Erasmus University Rotterdam

Erasmus University Rotterdam

School of Economics

Section Accounting, Auditing and Control

Does Corporate Social Responsibility enhance Corporate Financial Performance?

An empirical study of the Dutch manufacturing sector

Date : 27 July 2011

Author : Natalja Korobanjko

Student number : 349925

Supervisor : E.A. de Knecht, RA

Co-reader : Dr. sc. ind. A.H. van der Boom

Table of contents

Preface 3

Chapter 1 Introduction 4

1.1 Background 4

1.2 Objective 5

1.3 Research question 5

1.4 Methodology 6

1.5 Limitations 7

1.6 Structure 7

Chapter 2 CSR and financial performance 8

2.1 Definition of CSR 8

2.2 Theories behind CSR 9

2.3 Definition of financial performance 13

2.4 Improving financial performance through CSR 15

2.5 Summary 18

Chapter 3 Literature review 19

3.1 The type of relationship 19

3.2 The direction of causality 21

3.3 Prior studies 21

3.3.1 Griffin and Mahon (1997) 22

3.3.2 Waddock and Graves (1997) 23

3.3.3 McWilliams and Siegel (2000) 24

3.3.4 Orlitzky et al. (2003) 26

3.3.5 Margolis et al. (2007) 26

3.3.6 Peters and Mullen (2009) 29

3.4 Biases and problems in existing research 30

3.5 Formulating hypotheses 33

3.6 Summary 34

Chapter 4 Research design 35

4.1 Research approach 35

4.2 Measuring CSP 36

4.2.1 CSR disclosures 36

4.2.2 Transparency Benchmark 38

4.3 Measuring financial performance 39

4.4 Control variables 40

4.5 Research methodology 42

4.6 Sample and data selection 46

4.7 Summary 47

Chapter 5 Empirical research 48

5.1 CSP data 48

5.2 Financial performance data 52

5.3 Control variables data 53

5.4 Empirical analysis of the CSP-FP relationship 53

5.5 Empirical analysis of the causality 56

5.6 Empirical analysis of the longitudinal effect 61

5.7 Summary 66

Chapter 6 Conclusion 67

Reference list 71

Appendix 74

Preface

This thesis forms the concluding part of my Master degree in Accounting, Auditing, and Control. At the moment that I am writing this preface, I am looking back at an exciting and intensive year full of new experiences in a world that was completely unknown to me until last September: the world of accountancy and auditing. While for most students a Master degree signifies the end of their studying period, I realize that my journey is just starting. Inspired by the professors and other professionals I have decided to continue my studies in this field and I am consequently looking forward to the coming years of specialization towards registeraccountant.

I would like to thank Evert de Knecht, my thesis supervisor at the Erasmus University, for reading and advising on my thesis. This thesis has been written during my graduation internship at PwC. I would like to thank Wilko de Vos, my thesis supervisor at PwC, for his time, the brainstorm sessions, and the good chats we had.

Special thanks go to Jasper Meijerink. I would like to thank him for all his patience, support, understanding, and unbridled confidence in me. Finally, I would like to thank my mother for her endless support.

Chapter 1 Introduction

1.1 Background

Corporate social responsibility (CSR) is a hot issue nowadays. During the last decades, in addition to the traditional financial statements, a steep increase exists in the number of companies that involve themselves in CSR and report on environmental and social aspects of their firm’s operations. In addition, these numbers are growing every year. A survey by KPMG released in 2008 supports the fact that social and environmental reporting has grown substantially: from 13% in 1993 to nearly 80% across the largest 250 companies worldwide (G250) in 2008 (KPMG, 2008, p. 13). These percentages show that firms nowadays are not only expected to generate profits for their shareholders but in addition to consider their obligations to society. However, does it pay off for firms to be socially responsible? This research will investigate whether it can be proven that more socially responsible companies see their behaviour being rewarded in terms of financial outcomes. Before continuing, it is essential to signal that in previous research the terms CSR and Corporate Social Performance (CSP) have been used interchangeably. CSR is a construct and consequently cannot measure. Consequently, this research will follow prior research and use CSP as a measure for CSR.

