“I don’t think you can say, ‘I do my church stuff on Sunday between nine and noon, and the rest of the time I am either out for myself or running my business’. My faith influences how I think, what I do, what I say.” – this is a quote of Donnie Smith (CEO Tyson Foods) published in the Wall Street Journal. A phrase not likely to come from the mouth of an accounting manager in the first place. But his statement indicates that management decisions and religious social norms are more closely linked than commonly assumed. This is also shown in a new study published by Christian Hofmann and Nina Schwaiger. The TRR 266 researchers provide empirical evidence that the degree of religiousness in the corporate environment influences the extent to which managers practice tax avoidance and earnings management – directly and indirectly.
Social norms are an important moral compass. They affect how we behave in certain situations. They can help us gain more social recognition. Violating them in turn entails the cost of social disregard or even exclusion. But is this fact also transferable to decisions on financial reporting? Do norms have an impact on whether firms are more prone to avoid taxes and manage earnings?
Religion and crime: it’s all about the interrelations
We have investigated this question empirically, focussing on two different types of norms: religion and crime. Religion belongs to the injunctive norms. These refer to how we should behave. In other words, what behavior is approved or disapproved of by others. Crime, in turn, is one of the descriptive norms. These norms indicate how others actually behave in everyday life. So, while religious social norms prevent us from acting immorally as we fear social ostracism, a high crime rate in our environment can have the opposite effect as we, for example, have to fear less reputational loss.
We specifically focus on the interrelations between these two norms. It has been empirically proven that religiousness relates to crime rates. However, the effects of these two factors on financial reporting have so far only been considered independently. Thus, it remained unclear whether there is a direct relation between religious social norms and financial reporting decisions. Or an indirect one, which can be explained via the crime rate in the geographical environment of the firm.
Financial reporting: religion shows effect
Our answer to this question is clear: there is both a direct and indirect relation. Our results suggest that firms that are more exposed to religious social norms in their environment are less prone to avoid taxes and manage their earnings. The crime rate acts in part as a kind of mediator, especially when it comes to accrual-based earnings management. In this case, the lower crime rate makes that firms are less inclined to practice this form of earnings management. The lower crime rate, in turn, is a result of the greater religiousness in the geographical environment of the firm.
Interestingly, these firms engage less in real earnings management. A possible reason: accrual-based and real earnings management often act as substitutes. While real earnings management tends to reduce the long-term firm value, accrual-based earnings management is perceived as less ethically acceptable by managers. Thus, the more widespread crime, the lower are arguably the managers’ reputational cost when engaging in accrual-based earnings management, suggesting that managers will engage more in accrual-based earnings management and less in real earnings management. A direct correlation exists between religiousness and the tendency to avoid taxes. In this case, a higher degree of religiousness in the corporate environment leads to less firm-level tax avoidance.
Explaining and predicting firm behavior
Our results are particularly interesting for investors and regulatory authorities. We provide another important piece of the puzzle that helps explain and understand firm behavior: the role of norms. Our findings may also help with regulatory decisions.
Read the publication “Religion, crime, and financial reporting” by C. Hofmann and N. Schwaiger published in “Journal of Business Economics”.
To examine the research question, we collected data on religious adherence and crime measured at the German municipality level, covering 32,973 municipality-years observations. We measured religious adherence as the proportion of Christians, relative to the total population in a municipality. And we captured criminality as the natural logarithm of the number of all types of crime per 100,000 habitants, measured at the district level.
We have combined this data with data on tax avoidance and earning management at firm level.
The dataset covers the years 2011-2017, resulting in 1742 firm-year observations of German publicly listed firms drawn from Thomson Reuters Datastream regarding earnings management and 782 firm-year observations regarding tax avoidance.