Sustainability performance and earnings management: institutional and regulatory perspectives

Soeprajitno, Raden Roro Widya Ningtyas; Na’im, Ainun; Kusuma, Indra Wijaya; Rakhman, Fuad Article Sustainability performance and earnings management: institutional and regulatory perspectives Cogent Business & Management Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Soeprajitno, Raden Roro Widya Ningtyas; Na’im, Ainun; Kusuma, Indra Wijaya; Rakhman, Fuad (2024) : Sustainability performance and earnings management: institutional and regulatory perspectives, Cogent Business & Management, ISSN 2331-1975, Taylor & Francis, Abingdon, Vol. 11, Iss. 1, pp. 1-25, https://doi.org/10.1080/23311975.2024.2381663 This Version is available at: https://hdl.handle.net/10419/326451 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ Cogent Business & Management ISSN: 2331-1975 (Online) Journal homepage: www.tandfonline.com/journals/oabm20 Sustainability performance and earnings management: institutional and regulatory perspectives Raden Roro Widya Ningtyas Soeprajitno, Ainun Na’im, Indra Wijaya Kusuma & Fuad Rakhman To cite this article: Raden Roro Widya Ningtyas Soeprajitno, Ainun Na’im, Indra Wijaya Kusuma & Fuad Rakhman (2024) Sustainability performance and earnings management: institutional and regulatory perspectives, Cogent Business & Management, 11:1, 2381663, DOI: 10.1080/23311975.2024.2381663 To link to this article: https://doi.org/10.1080/23311975.2024.2381663 © 2024 The Author(s). Published by Informa UK Limited, trading as Taylor & Francis Group Published online: 31 Jul 2024. Submit your article to this journal Article views: 2741 View related articles View Crossmark data Citing articles: 2 View citing articles Full Terms & Conditions of access and use can be found at https://www.tandfonline.com/action/journalInformation?journalCode=oabm20 ACCOUNTING, CORPORATE GOVERNANCE & BUSINESS ETHICS | RESEARCH ARTIClE Cogent Business & ManageMent 2024, VoL. 11, no. 1, 2381663 Sustainability performance and earnings management: institutional and regulatory perspectives Raden Roro Widya Ningtyas Soeprajitno , Ainun Na’im , Indra Wijaya Kusuma and Fuad Rakhman Department of accountancy, Faculty of economics and Business, universitas gadjah Mada, Yogyakarta, indonesia ABSTRACT This study investigates the effect of companies’ sustainability performance on their future earnings management. Applying moral licensing theory, we predict that sustainability performance decreases accruals, while increases real earnings management. We analyse a dataset comprising of 47,186 firm-year observations from 44 countries during 2002–2021. We use a two-stage Heckman approach to address potential endogeneity and conduct supplementary fixed-effects regression tests for separate periods of before-after crisis and regulatory effectiveness, quality and enforcement. Our findings suggest that firms with superior sustainability performance have an impact on decreased (increased) accrual-based (real) earnings management. We also found a greater impact of sustainability initiatives by companies in countries with lower regulatory effectiveness, lower regulatory quality standards, and mandatory government regulation. This study is the first in encompassing SDGs practices through advanced testing, analysis and offering insights into the implications of government regulation on management decisions on earnings. Our research provides practical contributions for policymakers to evaluate ongoing efforts and development of corporate ESG-related policies as well as investors in using earnings information. 1. Introduction This research examines the effect of companies’ sustainability performance on their future earnings management under the moral licensing theory. This theory represents the concept of individuals behaving less responsibly in the future, as a result of their ethical actions in the past (Kouchaki, 2011). One real-life example is the Volkswagen diesel emissions scandal, involving emissions test cheating, which led to financial and environmental losses. Initially, the violation began with sustainability reporting highlighting efforts to green its fleet and gain stakeholder approval (Allam etal., 2020; Kuo etal., 2021; Zhang etal., 2021). In earnings management context, corporate managers may manipulate earnings to achieve profit targets by attributing their past ethical actions, namely sustainable performance. Thus, we argue that sustainable performance might be part of a strategic move by managers to bolster their reputation, credibility, and conceal their involvement in future earnings manipulation. Mutuc et al. (2020) explains that sustainable activities increase earnings management due to stakeholders’ pressure for high performance. Companies with high sustainability performance tend to make large investments (Goss & Roberts, 2011), which result in lower earnings and the inability to reach profit © 2024 the author(s). Published by informa uK Limited, trading as taylor & Francis group CONTACT ainun na’im [email protected].id Department of accountancy, Faculty of economics and Business, universitas gadjah Mada, Yogyakarta, indonesia. https://doi.org/10.1080/23311975.2024.2381663 this is an open access article distributed under the terms of the Creative Commons attribution License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited. the terms on which this article has been published allow the posting of the accepted Manuscript in a repository by the author(s) or with their consent. ARTICLE HISTORY Received 12 January 2024 Revised 16 April 2024 Accepted 13 July 2024 SUBJECTS Accounting; Management Accounting; International Accounting; Corporate Social Responsibility & Business Ethics; Business Ethics; Government; Business & Policy KEYWORDS Sustainability performance; earnings management; regulation; moral licensing and SDGs JEL CLASSIFICATION G30; G31; M40; M41; M42 REVIEWING EDITOR Collins Ntim, University of Southampton, United Kingdom of Great Britain and Northern Ireland 2 R. R. W. N. SOEPRAJITNO ETAl. targets (Zalata, Ntim, Aboud, et al., 2022). Furthermore, investments in sustainable performance take longer to yield returns (Brooks & Oikonomou, 2018; Qiu etal., 2016) which affect the stakeholders’ assessment of the companies’ performance. In such circumstances, stakeholders’ demand for performance and possibility of missed profit targets increase the incentives for managers to act opportunistically