSR ratings 8,702 -1.000 -0.167 0.000 1.000 2.317
GOV ratings 8,702 -1.000 -0.402 0.000 0.000 0.740
Equity_incen 8,415 0.227 0.438 0.482 0.652 0.277
(Continued on next page)

23  
 
  

Table 1 (continued)

Variable Definitions:
DA = discretionary accruals estimated using the Modified Jones Model;
Positive_DA = the value of positive discretionary accruals estimated using the Modified Jones
Model;
Negative_DA = the value of negative discretionary accruals estimated using the Modified Jones
Model;
Abs_DA = the absolute value of discretionary accruals estimated using the Modified Jones
Model;
Tobin’s Q = (AT+MVE-BVE-DT)/AT, where AT is total assets, MVE is market value of
equity calculated by multiplying common shares outstanding and stock price
(fiscal year close), BVE is book value of equity, and DT is deferred taxes. It is
winsorized the top and bottom 1% of its distribution;
CSR ratings =  the aggregated scores of the six ESG categories (environmental and social -
community, human rights, employee relations, diversity, and customers). Each
category has “strength” and “concern” variables, which are scored with the value
of 1; when a company meets the criteria for “concern” variables this is
transformed into a “-1.” CSR ratings are computed by summing the total scores of
strengths and the total scores of concerns over the six ESG categories;
GOV ratings =  the aggregated scores of the governance categories of ESG. GOV ratings are
computed by summing the total score of strengths and the total score of concerns
over ESG governance category; and
Equity_incen = (restricted stock grant +stock options granted)/total compensation.

In Table 1, the average discretionary accruals (DA) as a measure of earnings management

are -0.004 (median: 0.001) in the full sample, -0.003 (median: 0.001) in the pre-SOX sample,

and -0.004 (median: 0.001) in the post-SOX sample. We use the unsigned absolute value of the

discretionary accruals (Abs_DA) to examine the combined impacts of both income-increasing

and income-decreasing discretionary accruals. The average values of Abs_DA are 0.057 (median:

0.037), 0.054 (median: 0.036), and 0.057 (median: 0.038) in the full, the pre-SOX, and the post-

SOX sample respectively. Tobin’s Q is employed as a proxy for firm performance. The average

Tobin’s Qs are 2.076 (median: 1.665) in the full sample, 2.214 (median: 1.688) in the pre-SOX

sample, and 2.016 (median: 1.653) in the post-SOX sample. CSR ratings are used as a measure

for corporate social responsibility; these average values are 0.041, 0.495, and -0.167 in the full,

the pre-, and the post-SOX samples respectively. The median values of the CSR ratings are 0.000

24  
 
  

for all three samples. The average (median) GOV ratings for corporate governance are -0.355

(0.000), -0.251 (0.000), and -0.402 (0.000) in the full, pre- and post-SOX samples respectively.

Finally, Equity_incen which is measured by CEOs’ restricted stock grants and stock options

granted is employed as a proxy for management compensation. The averages of Equity_incen are

0.430 (median: 0.460) in the full sample, 0.415 (median: 0.414) in the pre-SOX sample,

and .0.438 (0.482) in the post-SOX sample. Generally, the summary statistics have similar values

in the three samples.

5.2  Correlation  analysis  

Table 2 presents correlation matrices of the pre-SOX period in Panel A and of the post-

SOX period in Panel B. In the pre-SOX period, the correlation coefficient between CSR and

Abs_DA is 0.020 (p = 0.205), indicating that there is not a significant association between them

on a univariate basis. The coefficient between Tobin’s Q and Abs_DA does show a significantly

positive correlation (b = 0.097, p < 0.001). The coefficient between Tobin’s Q and CSR ratings

also indicates a significantly positive association (b = 0.227, p < 0.001). In the post-SOX period,

the correlation patterns in each pair of the three variables show similar results compared to those

in the pre-SOX period. In the next section, we provide the results of PVAR regressions through

which we can examine causal directions because the model permits the possibility of reverse

relations.

