Corporate Social Responsibility and Internal Control Effectiveness

• Author: Yura Kim,Hyun‐Dong Kim,Young Sang Kim
• Date: 01 April 2017
• Published date: 01 April 2017
• DOI: http://doi.org/10.1111/ajfs.12172

Corporate Social Responsibility and Internal

Control Effectiveness*

Young Sang Kim

Northern Kentucky University, United States

Yura Kim**

University of Seoul, Republic of Korea

Hyun-Dong Kim

Sungkyunkwan University, Republic of Korea

Received 31 August 2016; Accepted 29 December 2016

Abstract

This study empirically examines whether corporate social responsible firms exhibit more

effective internal control over financial reporting. Specifically, we investigate whether socially

responsible firms apply business practices to ensure financial transparency and accountabil-

ity for their stakeholders. Using various measures of corporate social responsibility (CSR)

and a battery of robust regression analysis over the period from 2004 to 2012, we find that

CSR firms are more likely to have effective internal control under Section 404 of the

Sarbanes-Oxley Act (SOX). Our results are robust to the propensity matching of firm

characteristics, considering various measures of CSR, and adjusting for several endogenous

problems.

Keywords Corporate social responsibility; Internal control effectiveness; Material weakness;

Financial reporting quality

JEL Classification: G34, M14

1. Introduction

Corporate social responsibility (CSR) has become a new area of concern for the

wellbeing of society. Various stakeholders beyond shareholders and investors are

increasingly demanding that firms be responsible and accountable for their

*This work was supported by the 2015 Research Fund of the University of Seoul.

**Corresponding author: Yura Kim, Associate Professor, College of Business Administration,

University of Seoul, 163 Seoulsiripdae-ro, Dongdaemu-gu, Seoul 02504, Korea. Tel: +82-2-

6490-2256, Fax: +82-2-6490-2219, email: yurak0@uos.ac.kr.

Asia-Pacific Journal of Financial Studies (2017) 46, 341–372 doi:10.1111/ajfs.12172

©2017 Korean Securities Association 341

impact on society and the environment as a whole. Investors consider the ethical

conduct of firms when they make investment decisions,

1

while customers con-

sider environmental and corporate social impacts in their purchasing decisions.

As members of civil society, stakeholders are becoming increasingly aware of

CSR, and corporations are not only promoting the business accountability of the

entity itself, but are also ensuring that their business partners in the supply chain

are operating business in a socially responsible manner. In response to this

increasing demand in society, CSR or corporate sustainability are becoming very

important in the business agenda and are considered prominent features of busi-

ness and society today.

2

From an organizational perspective, CSR refers to business stewardship that

benefits the environment, society, and the economy. To be socially responsible and

sustainable, firms are under increased pressure to maintain a high level of ethical

standards and transparency in every business practice (Jones, 1995; Mackey et al.,

2007; Jo and Harjoto, 2011; Kim et al., 2012). The key objective of CSR from a

financial reporting point of view is to ensure that the firm’s control environment is

compliant, effective, efficient, and sustainable, and that its financial information is

accurate and transparent.

As firms face increased pressure to act in socially responsible ways, they are also

under great public scrutiny to provide accurate and timely financial reporting. The

Sarbanes Oxley Act (SOX, hereafter), signed into law on July 30, 2002, was designed

to enhance financial reporting quality so that potential stakeholders could stay fully

apprised of the firm’s financial situation. Under Section 404 of the SOX, companies

are mandated to publish any “material” information concerning the scope and ade-

quacy of the structure and procedures of their internal control over financial

reporting. The Exchange Act, Rules 13a–15(f) and 15d–15(f) define internal control

over financial reporting as a process “to provide reasonable assurance regarding the

reliability of financial reporting and the preparation of financial statements for

external purposes.”

In this paper, we study whether CSR firms apply business practices to ensure

financial transparency and accountability in order to satisfy their stakeholders.

Specifically, we examine whether CSR firms exhibit effective internal control over

financial reporting as measured by material weakness disclosure over financial

1

In the 2015 Good Must Grow survey, 65% of consumers said that they would consider pur-

chasing from socially conscious firms, up from 60% in 2013.

2

For instance, according to “2012 Corporate/ESG/Sustainability/Responsibility Reporting:

Does It Matter?,” an analysis released by the Governance and Accountability Institute, 57%

of S&P 500 index companies issued corporate sustainability or responsibility reports, up from

20% the previous year. The percentage of S&P 500 index companies that reported on sustain-

ability or responsibility also increased, rising from 72% to 75% and then to 81% in 2013,

2014, and 2015 respectively (www.ga-institute.com).

Y. S. Kim et al.

342 ©2017 Korean Securities Association

reporting under SOX Section 404.

3

The evidence concerning CSR motivation and

impacts on firm performance and/or policy implications is far from clear and the

link between CSR and internal control over financial reporting has not yet been

examined extensively in the literature. Prior research reports on the ethical aspect

of CSR activities. For example, Kim et al. (2012) claim that socially responsible

firms constrain both accruals and real earnings management and thus deliver more

transparent and reliable financial information to their stakeholders. Their research

is based on a theoretical foundation posting that moral firms operate based on trust

and cooperation with their stakeholders, which prevents opportunism (Jones, 1995).

Stakeholder theory suggests that entities should be accountable to all of their stake-

holders who can affect, or be affected by, the achievement of the objectives of the

entities (Freeman, 1984). Overall, socially responsible firms are not inclined to pur-

sue short-term gains, but set the right corporate culture and develop long-term cor-

porate–stakeholder relationships.

The contrary evidence finds that firms may be motivated to engage in CSR for

opportunistic reasons. The firm may use CSR as a medium with which to signal the

market that it is a good corporation (Mahoney, 2012). Entrenched managers may

conduct CSR practices to burnish their reputation, in turn causing agency conflicts

between managers and shareholders (Jensen and Meckling, 1976; Barnea and Rubin,

2010). Some firms engage in CSR activities irresponsibly, and thus bring negative

consequences to stakeholders, including shareholders, employees, customers, and

suppliers. For example, firms that engage in excessive CSR spending are more likely

to avoid taxes measured in terms of the likelihood of engaging in tax sheltering and

the extent of book-tax differences (Hoi et al., 2013).

To examine the impact of CSR on internal control over financial reporting

effectiveness, we utilize a firm’s corporate social ratings provided by MSCI ESG

STATS (previously known as KLD) to measure firms’ CSR activities and extrac t

internal control effectiveness measures from the Audit Analytics database. Our mea-

sure of internal control effectiveness over financial reporting is material weakness

disclosure under Section 404 of the SOX. As external auditors influence the likeli-

hood of internal control deficiencies (e.g., Zhang et al., 2007), we include external

auditor-related variables. Using a large sample of US firms over the period

2004–2012, we find that CSR firms are more likely to have effective internal control

over financial reporting. Specifically, CSR firms are less likely to have material

3

Material weakness is defined as a deficiency, or combination of deficiencies, in internal con-

trol over financial reporting, such that there is a reasonable possibility that a material mis-

statement of the company’s annual or interim financial statements will not be prevented or

detected in a timely way (Public Company Accounting Oversight Board (PCAOB) Auditing

Standard No. 2, 2004. The PCAOB Auditing Standard No. 5 replaces the term “more than

remote likelihood” with “reasonable possible” when defining internal control material

weakness.

CSR and Internal Control Effectiveness

©2017 Korean Securities Association 343