and to engage in earnings and accruals management (Abdelfattah & Elfeky, 2021; Buertey et al., 2020; Prior et al., 2008). On the other hand, Shi et al. (2022) argue that with sustainable activities, companies become more conservative or decrease earnings, because managers adopt a pro-social and transparent approach in their financial report disclosures. The managers hold a commitment to gaining long-term profits (Gaio etal., 2022), maintaining the credibility of information, and avoiding policies that could negatively impact their finances (Ahmad, Hayat, et al., 2023; Ehsan et al., 2022). Researchers believe that companies practicing corporate social responsibility (CSR) may be less inclined to engage in earnings manipulation because they prioritize the long-term needs of stakeholders (Ahmad, Subhan, et al., 2023). Therefore, despite uncertainties surrounding the direct effects of CSR practices on financial performance, managers seem to prioritize maintaining the company’s reputation and stability over the long term by ensuring transparency and integrity in their financial reporting, particularly in the context of earnings management. Similar dynamics are also reflected in the manipulation of real earnings, where managers have an incentive to manipulate real activities throughout the year to meet specific profit targets, before eventually resorting to accrual manipulation. Graham etal. (2005) indicate that managers have a greater incentive to engage in real-based earnings than accrual-based manipulation because accrual-based manipulation is more likely to attract the attention of auditors and regulators, compared to real-based manipulation. Alternatively, the company is more likely to be interested in applying both approaches of manipulation to control the high risk, rather than solely implementing accrual-earnings. This study utilizes ESG (Environmental, Social and Governance) scores to represent sustainability performance from Thomson Reuters and two measures of earnings management (accrual-based from Jones [1991] and Dechow et al. [1995]; and real-based from Roychowdhury [2006] and Kim et al. [2012]). The study analyzes a long-event period from 2002 to 2021, to capture earnings management trends in 44 selected countries. We employ a two-stage least squares (2SlS) Heckman test to address endogeneity issues, involving country-specific and firm-level factors, and document any crashes throughout the period. We verify the robustness of our main results using industry-year fixed effects regression in the same observation period, while also testing the relationship between accrual and real earnings management. For additional testing, we used three separate sustainability pillars against earnings management, as well as industry and year-based tests. This study is motivated by Ehsan et al. (2020) and lokuwaduge and Heenetigala (2017), who underline the importance of institutions inherent in each country such as government regulations and policies that affect corporate decisions. Specifically, this research analyzes whether government regulations and policies with regard to sustainability motivates managers to do earnings management, filling the gap in the literature of sustainability and earnings management. This research contributes empirically to the literature in several ways. First, this study acknowledges that the moral licensing theory has not been studied in the context of sustainability and earnings management, compared to the agency, legitimacy, or stakeholder theories. Nevertheless, we find compelling arguments to explain managerial behavior in ethical strategic decisions concerning sustainability performance and earnings management. Therefore, this research borrows from the psychological theory to elucidate the relationship between sustainability reporting practices and earnings management. Second, recent studies have recommended future research that focusses on the practices of SDG adopters (Sofian et al., 2022) and regulatory roles (Santos-Jaén et al., 2021). More specifically, this study capitalizes on the research gap to gain insights into variations in regulatory levels, the effectiveness of their implementation, and the existence of mandatory government disclosure policies for ESG. Thus, this research provides a new perspective through cross-country, long-period studies for shaping future research endeavours. Third, this study aims to contribute by providing empirical evidence through an appropriate approach and established statistical sophistication, following Ehsan et al. (2022) recommendation concerning endogeneity issues arising from reverse causality and potential selection bias. Fourth, this study provides robustness tests and model sensitivity, as well as the separate utilization of ESG measurement COGENT BUSINESS & MANAGEMENT 3 components that offer a more detailed explanation of the relationships. Finally, this study provides practical contributions by recommending government regulatory involvement to standardize companies’ reporting activities. While this involvement may be well-intentioned, it is limiting and its reliance on generally accepted practices makes sustainability activities costly and difficult to internalize. Ultimately, this situation incentivizes companies to engage in misleading earnings manipulation practices, due to information opacity. The remainder of this article is structured as follows: the second part reviews the relevant literature regarding the development of the sustainability performance concept. The third part presents explanations about the perspectives of moral licensing as well as how earnings management is interpreted in this research. Fourth, it contains the development of hypotheses, followed by the research design, and then continues with empirical results and discussion. In the final section, we conclude with the conclusion, limitations, and recommendations from this study. 