This paper examines whether firms manage earnings using their corporate philanthropy programs. Specifically, I seek to determine if firms strategically time the funding of their corporate-sponsored foundations (1) to increase earnings in order to report small positive earnings changes or (2) to create cookie jar reserves. I also investigate whether firms with higher stock price sensitivity to earnings news are more inclined to engage in such behavior. A firm records contribution expense when it transfers resources to its corporate-sponsored foundation (“payins”).
The foundation then makes grants (“payouts”) to public charities. Because the economic effect, payouts, is separate from the financial reporting effect, payins, corporate foundations offer an opportunity for managers to exercise discretion to influence reported earnings.
Scrutiny from legislators and regulators related to ineffective corporate governance extends to corporate philanthropy, making the study of earnings management in this setting particularly timely. Recently proposed corporate governance legislation was motivated by the belief that corporate philanthropy can be an opportunistic use of shareholder resources which should be curbed. For example, at the time Sarbanes-Oxley was being formulated, Congressional staff considered an amendment which would have brought corporate-sponsored foundations under the jurisdiction of the SEC by requiring corporations to disclose the activities of their foundations.
In addition, the first version of the Sarbanes-Oxley Act of 2002 passed by the House required firms to disclose all corporate contributions. While this paper does not directly address the question of whether contributions are made by management for opportunistic reasons, it is the first study to examine whether contributions are used by management to meet financial reporting objectives. Thus, it provides empirical evidence relevant to the current public policy debate on the governance of corporate philanthropy and to the regulatory question concerning disclosure of direct corporate giving.
In order to measure manipulation of corporate foundation payins, I develop a model of expected payins in the absence of discretion. The model makes no assumptions about the motives for payouts other than that the level of payouts is exogenously determined by management and, thus, payins are discretionary with respect to timing, not amount. The discretionary payin measure equals the difference between actual payins and expected payins from the model. I predict that firms with reported earnings slightly above prior year earnings made lower discretionary payins (i.e., greater income-increasing behavior) than firms that just missed this benchmark. In addition, I predict that firms with reported earnings well above prior period earnings made income-decreasing discretionary payins, consistent with reserve creation. Furthermore, I predict that firms with high stock price sensitivity to earnings news, as measured by the length of a firm’s string of non-negative earnings changes through year t-1, will engage in these types of earnings management behaviors to a greater extent than less sensitive firms.
Empirical results are consistent with the above predictions. Firms appear to time foundation payins to meet or slightly beat prior year earnings, particularly when they have a strong equity market incentive to do so. Firms with small increases in earnings record lower discretionary contribution expense than firms with small decreases in earnings. In addition, my results provide evidence that firms with large increases in reported earnings make large discretionary payins to their foundations, creating cookie jar reserves.
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