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Introduction
Managers have high level of accounting discretion on corporate social responsibility (CSR) expenditure under the current financial reporting framework because of the lack of accounting standards to address CSR expenditure directly. Thus, many prior researchers examine whether accounting earnings reflect the evaluation of potential economic benefits from CSR spending appropriately and one of the commonly used statistical tests has been relating CSR to earnings response coefficient (ERC): CSR–ERC relation.
ERC measures the relation between unexpected stock returns and unexpected earnings (UEs). Under the wide-window approach, for example, ERC represents the consistency of information reflected in the two variables – stock returns and earnings. Thus, the CSR–ERC relation is expected to help evaluate how well accounting earnings reflect CSR implications.
Many previous studies find a positive relation between CSR and ERC (Holbrook, 2013; Gao and Zhang, 2015), which implies that accounting earnings address the economic substance of CSR spending appropriately. Most prior studies, however, examine the relation primarily under the circumstances of common-law and mature stage of CSR development (e.g. the USA). Few studies have investigated the CSR–ERC relation under the code-law environment and/or early stage of CSR development. Such different circumstances can generate different accounting environment where the managerial accounting discretion on CSR expenditure is easily validated and, in turn, the ability of earnings to capture CSR implications can be decreased.
This expectation is supported by the international institutional theory, which argues that earnings are determined more aggressively, and the degree of earnings management is higher in the code-law tradition than in the common-law tradition (Ball et al., 2000; Leuz et al., 2003). The aggressive reporting in the code-law tradition can attenuate the function of earnings to incorporate CSR implication. Furthermore, the literature on CSR development posits that the firm’s stance on CSR can be differentiated by the stages of CSR development. Such differential stance on CSR may affect the way CSR expenditure is recognized. For example, in the early stage of CSR, a firm merely tries to defend against negative CSR issues or to show its compliance with related regulations (Zadek, 2004). This passive stance can also attenuate the function of earnings to incorporate CSR implication.
In practice, it seems that firms count on non-financial disclosures to convey the CSR information...