2. Sustainability performance reform The term ‘sustainability’ originates from the concept of sustainable development as defined in the 1987 United Nations report ‘Our Common Future’. ‘Sustainable’ refers to how current needs can be met without compromising the ability of future generations to meet their own needs. The United Nations identifies three main pillars of sustainability, namely, economic, environmental, and social, in the term ‘triple bottom line’. In its evolution, companies can adopt the concept of sustainability that aligns with development goals (Chih etal., 2008). Initially, the concept of sustainability in business was primarily expressed through corporate social responsibility (CSR) as a form of social initiative, charity, and community project. However, a shift in strategy has led companies to integrate ESG as a commitment to consistent sustainable actions aligned with the values of SDGs. The goal is not only to fulfil the sustainable development responsibilities outlined, but also to meet the needs of the company, current stakeholders, and those of the future. This study specifically uses ‘ESG’ measurements to represent sustainability performance in response to the popularly evolving term. We concur with löw and Cordovez (2023), that there is a definitional difference between CSR, ESG, and sustainability, but they are communicated somewhat synonymously in some studies. For us, ESG represents how a company operates sustainably, based on the three main pillars, and is a broader measurement than CSR (Gillan et al., 2021). The Sustainability Accounting Standards Board (SASB) also states that sustainability relates to measuring environmental, social, and governance aspects to create long-term value. We also understand that the ESG framework is not a direct embodiment of the sustainability concept. Nevertheless, ESG facilitates measurement, risk and opportunity identification (Murata & Hamori, 2021), as well as improving transparency and reporting accountability (Sachs etal., 2022). Consequently, ESG also communicates non-financial information while maintaining good relationships and trust with stakeholders, investors, regulators, and the public (Friede et al., 2015). The development of ESG is not just a trend but is also recognized by investors as a business concept that can become a common standard in investment (Chinn etal., 2021; Murata & Hamori, 2021). Therefore, the ESG topic is not only of interest to companies but also provides a space for researchers and academics to fill gaps and make advancements. This study is interested in examining the motives and behaviors of companies engaging in sustainability activities as a strategic management action within the realm of ethics. 3.Theoretical literature review 3.1. Moral licensing perspective Hockerts (2015) simplifies the idea that the cognitive theory, when applied to corporate social responsibility, is related to the expectation of an increase in sustainability exposure that influences the mental framework of society. This theory apply social psychology to explain how individuals process information based on previous experiences (Fiske & Taylor, 2013; Reed, 2012). Bansal and Roth (2000) emphasize that cognitive structures in sustainable performance have a one-way relationship with their motivations. 4 R. R. W. N. SOEPRAJITNO ETAl. Companies with higher sustainability performance should have strong intrinsic and extrinsic motives, that leads to both more competitive and more ethical. The cognitive theory’s use to explain the effect of the sustainability issues with earnings management is viewed as the moral aspect of corporate management, otherwise known as the moral licensing behavior, as explained by moral licencing theory. In this context, we examine the effect of sustainability performance on earnings management in the future to support the moral licensing theory. Moral licensing is behavior when individuals who initially behave morally may display immoral behavior in the future (Merritt etal., 2010). They argue that their good deeds provide a sense of moral security for themselves. In this context, companies increase their sustainability activities with the motive of obtaining a license, building a reputation, and sending positive signals to maintain stakeholder relationships, thereby concealing their manipulative behavior. For individuals who have behaved poorly, gaining a moral license before their wrongdoing can mitigate any damage to their personal reputations and promote forgiveness, thus limiting the potential harmful effects of their poor behavior and enhancing their attractiveness (Klotz & Bolino, 2013; Wang & Chan, 2019). Once the prerequisite for moral credit exists, some leaders are susceptible to the bias that this moral credit can be exchanged, or offset, against future transgressions. Ormiston and Wong, (2013) argue that leaders who consider themselves morally licensed may feel exempt from responsibility, thereby influencing an organization’s social responsibility practices and substantially worsening its performance. These perspectives can complement the analysis of the motives behind management’s behavior, involving how managers base strategic decisions on other decisions. 3.2. Earnings management: ethical or unethical? McKee (2005) questioned the line between ethical and unethical earnings management, assuming that there is no clear distinction between the two. Grasso etal. (2009) considered that a higher level of earnings management is unethical practices. However, earlier research, (for example, Bruns and Merchant [1990]) which surveyed 649 managers, found that no respondents truly saw earnings management as either ethical or unethical behavior. Rosenzweig and Fischer (1994) adopted a questionnaire from Bruns and Merchant (1990) involving two manipulations: Accounting manipulations (such as recording expenses at the wrong time) and operational decision manipulations (such as delaying operational decisions or offering terms to pull sales from the upcoming year to the current year). The study revealed that accountants are more sensitive to accounting manipulations than operational manipulations. However, despite operational manipulations are not being governed by explicit standards, this does not make them more ethical than accounting manipulations. This strengthens the argument brought by Bruns and Merchant (1990) that essentially earnings management practices can obscure information, mislead users of financial reports, and undermine the credibility of the accounting data itself. These impacts can lead to inaccurate assessments of a company’s financial health and influence the decisions made by its stakeholders. Due to its impact, earnings management contradicts significant ethical standards in the field of management accounting and cannot be overlooked. From the stakeholders’ perspective, earnings management is associated with a tendency toward unethical behavior (Barghathi et al., 2020). Their study’s results also