Managerial Efficiency, Corporate Social Performance, and Corporate Financial Performance

The Principles for Responsible Investment is the international network of CSR investment signatories cofounded by the European Commission and supported by the United Nations. Currently, more than 1300 signatories are involved in CSR investment. See http://​www.​unpri.​org for information on CSR investment.

Unlike CSR, which refers to a firm’s programs or investment regarding social issues, CSP represents the overall quality of such CSR-related investments as judged by a third-party rating agency or organization in lieu of stakeholders’ assessments, because each stakeholder has a limit to accessing and evaluating the full range of CSR activities. In addition, in contrast to CSR’s nature as a one-time commitment, CSP is cumulative and composed of continual CSR investment (Barnett 2007).

The score is published by the end of each calendar year by the third party based on the observations and collections of performance data independent of individual firms. Each area of the KLD score is composed of strength elements and concerns scores, and the net score of these positive and negative scores is used in similar studies. For example, in the environment area, the aspects measured for the positive aspects are the use of a pollution prevention program, a recycling procedure, and deployment of clean energy. If a company uses equipment or has instituted a program to prevent pollution but the company does not have a recycling procedure or use recycled material or a clean energy source, the score will be 1 for the environment. For the negative aspects, such as generating hazardous waste; having problems in regulatory compliance; and producing ozone-depleting chemicals, substantial emissions, and agriculturally toxic chemicals, the same company can score 2 by paying fines for the noncomplying emission control problem. Then, an overall environment CSP score for this company will be −1 (1–2). The KLD score stacks all scores from the seven areas. The full description of the seven areas and area-specific measures are provided in “Appendix”.

Peters and Taylor (2017) demonstrate that this measure is better to incorporate intangible investments in firm value than the traditional Tobin’s Q.

Corporate governance is another important intermediary that affects the relationship between CSP and corporate financial performance. As stated in Hong et al. (2016), if managers use CSR to maximize all stakeholders’ value, corporate governance is likely to promote CSR and thus improve corporate financial performance. On the other hand, if managers’ engagement in CSR is an agency cost, corporate governance is likely to reduce CSR activities. In this study, we do not directly test the role of corporate governance because of our interest in managerial efficiency. However, we conduct a sensitivity test by using a separate independent variable of the governance KLD score from our main variable of CSP. Untabulated results indicate that results based on the new measure of CSP (excluding governance score) are consistent with our main findings.

It is worth noting that we use the term “limited resource” to refer the firm’s general and fundamental economic situation in which a firm has fewer resources to fill all (unlimited) needs from the firm’s stakeholders (i.e., economic scarcity). Therefore, the term limited resource does not necessarily mean a firm’s financial constraint, which indicates a firm’s situation facing high costs of external financing (or a shortage of internal funding), or a firm’s financial distress indicating a difficulty to pay off a firm’s financial obligation.

The response from managers to the regulation can vary according to how managerial discretion is exercised. If a firm chooses a minimum level of environmental CSR investments up to the expected penalties or fines on the non-compliance, the benefits (i.e., saving penalties or fines) from this CSR can be offset with the cost of CSR (i.e., investment on CSR), resulting in zero profit. Likewise, if a manager voluntarily chooses higher environmental standards than the regulated ones, the costs of the environment-related CSR exceed the potential direct benefits.

We refer to the optimal level in the context of economic optimality that marginal benefits are equal to marginal costs. Since the economic marginal benefit from pure altruism is likely to lower than economic marginal costs of such CSR, the CSR investment rooted in pure altruism leads to sub-optimal investment.

Outcomes that are similar to those from altruistic incentives can be caused by management entrenchment, too. For example, Johnston (2005) argues that managers use CSR to greenwash unethical choices that firms make or to hide poor financial performance. Furthermore, in line with agency theory, top managers’ inflated self-confidence due to hubris may drive them to underestimate strategic need but to overestimate the resources in their hands to promote their own empire building (Malmendier and Tate 2005). Similarly, CSR motivated by management entrenchment will result in an inefficient management of resources such that even with high CSP, there will be a negative influence on the CSP–CFP relation.

The insurance effects of CSR refer to a case in which CSR activities can mitigate or reduce the impact of the occurrence of a negative event. For example, building a good reputation via long-term CSR engagement (i.e., insurance premium) can mitigate the decrease in stock price (i.e., insurance coverage) when the firm announces bad news (e.g., the SEC’s investigation of securities fraud).

An alternative proxy of CFP is stock return (or cumulated abnormal return) regarding the report of the KLD CSR score. While change in stock price can be a good indicator for both current financial performance and future nonfinancial performance, we use Total Q rather than stock returns or any short-term window abnormal returns because stock returns without a clear event window provide a “noise” indicator. Unlike an accounting earnings announcement, KLD does not provide any specific announcement date, so it is difficult to match a relevant testing returns window.

While we adopt the lag-lead testing approach to clarify the causal relationship between managerial efficiency and CSP (and corporate financial performance), there is still a potential endogeneity issue when able managers engage in CSR activities. We conduct additional tests using a two-stage regression model to control for potential endogeneity. In the first-stage regression, we obtain a predictive value of CSP and use it in the second-stage regression on corporate financial performance. The untabulated results are qualitatively consistent with our main findings.

We also add the KZ index (Kaplan and Zingales 1997) as a proxy of financial constraint to a set of control variables. The KZ index is based on the following five factor model:where Cash flow is the sum of operating income (data item IB) and depreciation (data item DP) scaled by beginning balance of property, plant, and equipment (data item PPENT); Q is Tobin’s Q measured as the sum of [assets (data item AT)—book value of common equity (data item CEQ)—deferred tax (data item TXDB) + market value of equity (data item CSHO * data item PRCC_F)] scaled by book value of common equity (data item CEQ); LEV is long-term debt ratio measured as the sum of [short-term debt (data item DLTT) + long-term debt (data item DLC)] scaled by the sum of [short-term debt (data item DLTT) + long-term debt (data item DLC) + stockholders’ equity (data item SEQ)] (if stockholders’ equity is negative, we set LEV equal to 1); DIV is dividend payment for common stock and preferred stock shareholders (data item DVP + data item DVC) scaled by beginning balance of property, plant, and equipment (data item PPENT); Cash holding is measured as cash (data item CH) scaled by beginning balance of property, plant, and equipment (data item PPENT). Larger (smaller) values of KZ Index correspond to higher (lower) levels of financial constraints. Untabulated results of this robust test show that our main findings are not sensitive to the additional variable of financial constraint.

The untabulated mean (median) value of a firm’s efficiency from the whole sample from 2003 to 2011 is 0.587 (0.608). The managerial efficiency data are available at Professor Sarah McVay’s website (http://​faculty.​washington.​edu/​smcvay/​research.​html).

For the robustness of our tests, we used a ranked score of CSP. Untabulated results show that the results based on the ranked variable of CSP are consistent with those based on the raw value of CSP.

Following Clogg et al. (1995), we use the following Z-statistics to test whether the coefficients are the same between the two partitioned groups:

\(Z = \frac{{(\hat{\beta }_{\text{HighME}} - \hat{\beta }_{\text{LowME}} )}}{{\sqrt {s^{2} (\hat{\beta }_{\text{HighME}} ) + s^{2} (\hat{\beta }_{\text{LowhE}} )} }},\)

where \(\hat{\beta }_{\text{HighME}}\) and \(\hat{\beta }_{\text{LowME}}\) are coefficient estimates from the two subsamples and \(s^{2} \left( {} \right)\) are the squared standard errors of the coefficients.