25  
 
  

Table 2
Correlation Matrix for the Key Five Variables
1 2 3 4 5
Panel A: Correlation Matrix, Pre-SOX Period (1992-2001)
Abs_DA 1.000
CSR ratings 0.020
1.000
(0.205)
Tobin’s Q 0.097*** 0.227***
1.000
(0.000) (0.000)
GOV ratings -0.052*** 0.032** -0.114***
1.000
(0.001) (0.043) (0.000)
Equity_incen 0.104*** 0.060*** 0.196*** -0.201***
1.000
(0.000) (0.000) (0.000) (0.000)

Panel B: Correlation Matrix, Post-SOX Period (2002-2009)

Abs_DA 1.000
CSR ratings -0.000
1.000
(0.981)
Tobin’s Q 0.067*** 0.176***
1.000
(0.000) (0.000
GOV ratings 0.008 -0.010 0.038***
1.000
(0.451) (0.337) (0.001)
Equity_incen 0.030*** 0.109*** 0.084*** -0.203***
1.000
(0.006) (0.000) (0.000) (0.000)
The p-values are shown in parentheses.
***, **, * indicate significance at 1%, 5% and 10% level respectively.
Variable Definitions:
Abs_DA = the absolute value of discretionary accruals estimated using the Modified Jones
Model;
the aggregated scores of the six ESG categories (environmental and social -
CSR ratings =
community, human rights, employee relations, diversity, and customers). Each
category has “strength” and “concern” variables, which are scored with the value
of 1; when a company meets the criteria for “concern” variables this is transformed
into a “-1.” CSR ratings are computed by summing the total scores of strengths and
the total scores of concerns over the six ESG categories;
Tobin’s Q = (AT+MVE-BVE-DT)/AT, where AT is total assets, MVE is market value of equity
calculated by multiplying common shares outstanding and stock price (fiscal year
close), BVE is book value of equity, and DT is deferred taxes. It is winsorized the
top and bottom 1% of its distribution;
GOV ratings = the aggregated scores of the governance categories of ESG. GOV ratings are
computed by summing the total score of strengths and the total score of concerns
over ESG governance category; and
Equity_incen = (restricted stock grant +stock options granted)/total compensation.

26  
 
  

5.3  The  empirical  Results  of  PVAR  regression

We report results for the pre- and post-SOX periods in Panel A and Panel B in Table 3.

5.3.1  The  Results  of  CSR  and  Earnings  Management    

We observe that CSR has a significantly positive influence on EM (b = 0.008, t = 2.270)

in Panel A of Table 3. This indicates that before the passage of SOX, firms which are actively

associated with CSR are also more likely to manage earnings through discretionary accruals,

consistent with H1. We find that there is no statistically significant relationship between CSR

and EM (b = 0.001, t = 0.052) in the post-SOX period in Panel B of Table 3, indicating that the

positive relation between CSR and EM is limited to the pre-SOX period. While the pre-SOX

period was characterized by increasing accrual-based earnings management, the use of accrual-

based earnings management was reduced after the passage of SOX (Cohen, Dey, and Lys, 2008).

Given this higher propensity of managers to engage in opportunistic behavior before SOX, this

combination of results favors the opportunistic interpretation of CSR and DA (Prior, Surroca,

and Tribo, 2008). We also observe that MC (equity-based to total pay) is positively associated

with EM in the pre-SOX era but not in the post-SOX era, consistent with opportunistic earnings

management in the pre-SOX era, diminishing in the post-SOX era (Cohen, Dey and Lys, 2005).

27  
 
  

Table 3
Regression Results of a 5-variable PVAR Model

Response of Response to
Abs_DA Tobin’s Q Equity_incen
CSR(t-1) GOV(t-1)
(t-1) (t-1) (t-1)

Panel A: Pre-SOX Period, 1992-2001 (2,198 obs used)