indicate that earnings management will only be approved, on average, by stakeholders if it is congruent with the interests of others and is intended for the benefit of the company. In their findings, stakeholders may view earnings management as an ethical practice, but it must still adhere to generally accepted accounting principles and applicable laws. In contrast to the stakeholders, non-stakeholder perspectives are not influenced by the intention to benefit the company, and therefore, earnings management is considered unethical behavior. The reason is that non-stakeholders receive a distorted financial information, which can mislead their decisions. Based on the explanation above, the support for earnings management as unethical behavior, irrespective of its intentions, strengthens our argument in this case. Therefore, our study does not distinguish or identify specific conditions that could transform an unethical perspective into an ethical one. This study further interprets earnings management solely as unethical management behavior. COGENT BUSINESS & MANAGEMENT 5 4. Hypotheses development 4.1. Sustainability performance and earnings management This study examines the relationship between a company’s sustainable performance and earnings management in the future, using the perspective of moral licensing. In the context of accrual earnings management, managers have discretion over accrual recognition, accounting policies, and changes to manipulate earnings (Adut et al., 2013; Dechow et al., 1995; Healy, 1985). Managers who incorporate sustainability activities into their operations will have higher moral values, reputations, and credibility in the eyes of stakeholders and the public. Therefore, managers prioritizing their personal interests will credit their current performance to secure an improved future reputation and credibility (Habbash & Haddad, 2019), by choosing to build sustainable performance. Managers with positive sustainable performance typically face more demands to meet targets, due to the associated costs of ESG’s implementation. Thus, managers have a greater incentive to report higher earnings to achieve performance targets (Abdelfattah & Elfeky, 2021; Buertey et al., 2020; Mutuc et al., 2020) and secure their bonuses (Healy, 1985). Additionally, another consequence of past credibility is that companies can successfully mask earnings management practices and find it easier to gain understanding, forgiveness, and leniency from stakeholders. Borralho et al. (2022) used data from companies listed on the French and Spanish stock exchanges from 2009 to 2019 to investigate whether companies strategically use ESG to compensate for earnings management practices. Their findings confirm this, and also indicate that ESG activities carried out by companies allow for the diversion of stakeholder attention from non-standard reporting procedures. This is in line with Jian etal. (2023) and Jordaan etal. (2018), who suggest that social responsibility practices ultimately become opportunistic when managers use them as reputation insurance to offset the negative impacts of specific mistakes, or divert attention from unethical actions. Therefore, companies tend to engage in earnings management to conceal their issues (Chih et al., 2008) and hide their dishonesty behind sustainable activities to achieve a form of licensing (Shi et al., 2022). Conversely, Ehsan et al. (2022) examined the relationship between CSR and earnings management in the context of manufacturing companies in Pakistan, as a developing economy. They documented a negative relationship between the two, supporting the idea that committed companies benefit in the long term and avoid policies with distorting effects on their accounts. Furthermore, managers are highly motivated to avoid suspicion from stakeholders, because it carries the risk of losing reporting credibility in the published information. This compels companies to secure future performance targets by considering the economic conditions and external factors, to avoid excessive public scrutiny, and exercise caution in their accounting and audit practices (Choi etal., 2013; Kim etal., 2012). This study reinforces the opportunistic argument about the possibility of accrual earnings practices being motivated by sustainability activities. However, material accrual management may attract the attention of auditors and regulators (Graham et al., 2005), and result in greater risks for managers. Thus, managers tend to restrict their accrual-based earnings management. On another perspective, Roychowdhury’s research (2006) shows that managers may manipulate real earnings to avoid reporting losses using various activities such as implementing price discounts to temporarily boost sales, overproduction to report lower cost of goods sold, and reducing discretionary expenses to enhance reporting margins. Extending Roychowdhury (2006), this study examines the real (operational based) earnings management in the context of moral licensing phenomena, so that managers tend to manage earnings after getting the sustainability performance. With two ways to do earnings management: accruals vs real earnings management, how management selects, or combines the approaches? Graham et al. (2005) explain that real-based activities are given more consideration than accrual-based activities, because accrual-based activities are more likely to attract the attention of auditors and regulators compared to real-based activities. Moreover, companies relying solely on accrual manipulation carry a disproportionately higher risk. This argument is further strengthened by Zalata, Ntim, Alsohagy, et al. (2022), who explains that real-based earnings management is less likely to be detected compared to accruals. Zang (2012) explicates the conditions under which managers use less (more) accrual-based manipulation, if real manipulation activities during the year turn out to be unexpectedly high (low). He concludes that managers make trade-offs in profit manipulation, where the choice of using accrual becomes a strategic decision stemming from the adjustment process for the results of manipulating real activities during the year. Zang’s findings lead to the assumption that, to some extents companies will resort to 6 R. R. W. N. SOEPRAJITNO ETAl. real earnings management to avoid getting too involved in risky accrual activities. Elleuch Hamza and Kortas (2019) tested the relationship between accrual and real earnings management in the specific context of weak regulatory environments, finding that they not only fulfil a complementary but also exhibit a substitutive explanation between accrual vs real earnings management. This study adopts the complementary logic to explain the relationship between accrual and real earnings, as described by Graham etal. (2005), due to the generality that conform with this study. Building on the accrual hypothesis, real-based earnings should take the opposite side, being positively influenced by sustainability performance. Therefore, we propose the following hypothesis: H1: Companies with higher sustainable performance tend to report upward (downward) real-based (accruals-based) earnings management. 