Prior studies have extensively examined the link between CSP and financial performance, yet the outcomes are mixed. The major part of the studies confirms the existence of a positive relationship between these two variables and supports this outcome by referring to the stakeholder theory. This theory by Freeman (1984) states that companies which incorporate stakeholders’ (consumers, employees and even communities or societies) interests into their business operations will in the medium to long run see their financial and economic performance improve. Investment in CSR will positively affect the firm’s financial performance through different channels, for instance: improvement in reputation and branding, increased access to capital, lower cost of capital, increased operational efficiency, enhanced ability to identify and to manage risks and an increased attractiveness to high quality employees. On the other hand, based on the idea that adapting CSR will lead to additional financial costs and that the benefits of the implementation will not outweigh these costs, some studies claim that CSP and financial performance are negatively related. Finally, certain researchers state that no relationship exists between CSP and financial performance. They argue that too many variables exist which influence this relationship. Consequently, a relationship between CSP and financial performance can only exist by chance.

1.2 Objective

As signalled before, many studies have investigated the relationship between CSP and financial performance. Although the obtained results are not conclusive, the number of papers dealing with this subject increases the challenge to create a twist that can enrich and add value to the existing research. This research will primarily add value by focusing on the Netherlands. An overview of the available studies reveals a strong emphasis on the US or European markets as a whole. However, relatively few studies exist that have focused on the Netherlands explicitly. In addition, major part of prior studies used samples that contained multiple industries. However, as this approach does not distinguish between industries, assuming that all industries are comparable, the use of multi-industry samples can have a big biased effect on the results (Griffin and Mahon, 1997). Yet every industry is unique in its own way, which creates a ‘specialization’ of social interests (Holmes, 1977). To overcome this problem, current research will focus on one single industry, the Dutch manufacturing industry. Finally, many researchers attribute a lack of focus to prior research on the existence of the long-term effect in the relationship between CSP and financial performance. In order to investigate whether the relationship between CSP and financial performance strengthens over time, this research will add value by examining the longitudinal effect between the two variables.

This research can be interesting for management, regulators, and auditing firms. If adopting CSR indeed leads to a positive effect in the financial performance, in order to improve its business, it can trigger management to be more socially responsible. Regulators can use this research to improve compliance of their guidelines. Another group that can be interested in this research are the auditing firms. Recently these firms provide assurance of CSR disclosures and are consequently eager to investigate the prospects of this new service.

1.3 Research question

In investigating the relationship between CSP and corporate financial performance (CFP) this research will follow the structure of prior studies and examine the sign of the relationship, the causality, and the longitudinal effect. This paper, however, will not focus on determining the direction of the causality within the relationship between CSP and financial performance. This has been comprehensively studied in prior research and consequently will not add value to this topic. Since it is mediated by the management’s decision to invest indeed any surplus budgets in CSR, a higher social performance is not a necessary a consequence of financial performance. Moreover, in many if not all cases, a positive financial performance is a conditio sine qua non for further investment in CSR. This would automatically lead to a correlation between these two data, but this correlation does not imply a necessary causal relation, amongst others for the reason just stated that it in addition requires managerial decision-making. Accordingly, since the impact of CSP on financial performance is external to the company’s decision-making process and surplus budget allocation, the causal relation from CSP to financial performance is the most relevant to investigate.

The research question is:

‘Does corporate social responsibility enhance corporate financial performance?’

1.4 Methodology

This research will use the scores of the Transparency Benchmark (TB) of the Dutch Ministry of Economic Affairs as a CSP measure. The TB provides scores on a scale of 0 to 100 for the largest Dutch companies. In 2010, the methodology of the TB has been changed, leading to an extension of the scale’s upper range up to 200. Consequently, the awarded scores in 2010 are not comparable to the scores of the prior years and are excluded. This research will use the TB scores of 2006-2009 that are derived from the website of the Dutch Ministry of Economic Affairs[1]. It is important to note that this research uses disclosures as a proxy for CSP and not the actual performance.

Brealy and Myers define financial performance as an indicator of the firm’s ability to generate revenues from its daily operations (Brealy and Myers, 2003, p. 321). Comparison of prior research shows that financial performance measures are divided into three categories: ‘market-based measures (investor returns), accounting-based measures (accounting returns) and perceptual (survey) measures’ (Orlitzky et al., 2003, p. 407). This research will use accounting based measures and will consequently measure the financial performance of a company by means of the return on assets (ROA) and the return on equity ratio (ROE).

