Adoption of CSR and Sustainability Reporting Standards: Economic Analysis and Review

Hans Bonde Christensen is Professor of Accounting at the University of Chicago Booth School of Business; Luzi Hail is Professor of Accounting at the Wharton School of the University of Pennsylvania; and Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business. This post is based on their recent paper.

Sustainability and Corporate Social Responsibility (CSR) have become important to many corporations and the majority of large firms today voluntarily provide reports on their CSR initiatives, risks, and activities. However, because there are no commonly agreed upon (or mandatory) CSR reporting standards there is substantial heterogeneity in CSR disclosures. This heterogeneity makes it difficult for the various stakeholders to use and compare CSR information and may prevent firms from reaping the full benefits of their CSR activities. In the paper Adoption of CSR and Sustainability Reporting Standards: Economic Analysis and Review, we draw on a broad set of literatures to analyze and evaluate the likely consequences of a mandate that would require U.S. publicly listed firms to adopt a common set of CSR reporting standards.

Specifically, the paper (i) discusses insights from extant literature in accounting, finance, management, and economics that are relevant for an assessment of the economic effects of CSR reporting; (ii) reviews the key determinants and the current state of CSR reporting; (iii) discusses potential effects of mandatory CSR reporting standards for important stakeholders such as investors, lenders, analysts and the media, consumers, employees, but also for society at large; (iv) outlines firm responses and real effects from mandatory CSR reporting standards; and (v) considers important implementation issues for an effective CSR reporting mandate. Considering that CSR and CSR reporting have become hot topics for many practitioners and academics, we also outline important questions and unresolved issues, and point to avenues for future research based on our review of the literature.

What Extant Literature Tells Us

To the extent that firms’ CSR disclosures provide new information that is relevant to capital market participants, much of the existing literature in accounting, finance, and economics on the effects of corporate disclosure and reporting applies. This literature suggests that more and better (CSR) information can benefit capital markets through greater liquidity, lower cost of capital, and better capital allocation. In addition, corporate disclosures can have real effects on firms’ own operations and activities. Such real effects seem particularly relevant in a CSR context as one of the goals of CSR reporting could be exactly to influence firms’ CSR activities and policies in a certain way. Real effects are more likely to follow from reporting mandates than from voluntary disclosures. This insight implies that a CSR reporting mandate can lead to intended as well as unintended consequences for a firm’s (CSR) activities, which are not always beneficial from an investors’ or societal perspective.

Prior literature also shows that corporate disclosures involve proprietary and litigation costs. Proprietary costs can be relevant for CSR reporting; they mainly arise when (CSR) disclosures are specific and detailed as well as for smaller firms. The relation between disclosure and litigation risk is nuanced and depends on the disclosure type, news content, and on insiders’ trading behavior. From the international financial reporting literature, we can infer that the role of standards in harmonizing reporting practices is limited, particularly when managerial reporting incentives differ across firms (and countries). This insight should equally apply to mandatory CSR reporting. Moreover, it points to a crucial role that the reporting infrastructure and the relevant enforcement mechanisms play when implementing CSR standards.

Current State of CSR Reporting

Our review of the CSR literature and of CSR reporting practices by U.S. firms shows that there is substantial variation in CSR disclosures. While this evidence could be viewed as suggesting a need for harmonization and CSR standards, the observed variation likely also reflects heterogeneity in firms’ business activities, in the decision usefulness of these activities for firms (and their investors) and in firms’ perceived costs and benefits of providing CSR information to outside stakeholders. In light of this heterogeneity, harmonizing CSR standards alone is unlikely to lead to harmonized CSR reporting practices.

Many of the individual determinants of voluntary CSR reporting shown in the literature are similar to the factors found to be related to voluntary financial reporting. This result suggests that there exists substantial commonality in the economic forces that drive the two sets of disclosure choices (and makes it difficult to separate them empirically).