5. Research design 5.1. Sample and data This study focused on adopting the time frame from 2002 to 2021 to observe companies’ sustainability performance regarding earnings management behavior in the future (t + 1). We utilized an extended period to capture managerial behavioral trends and past motivations, incorporating institutional effects and government regulatory forces. This study also controlled for the relevant effects of the adoption of IFRS (International Financial Reporting Standards) in enhancing corporate transparency and the impact of the global development strategy, the Sustainable Development Goals (SDGs). To achieve the objectives, we collected 47,186 firm-year observations (unbalanced data) from 44 countries as the final sample (see Table 1, Panel A for the sample selection process). We present a detailed distribution of the sample based on country (Panel B) and industry and year (Panel C). Panel B: sample Distribution by Country no Country of exchange total no Country of exchange total 1 argentina 169 23 Malaysia 334 2 australia 2530 24 Mexico 336 3 austria 209 25 Morocco 13 4 Belgium 377 26 netherlands 456 5 Brazil 77 27 new Zealand 287 6 Canada 2085 28 norway 429 7 Chile 246 29 oman 24 8 China 2277 30 Peru 125 9 Colombia 86 31 Philippines 87 10 Denmark 419 32 Poland 192 11 Finland 450 33 Portugal 96 12 France 1290 34 Qatar 90 13 germany 1581 35 Russia 295 14 greece 172 36 singapore 163 15 Hong Kong 2094 37 south africa 689 16 Hungary 41 38 spain 505 17 india 637 39 sweden 1283 18 indonesia 105 40 switzerland 961 19 italy 487 41 thailand 81 20 Japan 4243 42 turkey 130 21 Korea; Republic (s. Korea) 1135 43 united Kingdom 3102 22 Kuwait 41 44 united states of america 16,757 total 47,186 table 1 Panel B reports the distribution sample by country and year from 44 countries of 47,772 observation firm-year. Table 1. sample selection and sample distributions. Panel a: sample selection process selection criteria observations initial observations—companies that have an esg score on thomson Reuters in period 2002–2021. 54,557 excluded: Companies with missing data or incomplete information about all the variables used. (7,005) Companies from conflict countries and samples with less than 10 observations (366) Final observations 47,186 this table reports the sample selection for the period 2002–2021 and the industry breakdown of the sample firms. Panel a reports the selection of the firm-year observations to answer the hypotheses in this study. (Continued) COGENT BUSINESS & MANAGEMENT 7 Panel C: sample Distribution by industry or Year Based on industry Code and name of industry total Based on Year of observation total [11] agriculture, Forestry, Fishing, and Hunting 237 2002 402 [21] Mining, Quarrying, and oil and gas extraction 3575 2003 421 [22] utilities 671 2004 769 [23] Construction 2021 2005 908 [31-33] Manufacturing 19,981 2006 999 [42] Wholesale trade 1520 2007 1130 [44 - 45] Retail trade 3482 2008 1370 [48 - 49] transportation and Warehousing 1562 2009 1574 [51] information 3939 2010 1576 [52] Finance and insurance 2411 2011 1728 [53] Real estate and Rental and Leasing 1645 2012 1824 [54] Professional, scientific, and technical services 2891 2013 1928 [55] Management of Companies and enterprises 10 2014 2034 [56] administrative and support and Waste Management and Remediation services 963 2015 2658 [61] educational services 217 2016 3171 [62] Health Care and social assistance 621 2017 3790 [71] arts, entertainment, and Recreation 307 2018 4439 [72] accommodation and Food services 931 2019 5266 [81] other services 202 2020 5867 2021 5332 total 47,186 total 47,186 table 1 Panel C reports distribution sample by two-digit code from the north american industry Classification system (naiCs) on the left side and year period (2002–2021) on the right side. The entirety of the company-level data utilized the Thomson Reuters database, while the national-level data made use of full access from the World Bank, the Sustainable Development Report, and the Principles for Responsible Investment Report. 5.2. Model for testing the hypotheses To test the hypothesis, this study estimated cross-country equations using two-stage least squares (2SlS). This estimation was used to address endogeneity issues in the relationship between ESG and earnings management, as well as any unobservable heterogeneity that varied across companies but remained constant over time (Greene, 2003). Choi et al. (2018), Kyaw et al. (2017) and Pathak & Gupta (2022) highlight concerns about endogeneity issues stemming from the use of CSR as an exogenous variable. First, managerial policy considerations regarding the commitment to ESG could be influenced by overall policies or other internal factors, leading to non-random sample selection and creating sample selection bias. Second, issues of simultaneity are inevitable due to the possibility of simultaneous decision-making by managers regarding the selection of ESG and earnings management. In other literature, endogeneity problems arise due to the presence of reverse causality, which adds complexity to determining the direction of the CSR-EM relationship (e.g, Abdelfattah and Elfeky [2021], Almahrog etal. [2018], Borralho etal. [2022], Ehsan etal. [2022], Ehsan et al. [2020], Faisal etal. [2018], Kim etal. [2019], liu et al. [2017], and Palacios-Manzano etal. [2021]). Based on the licensing theory, there is a possibility that moral behavior in the present affects future occurrences, and it could also be that future occurrences influence present behavior. These are interrelated as long as managers can plan their strategies accordingly. This study incorporated the use of instrumental variables in the Heckman 2SlS estimation, namely (1) lagged ESG (ESGit-1) and (2) probability of ESG (ProbESG) concerning the endogenous variable. In the first stage, this study conducted a probit regression for each instrumental variable with respect to the endogenous variable, with the following equation. Table 1. Continued. 