Abs_DA (t) 0.047* 0.014** 0.008** -0.002 0.013**
(1.728) (2.210) (2.270) (-0.519) (2.016)
Tobin’s Q (t) 0.248 0.507*** -0.036 -0.009 -0.005
(0.781) (4.930) (-0.946) (-0.189) (-0.065)
CSR (t) -0.314 -0.157 0.465*** 0.042 -0.146
(-0.751) (-1.342) (5.902) (0.476) (-1.247)
GOV (t) 0.237 0.056 0.006 0.320*** 0.053
(1.373) (1.183) (0.195) (8.331) (1.043)
Equity_incen (t) -0.147 0.003 0.010 0.022 -0.002
(-1.405) (0.118) (0.647) (1.108) (-0.079)
Panel B: Post-SOX Period, 2002-2009 (4,382 obs used)
Abs_DA (t) 0.022 0.008*** 0.001 0.001 -0.006
(1.106) (3.770) (0.052) (0.294) (-1.481)
Tobin’s Q (t) 0.162 0.529*** 0.051* -0.079*** 0.051
(0.973) (17.465) (1.695) (-2.436) (1.170)
CSR (t) -0.070 -0.048* 0.423*** -0.052 0.004
(-0.353) (-1.675) (6.530) (-0.962) (0.063)
GOV (t) -0.020 -0.040*** -0.018 0.267*** -0.145***
(-0.165) (-2.712) (-0.566) (9.101) (-3.862)
Equity_incen (t) 0.069 0.018*** 0.008 -0.005 0.126***
(1.277) (2.548) (0.672) (-0.438) (6.808)
The coefficients in the table represent the regression the row variables on lags on the column variables.
Heteroskedasticity adjusted t-statistics are shown in parentheses.
***, **, * indicate significance at 1%, 5% and 10% level respectively.
Variable
Definitions:
Abs_DA = the absolute value of discretionary accruals estimated using the Modified Jones
Model;
CSR ratings = the aggregated scores of the six ESG categories (environmental and social -
community, human rights, employee relations, diversity, and customers). Each
category has “strength” and “concern” variables, which are scored with the value
of 1; when a company meets the criteria for “concern” variables this is
transformed into a “-1.” CSR ratings are computed by summing the total scores
of strengths and the total scores of concerns over the six ESG categories;
Tobin’s Q = (AT+MVE-BVE-DT)/AT, where AT is total assets, MVE is market value of
equity calculated by multiplying common shares outstanding and stock price

28  
 
  

Table 3 (continued)

(fiscal year close), BVE is book value of equity, and DT is deferred taxes. It is
winsorized the top and bottom 1% of its distribution;
GOV ratings = the aggregated scores of the governance categories of ESG. GOV ratings are
computed by summing the total score of strengths and the total score of concerns
over ESG governance category; and
Equity_incen = (restricted stock grant +stock options granted)/total compensation.

5.3.2  The  Results  of  CSR  and  Firm  Performance

We find that the coefficient on the directional relation from CSR to FP is statistically

insignificant (b = -0.036, t = -0.946) during the pre-SOX period as shown in Panel A of Table 3.

We find that the coefficient for this relationship between CSR and FP after SOX is statistically

significant and positive (b = 0.051, t = 1.695) as shown in Panel B of Table 3. This is consistent

with a positive role of CSR as predicted by H2 in the post-Sox period.

We also observe that there is a reverse relationship between CSR and FP after SOX. The

coefficient representing the influence of FP on CSR is significantly negative (b = -0.048, t = -

1.675) as shown in Panel B of Table 3. This suggests that some high-performing firms may elect

not to engage in CSR activities.

5.3.3  The  Results  of  Earnings  Management  and  Firm  Performance  

In Panels A and B in Table 3, empirical results show that the coefficients representing the

influence of firm performance on earnings management are positive and statistically significant

(b = 0.014, t = 2.210 in pre-SOX period, and b = 0.008, t = 3.770 in post-SOX period). Our

findings support H3 that high Tobin’s Q firms are more likely to engage in EM in both eras. In

fact, these results indicate a reverse relationship between firm performance and earnings

management – that firm performance drives earnings management. This suggests that high-

29  
 
  

performing firms engage in informative earnings management to signal persistence of earnings

(Hand 1989).

5.3.4.  The  results  of  other  endogenous  variables  (MC  and  CG)  

As mentioned earlier, we find that the coefficient representing the influence of MC on

EM is positive and statistically significant (b = 0.013, t = 2.016) in the pre-SOX period as shown

in Panel A of Table 3. This indicates that managers with high equity-based compensation have

more incentive to promote the use of discretionary accruals, consistent with the evidence that

managers who have equity incentives are more likely to manipulate reported earnings

(Bergstresser and Philippon, 2005; Cheng and Warfield, 2005). This relation is not sustained in

the post-SOX period, consistent with less opportunistic EM behavior by managers post-SOX.

We do find that the coefficient of the impact of FP on MC is positive and significant (b = 0.018, t

= 2.548) in Panel B of Table 3. This evidence suggests that high Tobin’s Q firms implement

more equity-based compensation plans, demonstrating better alignment of equity compensation

in the post-SOX era.

