Do companies skirt CSR law through earnings management?

By Vivek Kumar

The Companies Act 2013, among several other new provisions, mandated companies meeting either of the three criteria, namely a net worth of Rs 500 crore or more, or a turnover of Rs 1,000 crore or more, or a net profit of Rs five crore or more during any financial year to spend 2% of average net profits of the past three financial years. Expectedly, there was a mixed response to the law. There was support for ushering in the social responsibility of companies in a section of society. The expectation to report was also appreciated. However, critics pointed out that social responsibility cannot be mandated and should have remained voluntary. These critics argued that the mandatory nature of CSR expenditure makes it akin to a tax, and companies might find ways to skirt the law. 

The study by Manish Bansal and I aimed to explore one specific pathway companies might use to skirt the law – earnings management. The term earnings management is a euphemism for the deliberate practice of manipulating a company’s financial statements. Notably, earnings management may not always be illegal; it might be unethical without breaking laws. Typically, earnings management is done to present a favourable picture of the company’s financial prospects. Thus, this practice is usually directed toward stock market investors or financial institutions that provide credit to the company, as doing so can boost the stock price or enable access to a higher quantum of capital.

The question we asked in the study was rather novel – Do companies use earnings management to avoid spending on CSR? As there are three thresholds for being eligible to spend on CSR, companies close to meeting either of the three thresholds may manipulate their financials to avoid meeting the particular threshold.  As earnings management can only slightly change the financials without being illegal, companies much beyond meeting the threshold are unlikely to modify their financials downward.

Before embarking on solid statistical evidence, we plotted the number of companies around the three thresholds. The thresholds are pretty interesting because they are round numbers which people usually love to breach. For example, it is well known that in self-reported data on the heights of individuals, there are more people just above six feet than just below six feet, and this anomaly magically vanishes in measured data. Similarly, imagine the happiness of a company owner when the company crosses Rs 1000 crores in revenue. It would not be surprising if the companies managed their earnings to cross these thresholds before the CSR law came into the picture. In fact, there were more companies just crossing the three thresholds than just falling short of the threshold before the CSR law was implemented. However, the picture completely changed after the implementation of the CSR law. There were more companies just below the thresholds for all three thresholds than just above the thresholds. This is a rather strong indicator of the earnings management that went into skirting the CSR law.

The change in the number of companies around the threshold due to the law is pretty damning evidence but insufficient to meet the requirements of prestigious peer-reviewed journals. We collected 18,205 firm-years data of companies listed on BSE. We also controlled for other aspects, such as changes in cash flow from operations, production costs, and discretionary expenditures, that may affect the decrease in turnover, net worth or net profits. The suspicions of earnings management to reduce CSR expenditure liability withstood these more stringent tests. 

The unmistakable conclusion from the study is that firms indeed sought to avoid spending on CSR by manipulating the financial statements so that the companies fall short of crossing the threshold required for being obligated to make the expenditures. The study affirmed the apprehensions of a section of the society that the CSR law would be seen as a new form of tax. Thus, the study indirectly supports the prolific philanthropist Azim Premji’s views that social responsibility must come from within and should not be mandated.

The study has broader implications for corporate policy-making in India by highlighting the need for second-order thinking when crafting regulations. The first-order thinking says that we need to improve the condition of a billion plus people in India, and therefore, let’s make a law to compel corporations to contribute to this cause. The second-order thinking, however, requires planning for the reaction of the corporations to such a legal provision and creating safeguards such that skirting the law becomes more difficult.

The author is chairperson, strategic management, IIM Kashipur.

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