14 R. R. W. N. SOEPRAJITNO ETAl. Panel B. Fixed effect Regression esgt on earnings Managementt+1 Without High Regulated industry earnings management Accrual-based earnings management Real-based earnings management (1) (2) (3) (4) (5) (6) Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.114*** −0.034*** 0.046*** 0.057*** 0.050*** 0.059*** (-16.29) (-3.46) (18.14) (17.90) (20.46) (19.83) Control Variable Included Yes Yes Yes Yes Yes Yes Industry Fixed Effect Yes Yes Yes Yes Yes Yes Year Fixed Effect Yes Yes Yes Yes Yes Yes _cons 0.062** 0.272*** 0.787*** 1.184*** 0.644*** 1.024*** (2.15) (7.32) (50.71) (61.06) (42.60) (56.18) F 131.269 112.350 428.004 626.160 340.038 565.972 r2 0.069 0.047 0.335 0.378 0.335 0.385 r2_a 0.068 0.046 0.334 0.378 0.334 0.384 N44,104 44,104 44,104 44,104 44,104 44,104 the table displays t-test results, denoted as. *t > 1.645. **t > 1.960. ***t > 2.326, indicating significance at 10%, 5%, and 1% levels, respectively. Panel C. Fixed effect Regression—Relational of Real-based on accrual-based earnings Management accrual-based earnings Management Jonesit + 1 Mdf. Jones it + 1 (1) (2) (3) (4) (5) (6) (7) (8) CFoit + 1 −0.393*** −0.084*** (−17.23) (−2.95) PRoDit + 1 −0.276*** −0.071*** Table 4. Fixed effect regression. Panel a. Fixed effect Regression esgt on earnings Managementt+1 earnings management accrual-based earnings management Real-based earnings management (1) (2) (3) (4) (5) (6) Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.116*** −0.049*** 0.044*** 0.055*** 0.048*** 0.057*** (-17.24) (-5.18) (17.89) (17.80) (20.26) (19.74) goVjt −0.025*** −0.127*** s0.002 −0.001 0.004** 0.000 (-4.59) (-15.58) (0.85) (-0.49) (2.23) (0.22) Reg_Qualityjt 0.032*** 0.137*** −0.008*** −0.008*** −0.010*** −0.009*** (7.05) (20.12) (-4.90) (-3.74) (-7.08) (-5.06) gDPgrowthjt 0.267*** 1.165*** −0.022 −0.008 −0.052** −0.033 (4.09) (12.18) (-0.90) (-0.26) (-2.37) (-1.13) sDgjt −0.008 −0.016*** −0.017*** −0.023*** −0.017*** −0.022*** (-1.61) (-2.66) (-7.16) (-7.02) (-7.78) (-7.40) iFRsjt 0.018*** −0.070*** 0.008*** 0.012*** 0.008*** 0.012*** (8.10) (-23.40) (8.94) (9.73) (10.57) (11.02) FiRMsiZeit −0.001 −0.011*** −0.037*** −0.055*** −0.031*** −0.047*** (-0.55) (-6.70) (-52.34) (-62.73) (-44.03) (-57.22) LeVit −0.132*** −0.016** 0.104*** 0.141*** 0.108*** 0.141*** (-22.27) (-2.18) (37.37) (41.21) (39.05) (42.90) Roait −0.047** −0.142*** 0.028** 0.056*** 0.053*** 0.071*** (-2.04) (-5.24) (2.10) (3.58) (3.82) (4.56) Lossit 0.014*** 0.012*** −0.002 0.002 −0.001 0.003 (4.28) (2.79) (-1.38) (1.19) (-0.89) (1.33) RD_intensityit −0.002 −0.037*** 0.016*** 0.023*** 0.014*** 0.020*** (-0.56) (-8.57) (10.72) (11.72) (10.08) (11.67) Industry Fixed Effect Yes Yes Yes Yes Yes Yes Year Fixed Effect Yes Yes Yes Yes Yes Yes _cons 0.050* 0.245*** 0.778*** 1.170*** 0.634*** 1.011*** (1.82) (6.90) (51.57) (62.11) (43.25) (57.04) F 139.277 120.028 451.039 660.329 356.147 594.061 r2 0.070 0.045 0.332 0.377 0.329 0.382 r2_a 0.069 0.044 0.332 0.376 0.329 0.381 N47,186 47,186 47,186 47,186 47,186 47,186 the table displays t-test results, denoted as. *t > 1.645. **t > 1.960. ***t > 2.326, indicating significance at 10%, 5%, and 1% levels, respectively. (Continued) COGENT BUSINESS & MANAGEMENT 15 Panel C. Fixed effect Regression—Relational of Real-based on accrual-based earnings Management accrual-based earnings Management Jonesit + 1 Mdf. Jones it + 1 (1) (2) (3) (4) (5) (6) (7) (8) (−17.52) (−3.76) DiseXPit + 1 −0.462*** −0.121*** (−17.75) (−3.67) ReMit + 1 −0.329*** −0.090*** (−18.00) (−4.02) goVjt −0.015*** −0.016*** −0.014*** −0.016*** −0.123*** −0.123*** −0.123*** −0.123*** (−2.81) (−2.95) (−2.68) (−2.93) (−15.06) (−15.08) (−15.05) (−15.08) Reg_Qualityjt 0.018*** 0.019*** 0.017*** 0.018*** 0.131*** 0.131*** 0.131*** 0.131*** (4.02) (4.17) (3.76) (4.05) (19.37) (19.38) (19.33) (19.36) gDPgrowthjt 0.336*** 0.344*** 0.317*** 0.333*** 1.199*** 1.200*** 1.193*** 1.196*** (5.25) (5.35) (4.97) (5.19) (12.68) (12.68) (12.62) (12.65) sDgjt −0.019*** −0.019*** −0.020*** −0.020*** −0.020*** −0.020*** −0.021*** −0.021*** (−3.96) (−3.92) (−4.11) (−4.05) (−3.27) (−3.30) (−3.34) (−3.34) iFRsjt 0.018*** 0.018*** 0.019*** 0.019*** −0.070*** −0.070*** −0.070*** −0.070*** (8.25) (8.27) (8.69) (8.63) (−23.83) (−23.79) (−23.72) (−23.72) FiRMsiZeit −0.022*** −0.023*** −0.022*** −0.023*** −0.018*** −0.018*** −0.018*** −0.019*** (−20.51) (−21.18) (−20.50) (−21.76) (−12.83) (−13.47) (−13.56) (−13.84) LeVit −0.105*** −0.107*** −0.095*** −0.099*** −0.014* −0.012* −0.009 −0.009 (−18.31) (−18.85) (−16.82) (−17.66) (−1.94) (−1.75) (−1.29) (−1.37) Roait −0.056*** −0.052** −0.042* −0.043** −0.150*** −0.148*** −0.145*** −0.145*** (−2.58) (−2.38) (−1.95) (−2.00) (−5.55) (−5.49) (−5.40) (−5.40) Lossit 0.015*** 0.016*** 0.015*** 0.016*** 0.013*** 0.013*** 0.013*** 0.013*** (4.60) (5.06) (4.69) (5.13) (2.91) (2.99) (2.91) (3.00) RD_intensityit 0.002 0.002 0.002 0.002 −0.037*** −0.036*** −0.036*** −0.036*** (0.67) (0.65) (0.76) (0.87) (−8.53) (−8.46) (−8.43) (−8.39) Industry Fixed Effect Yes Yes Yes Yes Yes Yes Yes Yes Year Fixed Effect Yes Yes Yes Yes Yes Yes Yes Yes _cons 0.478*** 0.497*** 0.459*** 0.503*** 0.367*** 0.384*** 0.376*** 0.391*** (19.53) (20.22) (19.39) (20.73) (11.62) (12.18) (12.22) (12.49) F 157.350 158.871 156.889 159.008 116.029 116.414 116.299 116.540 r20.083 0.080 0.086 0.083 0.045 0.045 0.046 0.046 r2_a 0.082 0.079 0.085 0.082 0.044 0.044 0.045 0.044 N47,186 47,186 47,186 47,186 47,186 47,186 47,186 47,186 the table displays t-test results, denoted as. *t > 1.645. **t > 1.960. ***t > 2.326, indicating significance at 10%, 5%, and 1% levels, respectively. Table 4, Panel B, reports the results of testing by excluding samples from highly regulated industries (e.g., the finance and insurance industries, and utilities). Companies in strictly regulated sectors tend to have limited flexibility in managing earnings. Therefore, this research addressed concerns about potential bias in results influenced by sample characteristics. Surprisingly, by excluding highly regulated industries that are expected to face higher institutional pressures, our results remained consistent. Hence, the findings with our main sample provided confidence and robustness. In empirical terms, we conducted separate tests to prove whether real-based earnings and accrual-based earnings were indeed complementary, thereby offering a linear explanation consistent with our main test. The results in Table 4, Panel C confirm that real-based earnings had a negative effect on accruals, indicating contrasting management strategies. 