Doing good when doing well: evidence on real earnings management

Abstract

We provide evidence on earnings management by exploiting temporary exogenous shocks to utility firms’ sales arising from weather variation. We find that sample firms’ sales are highly sensitive to annual changes in average temperatures in the region where the firm operates, but this sensitivity disappears quickly as one moves down the income statement. This evidence, while indirect, is suggestive of earnings management activities. In search of direct evidence, we study charitable giving decisions by sample firms and uncover a significant positive sensitivity of charitable spending to weather-driven demand shocks, behavior that is highly consistent with the presence of real earnings management efforts. We find no convincing evidence supporting possible alternative explanations for this evidence, but we do find limited support for the presence of a larger giving–weather relation when earnings management incentives are likely to be elevated. If other real decisions with similar characteristics scale proportionally to charitable giving, our findings suggest that the overall magnitude of real earnings management activities could be quite substantial.

A comparison of analysts’ and investors’ information efficiency of corporate social responsibility activities

“…This theory is supported by studies showing managers’ involvement in philanthropic programs and charitable contributions that may not align with the firm’s main business functions or contribute to its financial performance, a dichotomy often referred to as immaterial versus material CSR (Sustainability Accounting Standards Board, 2017). Such engagements, while possibly not enhancing actual firm value, can inflate a firm’s CSR reputation and, consequently, garner positive investor responses (Bonini and Chênevert, 2008; Grieser et al , 2021).…”

“…Therefore, viewed through this lens, the positive market responses to CSR initiatives may indicate an overestimation influenced by amplified investor enthusiasm. This phenomenon suggests the possibility of a market mispricing scenario, wherein the market assigns excessive value to CSR initiatives in terms of the firm’s valuation and projected profits, potentially overlooking the actual effect of these activities (Bonini and Chênevert, 2008; Grieser et al , 2021).…”

“…Thus, from this standpoint, the optimistic market reactions to CSR activities might reflect an overvaluation driven by heightened investor sentiment. This raises a potential for market mispricing, where the market attributes undue benefits to CSR activities regarding the firm’s value and expected earnings, misjudging their true impact (Bonini and Chênevert, 2008; Grieser et al , 2021).…”