?What is the effect of sustainability performance on earnings management practices in UK companies

Abstract

Earnings management (EM) has been an important focus of research in accounting as it examines the strategies that firms use in order to manage the figures in their financial statements in order to meet the expectations of its stakeholders or the society in general (Almahrog et al., 2018). It is evident that EM can mask the real earnings of a firm, meaning that it alters the perception of the financial standing of a firm as per the investors, the regulators and all the interested stakeholders (Admati, 2017). With the increase in business frauds and accounting scams all over the world scholars and regulators have felt the need for knowing how firms have been involved in such scams and what measures could be taken to stop them. Among such factors, sustainability performance has been shown to become more significant in the last years, especially in the considerations concerning the environmental, social, and governance (ESG) qualitative aspects (Atan et al., 2016). The subject of ESG has recently been discussed by the stakeholders who demanded more information about the non-financial performance of companies. Sustainability performance requires that firms disclose information on the environmental impact, social responsibilities and control and management structures of the firm which is in conformity with the trend toward corporate sustainability and responsible business (Caputo et al., 2021). Scholars further suggest that the extent of sustainability transparency prompts firms to avoid unethical action likes earnings manipulation since they will be under pressure from investors, regulators, and the public. The significance of this topic increases with the current trend toward the sustainability and corporate social responsibility. This has been seen with concepts such as the United Nations Sustainable Development Goals, where firms globally have been forced to adopt sustainable business practices. As a result, there has been a growing emphasis on the part of the regulators and the standard-setting bodies on the formulation of frameworks that promote the provision of more disclosure of sustainability information. As influence from the European Union due to the directive on Non-financial Reporting many companies in UK are legally mandated to come up with the sustainability performances to balance financial and non-financial information disclosures. The research between sustainability practices and earnings management has hence emerged as an issue of interest, considering that while firms’ adoption of sustainability performance is encouraging, stakeholders understand if firms practicing sustainability performance are equally capable of maintaining ethical issues when providing financial reports such as the actual earnings. This study seeks to establish this relationship among non-financial organisations operating in the UK within the FTSE 350 index with using sustainability performances, analysed by ESG ratings, to assess the effects of earning management. This study is significant because the current literature has not answered the following question: to what extent does ethical and transparent reporting, such as sustainability performance, effectively reduce the agency problem and control for opportunistic managerial earnings management? It may help to shed more light for the political players, the regulators, the investors and the models of corporate governance and possibly may offer more insights towards addressing the right question required for determining the correct approach towards encouraging ethical behavior in the corporate world.