6.3. Additional analysis 6.3.1. 3 Pillars of ESG We conducted separate tests based on the three main pillars of ESG, to determine whether the sustainability performance components contributed equally to building the combined score. Borralho et al. (2022) and Block & Wagner (2014) provided evidence from their findings that the three ESG pillars make different contributions, and therefore, it is worthwhile to conduct separate testing. In this section, we maintained the 2SlS Heckman approach to mitigate the risk of inherent endogeneity in each model, with the performance probabilities of each as instrumental variables. The results using lagged ESG were similar, so we have not presented them here. Table 4. Continued. 16 R. R. W. N. SOEPRAJITNO ETAl. Table 5, panels A, B, and C present the results of the testing of the environmental, social, and governance pillars on earnings management. The impact coefficients varied among pillars, with the environmental aspect exerting significant influence, consistent with the emphasis on ‘environmental justice’ in ESG, driving earnings activities (Abdul-Rashid et al., 2017). Conversely, governance showed minimal impact, aligning with findings except for Mdf. Jones. Notably, the environmental pillar strongly influences earnings management, thus emphasizing its significance (Revinitiv, 2022). The social dimension, bridging environmental and governance influences, notably involved stakeholders, fostering sustainable corporate governance and collaboration (Rajesh, 2020). Overall, the study highlighted how all pillars motivate firms towards earnings manipulation within sustainability contexts, emphasizing their independent roles. 6.3.2. Phenomena based on the year of the crisis occurrence and industry Over an extended period, we have been pondering whether managers formulated different strategies when operating in the periods before the global economic crisis (2002–2007), during the crisis (2008 and Table 5. 2sLs Heckman for 3 pillar of esg. First stage second stage accrual-based earnings management real-based earnings management (1) (2) (3) (4) (5) (6) (7) N = 47,186 denvit Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 Panel a. environment Pillar Instrumental Variable: Probenv 3.630*** (23.33) envPillarscoreit −0.090*** −0.055*** 0.041*** 0.052*** 0.045*** 0.054*** (−18.60) (−7.98) (22.84) (21.94) (27.26) (25.29) MiLLs −0.183*** −0.203*** 0.129*** 0.199*** 0.098*** 0.171*** (−11.80) (−9.14) (22.43) (26.14) (18.60) (24.90) _cons −12.708*** 1.543*** 1.927*** −0.315*** −0.529*** −0.190*** −0.438*** (−48.88) (11.22) (9.76) (−6.18) (−7.82) (−4.05) (−7.19) r2 0.073 0.048 0.344 0.390 0.339 0.395 r2_a 0.072 0.047 0.343 0.389 0.339 0.394 r2_p 0.202 Panel B. social Pillar Instrumental Variable: Probsocial 4.759*** (16.69) socialPillarscoreit −0.085*** −0.034*** 0.033*** 0.040*** 0.036*** 0.042*** (−16.74) (−4.64) (17.37) (16.19) (20.95) (18.88) MiLLs −0.155*** −0.143*** 0.133*** 0.203*** 0.105*** 0.175*** (−8.27) (−5.32) (19.09) (21.95) (16.33) (21.02) _cons −11.558*** 1.144*** 1.278*** −0.205*** −0.334*** −0.139*** −0.284*** (−46.78) (8.18) (6.37) (−3.95) (−4.83) (−2.89) (−4.56) r2 0.070 0.046 0.383 0.333 0.070 0.387 r2_a 0.069 0.045 0.382 0.332 0.069 0.386 r2_p 0.154 Panel C. governance Pillar Instrumental Variable: Probgovernance 4.603*** (11.65) governancePillarscoreit −0.054*** −0.057*** 0.011*** 0.011*** 0.013*** 0.013*** (−10.63) (−7.83) (5.79) (4.61) (7.62) (5.73) MiLLs −0.806*** −0.748*** 0.958*** 1.371*** 0.830*** 1.225*** (−13.09) (−8.48) (42.41) (45.77) (39.75) (45.33) _cons −7.702*** 3.730*** 3.607*** −3.582*** −5.067*** −3.150*** −4.564*** (−29.83) (13.43) (9.07) (−35.13) (−37.48) (−33.42) (−37.43) r2 0.068 0.048 0.353 0.399 0.345 0.403 r2_a 0.067 0.047 0.352 0.399 0.344 0.402 r2_p 0.054 Notes. the first-stage probit regression models test the instrument variable (Probenv, Probsocial, Probgovernance) against the dummy variable of each pillar values suspected to be endogenous, which are then documented in MiLLs. the second-stage hypothesis testing includes MiLLs to capture potential bias and overcome any endogeneity problem. the testing includes industry and year fixed effects, spanning the period 2002–2021. Z-statistics are in parentheses. significance at *10%, **5%, and ***1%, denoted as *z > 1.645, **z > 1.960, ***z > 2.326. COGENT BUSINESS & MANAGEMENT 17 2009), after the crisis (2010–2019), and during the pandemic (2020 and 2021). Would the relationship between ESG and earnings management differ? Table 6, Panel A–D presents the results of robust industry-fixed effect regressions for these periods. The managerial strategies displayed consistency throughout the observation period, maintaining a balance between sustainability efforts and unavoidable earnings manipulation. However, the most pronounced impact of ESG on earnings management emerged post-2008 global crisis, marked by severe economic downturns, currency devaluation, and stock index collapses. This period witnessed firms leveraging regulatory and investor backing, using enhanced ESG transparency as a communication tactic to signify meeting profit targets amidst recovery efforts. We present fixed effect regression, based on industry, for all measurements in Appendix C. 6.3.3. Different perspectives based on regulation and the role of government in ESG This study takes into account the institutional characteristics inherent to each country, in response to a research call by Ehsan et al. (2020). lokuwaduge & Heenetigala (2017) emphasize the significance of regulations in influencing corporate decisions to implement ESG. Hence, it becomes intriguing to analyze whether there are differences for those operating in settings above or below the average regulatory environment. To be more specific, Jordaan et al. (2018) found that national-level institutional factors, such as the legal environment in which companies operate, play a crucial role in explaining the relationship between CSR and earnings management. Therefore, this study conducts a differentiated analysis at the country level, to gain insights