We also find that the coefficient of the relation from MC to CG is negative and

statistically significant (b = -0.145, t = -3.862) post-SOX as shown in Panel B of Table 3. This

result indicates that when managerial equity-based incentives play a greater role to align the

interests of managers and shareholders, the board’s monitoring potential is less important,

consistent with substitution effects between equity-based compensation and corporate

governance. Finally, we find that negative bi-directional relationships between FP and CG in

Panel B of Table 3: a negative coefficient representing the influence of CG on FP (b = -0.079, t =

-2.436) and a negative coefficient indicating the influence of FP on CG (b = -0.040, t = -2.712)

in the post-SOX period. These results suggest that stricter CG leads to lower firm value, possibly
30  
 
  

due to managers’ risk-averse tendencies after the implementation of SOX. It is plausible that

efforts to enhance corporate governance and improve accounting transparency via SOX led to

more cautious investment by CEOs, delivering bad news to investors. The negative relation from

CG to FP shows that high performance firms are less likely to augment governance, indicating

that stricter CG might not be value-adding in post-SOX era.

We summarize our findings in the context of the pre- and post-SOX periods as follows:

31  
 
  

6.  Conclusion  

We examine the interrelations between CSR, EM, and FP while taking into consideration

CG and MC in the contexts of pre- and post-SOX periods. To execute this study, we innovatively

employ rigorous panel vector auto regressive (PVAR) procedures. This methodology allows us

to assess the complex linkages between CSR, EM, FP, CG, and MC and to investigate causal

directions between all pairs of the considered variables.

The Sarbanes-Oxley (SOX) of 2002 is the most important legislative change influencing

managers’ earnings activities as well as corporate governance. We divide the complete sample

period from 1992 to 2009 into a pre-SOX period (from 1992 to 2001) and a post-SOX period

(from 2002 to 2009) and analyze the systematic change in the interrelations between the

considered variables for the two periods. We find that CSR had a positive influence on EM in the

pre-SOX, suggesting that managers invested in CSR activities from an opportunistic perspective

during this period. This result is not consistent with the Kim, Park, and Wier research (2012)

which documents a negative relationship between CSR and EM under the ethical theory of CSR.

However, during the post-SOX era, CSR has no impact on EM. We interpret these results as

suggestive that CSR was likely to be more opportunistic in the pre-SOX era and more aligned

with corporate objectives in the post-SOX era (the pre-SOX period was characterized by

increasing accrual-based earnings management and reduced accrual-based earnings management

occurred after the passage of SOX: Cohen, Dey, and Lys, 2008). Second, we find that there is no

relation between CSR and FP during the pre-SOX period, but there are bi-directional

relationships between them during the post-SOX period: CSR positively leads to FP, but FP

negatively affects CSR. The positive influence of CSR on FP indicates that the increased CSR

investment improves firm performance, consistent with previous studies documenting the

32  
 
  

positive relation between them (e.g., management regards corporate actions based on these

responsibilities as effective tools for improving intangible assets such as corporate image and

strengthening the effects of marketing tactics: Maignan, Ferrell, and Ferrell, 2005). And the

negative influence of FM on CSR shows that some high performance firms are less likely to

initiate CSR activities, suggesting that there might be substitution between CSR and firm

performance for some firms. Last, we find that FP positively affects EM in both pre- and post-

SOX periods. Because high Tobin’s Q is evidence of high intangible asset value (expected future

abnormal earnings), this suggests that managers use discretionary accruals to indicate the

persistence of earnings.

This study contributes to the accounting literature in the following ways. First, it

investigates interrelations between the variables with explicit consideration of endogeneity.

Second, by employing the innovative methodology of PVAR, we analyze the causal and bi-

directional relations between the considered variables, allowing us to assess interactions between

them and provide better understanding about the relations.

In the present study, we use governance scores (CGOV rating) from KLD STATS as our

proxy for the corporate governance (CG) variable. In future work, we will use a more

comprehensive measure of corporate governance for robustness, the corporate governance index

provided by the RiskMetrics database. Furthermore, PVAR treats all variables as endogeneous

and is based on a time-series approach. There is no room to include the influence of additional

explanatory variables on the endogenous variables (i.e. how R&D affects FP). Thus, it would be

appropriate to consider the influence of explanatory variables using a statespace model in future

research.

33  
 
  

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