How CSR Reporting Standards May Affect Investors and the Many Other Stakeholders

We conclude based on reviewing the extant literature that CSR reporting standards have the potential to improve information to investors and other stakeholders. The magnitude of the capital-market effects from a CSR reporting mandate depends, among other things, on the extent to which firms currently withhold material CSR information that, in principle, represents required disclosure under existing securities laws (e.g., Regulation S-K or Section 1502 of the Dodd-Frank Act). If firms largely comply with extant regulations, then CSR standards should not produce much new information for investors and the primary benefits must come from standardization, benchmarking, and cost savings.

If compliance is rather low, as some evidence suggests, and a reporting mandate is able to force out new or better CSR information, then capital markets should respond as theory predicts, for example, in the form of improved liquidity, lower costs of capital, and higher asset prices. At the same time, more transparency can increase proprietary costs and evoke heightened scrutiny by investors, analysts, or the general public. Thus, the net effects of a CSR reporting mandate are not a priori obvious or necessarily beneficial for investors.

We also point out that a large number of stakeholders other than investors have a legitimate interest in firms’ CSR activities and could benefit from improved CSR reporting (e.g., consumers, employees, and society more broadly). CSR standards are likely most useful to these stakeholders, who typically have more of an arms’ length, passive relationship with firms.

How CSR Reporting Standards May Affect the Reporting Firms

We expect that firms respond to a CSR reporting mandate by making changes to their business operations, including their CSR activities. The literature suggests that firms generally respond by expanding and adjusting their CSR activities, and that better governance, more societal or stakeholder pressure as well as peer and/or benchmarking effects are the main explanations for these real effects.

With a reporting mandate, we also expect managers to scale back on CSR activities that are not in shareholders’ best interest, reducing agency problems. In addition, mandatory CSR reporting could make it easier for influential stakeholder groups to exert pressure on firms to address externalities and to implement specific operational or strategic changes. While such real effects are often intended, it is also possible that unintended consequences arise and that certain (harmful) CSR activities simply shift abroad or to private (unregulated) firms, if the mandate unilaterally applies to U.S. public firms.

Implementation Issues of Mandatory CSR Reporting

We identify the following important implementation issues for an effective CSR reporting mandate: (i) the CSR standard setting process, (ii) materiality of CSR disclosures, (iii) the use of boilerplate language as avoidance tool, and (iv) enforcement or assurance of CSR reporting. The process of setting CSR standards is likely shaped by societal, political, and moral debates about the CSR topics themselves (over and above the typical economic arguments that dominate the debate over financial reporting standards). As a result, the usefulness of CSR standards to investors could be limited.

The materiality of CSR information can be defined using the same principles as for traditional financial disclosures but determining “what” is material to “whom” is more difficult. At the core of the problem is the observation that the empirical link between CSR activities and financial performance is tenuous, yet central to the definition of materiality (e.g., with the information needs of investors in mind). Because investors have preferences for non-monetary CSR issues and other stakeholders care about specific CSR issues and—by doing so—can affect firm performance, the scope of materiality for CSR disclosures is likely broad.

The issue of boilerplate language highlights the difficulty of forcing firms to provide meaningful CSR information. CSR standards can play a role in reducing boilerplate language by prescribing what and how firms have to provide information but only if the standards are specific enough (e.g., require specific metrics or numerical disclosures). However, specificity also means that the standards do not necessarily fit all firms but are a poor fit for some, potentially reducing the information content of the disclosures.

Finally, credible enforcement plays a major role if a widespread CSR reporting mandate is to have substantive economic effects. To achieve this goal and shape managers’ reporting incentives in the intended direction requires substantial investments in the enforcement infrastructure and in human expertise. A combination of private assurance with public enforcement is most likely to succeed in a securities market setting with few and sometimes large private corporations and many individual investors with limited resources.

Overall, the effectiveness of mandatory CSR reporting hinges crucially on carefully addressing these implementation issues.

The complete paper is available for download here.

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