In this research, CSP is the independent variable and financial performance the dependent variable. Additionally, two control variables are used: size (logarithm of total assets) and risk (debt ratio). The sample consists of 21 large Dutch manufacturing firms.

1.5 Limitations

One of the limitations is related to the Transparency Benchmark (TB). The used sample in this research is rather small due to the limited availability of TB scores per industry and consists of solely large companies. Furthermore, an increase of the researched time span is impossible due to the novelty of the TB and the recent changes in the methodology. Recent developments of the TB, like the increase in the number of rated firms, however, can improve the usefulness of this measure for research purposes. Besides expanding the sample by increasing the number of companies, further research could additionally focus on examining the relationship between the CSP and the financial performance for small and medium size (SME) companies.

This research examines the period 2006-2010 and consequently includes data obtained during the financial crisis. This increases the value of this research as just a small number of studies are available that have included the financial crisis period into their investigation of the relationship between CSP and CFP. However, further examination of the impact of the financial crisis on the relationship between CSP and CFP is needed to make sure that the crisis does not blur the acquired results.

1.6 Structure

The remainder of this paper has the following structure. Chapter 2 provides the theoretical framework for this research and comments on the concepts of corporate social responsibility (CSR), financial performance and the theories behind CSR. Chapter 3 consists of a review of prior research and the formulation of hypotheses. Chapter 4 covers the research design. Chapter 5 presents and comments the results of the empirical analysis. Chapter 6 concludes and provides suggestions for future research.

Chapter 2 CSR and financial performance

This chapter provides a better understanding of the concepts corporate social responsibility (CSR) and financial performance (FP), and in which way they are interlinked. To achieve this goal the following sections define the terms CSR and FP, and examine the theories behind CSR. Additionally, the final section further explains the relationship, by commenting on the channels through which CSR can positively affect the financial performance.

2.1 Definition of CSR

The term corporate social responsibility came into use with the rise of the multinational corporations in the early 1970s. During the past years, CSR and other terms like corporate citizenship and sustainable responsible business have been used interchangeably as synonyms. Besides the variance in terminology, great differences in the meaning of the term CSR were identified. This has been clearly formulated by Votaw who stated:

‘Corporate social responsibility means something, but not always the same thing to everybody. To some it conveys the idea of legal responsibility or liability; to others, it means socially responsible behaviour in the ethical sense; to still others, the meaning transmitted is that of ‘responsible for’ in a causal mode; many simply equate it with a charitable contribution; some take it to mean socially conscious; many of those who embrace it most fervently see it as a mere synonym for legitimacy in the context of belonging or being proper or valid; a few see a sort of fiduciary duty imposing higher standards of behaviour on businessmen than on citizens at large.’ (Votaw, 1972, cited by: Garriga and Melé, 2004, p. 52)

Almost forty years later, scholars still face this ambiguity. Review of recent scientific literature reveals that nowadays the number of definitions of CSR in circulation is still increasing. The wide range of definitions can be explained by the fact that CSR reporting is voluntary and not supported by the generally accepted reporting standards (GAAP) that provide a uniform definition.

This research uses the definition provided by the European Commission (EC):

‘CSR is a concept whereby companies integrate social and environmental concerns in their business operations and in their interaction with their stakeholders on a voluntary basis.’ (EC, 2001, p. 6)

This definition was chosen, because it clearly contains the two essential components of CSR. The first component refers to the company’s relationship with its stakeholders. The term ‘stakeholder’, referring to ‘those groups without whose support the organization would cease to exist’ (Freeman and Reed, 1983, p. 89), was first used in 1963 during an internal memorandum of the Stanford Research Institute (SRI, 1963). The main idea of CSR is that it includes public interest into corporate decisions. The stakeholder concept indicates that in addition to stockholders, other groups exist to which the corporation is responsible. These groups directly or indirectly are affected by the corporation’s actions. Based on this idea, instead of just maximizing the profit of its shareholders a corporation needs to be used as a mechanism to coordinate the stakeholders’ interests.[2]