into the role of regulations and government involvement in promoting ESG activities that stimulate earnings management. Table 7, panels A and B concentrate on evaluating the role of government effectiveness, policy credibility, and regulatory quality in influencing management reactions within ESG and earnings management contexts. The study establishes a connection between the government’s policy formulation and implementation effectiveness, the credibility of its commitments, and the quality of regulations, illustrating their impact on companies engaged in ESG and earnings management practices. The results reveal Table 6. Fixed effect regression based on crash period by year. Panel a Before global economics Crisis (2002–2007) N = 4625 Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.096*** −0.065** 0.028*** 0.030*** 0.035*** 0.036*** (-4.67) (-2.16) (5.68) (5.25) (7.29) (6.55) _cons 0.375** 0.233 0.827*** 1.152*** 0.681*** 0.996*** (2.04) (1.05) (8.94) (10.14) (7.28) (8.91) r2 0.101 0.187 0.623 0.688 0.617 0.689 r2_a 0.090 0.177 0.619 0.684 0.612 0.685 Panel B. During global economics Crisis (2008–009) N = 2944 Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.116*** −0.076** 0.026*** 0.032*** 0.029*** 0.034*** (-4.39) (-1.97) (4.16) (4.38) (4.80) (4.78) _cons −0.034 0.079 0.662*** 1.007*** 0.555*** 0.881*** (-0.15) (0.29) (7.29) (9.36) (6.26) (8.57) r2 0.101 0.068 0.657 0.716 0.660 0.720 r2_a 0.078 0.045 0.648 0.709 0.652 0.713 Panel C. after economics Crisis (2010–2019) N = 28,414 Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.136*** −0.094*** 0.044*** 0.054*** 0.048*** 0.056*** (-15.64) (-7.44) (15.71) (15.64) (17.45) (17.30) _cons −0.050 0.105* 0.819*** 1.225*** 0.654*** 1.046*** (-1.21) (1.92) (46.20) (55.47) (37.71) (50.52) r2 0.087 0.106 0.483 0.542 0.480 0.549 r2_a 0.085 0.104 0.482 0.541 0.479 0.548 Panel D. During global Pandemic Covid-19 (2020–2021) N = 11,199 Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 esgit −0.104*** −0.093*** 0.031*** 0.042*** 0.033*** 0.042*** (-6.88) (-4.71) (4.13) (4.21) (4.87) (4.68) _cons 0.326*** 0.575*** 0.384*** 0.623*** 0.305***s 0.534*** (3.84) (4.86) (9.88) (11.67) (9.00) (11.44) r2 0.067 0.084 0.117 0.134 0.116 0.137 r2_a 0.061 0.078 0.111 0.128 0.110 0.132 each model in panel includes control variable, industry and year fixed effect. the table displays t-test results, denoted as *t > 1.645, **t > 1.960, ***t > 2.326, indicating significance at 10%, 5%, and 1% levels, respectively. 18 R. R. W. N. SOEPRAJITNO ETAl. that companies implementing ESG are involved in both accrual reduction and real earnings increase under varying regulatory settings (high and low). Notably, the study underscores that the magnitude and strength of the coefficients, as well as the influence level (significance and t-value) between ESG and earnings, are more substantial in countries with lower government effectiveness and regulatory quality, while a diminished influence is observed in countries with higher effectiveness and regulatory quality. This contributes to a more comprehensive understanding of the intricate relationship between government policies, ESG practices, and earnings management across diverse regulatory environments. The examination unveils insights into how companies respond to regulations in implementing ESG, indicating an indirect correlation between high regulatory quality, rule of law (Naz & Sheikh, 2023), Table 7. Different perspective based on regulation and the role of government in esg. earnings management accrual-based earnings management Real-based earnings management (1) (2) (3) (4) (5) (6) Jonesit+1 Mdf. Jonesit+1 CFoit+1 PRoDit+1 DiseXPit+1 ReMit+1 Panel a. High government effectiveness n = 23,400 esgit −0.075*** −0.040*** 0.018*** 0.022*** 0.020*** 0.023*** (−10.23) (−4.77) (6.81) (6.24) (8.02) (7.17) _cons 0.026 0.039 0.690*** 1.060*** 0.518*** 0.882*** (0.62) (0.82) (32.26) (38.94) (25.30) (34.90) r2 0.093 0.051 0.282 0.318 0.224 0.296 r2_a 0.091 0.049 0.281 0.316 0.223 0.294 Low government effectiveness n = 23,786 esgit −0.131*** −0.092*** 0.051*** 0.064*** 0.055*** 0.066*** (−12.40) (−5.78) (13.07) (13.16) (14.63) (14.45) _cons 0.011 0.316*** 0.801*** 1.184*** 0.683*** 1.044*** (0.27) (5.51) (35.17) (41.55) (31.05) (39.02) r2 0.076 0.071 0.398 0.444 0.416 0.461 r2_a 0.074 0.069 0.397 0.443 0.415 0.460 Panel B. High Regulation Quality n = 23,264 esgit −0.067*** −0.053*** 0.005** 0.005 0.005*** 0.005* (−9.75) (−7.72) (2.00) (1.54) (2.58) (1.92) _cons 0.151*** 0.146*** 0.512*** 0.835*** 0.342*** 0.664*** (4.67) (4.35) (32.08) (37.86) (24.84) (34.94) r2 0.099 0.034 0.288 0.308 0.245 0.295 r2_a 0.097 0.032 0.286 0.307 0.244 0.293 Low Regulation Quality N = 23,921 esgit −0.130*** −0.079*** 0.047*** 0.060*** 0.052*** 0.062*** (−12.45) (−4.99) (12.80) (12.90) (14.46) (14.26) _cons −0.029 0.266*** 0.831*** 1.221*** 0.713*** 1.080*** (−0.68) (4.71) (36.16) (42.83) (31.91) (40.11) r2 0.076 0.072 0.429 0.478 0.445 0.494 r2_a 0.074 0.071 0.428 0.477 0.444 0.493 Panel C government imposed Corporate esg Disclosure (Mandatory) N = 39,197 esgit −0.113*** −0.011 0.043*** 0.056*** 0.047*** 0.058*** (−15.26) (−1.02) (16.84) (17.15) (19.11) (19.00) _cons 0.083*** 0.308*** 0.742*** 1.130*** 0.596*** 0.970*** (2.88) (8.17) (48.96) (59.05) (40.64) (54.27) r2 0.061 0.058 0.288 0.329 0.272 0.326 r2_a 0.060 0.056 0.287 0.328 0.271 0.325 government imposed Corporate esg Disclosure (Voluntary/others) N = 7,989 esgit −0.098*** −0.117*** 0.040*** 0.045*** 0.045*** 0.048*** (−5.92) (−5.55) (5.77) (5.30) (6.80) (6.08) _cons −0.021 0.095 0.885*** 1.269*** 0.769*** 1.127*** s (−0.26) (1.03) (16.69) (20.08) (14.71) (18.51) r2 0.172 0.097 0.503 0.565 0.522 0.583 r2_a 0.167 0.091 0.500 0.562 0.519 0.581 Control Variable Yes Yes Yes Yes Yes Yes Industry Fixed Effect Yes Yes Yes Yes Yes Yes Year Fixed Effect Yes Yes Yes Yes Yes Yes each model in panel includes control variable, industry and year fixed effect. the table displays t-test results, denoted as *t > 1.645, **t > 1.960, ***t > 2.326, indicating significance at 10%, 5%, and 1% levels, respectively. COGENT BUSINESS & MANAGEMENT 19 political stability (Gu etal., 2022), and reduced CSR investment. This reduction aligns with efforts to align interests between companies and governments, using CSR as a tool for information transfer, political risk mitigation, and conflict reduction amidst imperfect legal oversight. This elucidates the link between high ESG implementation under low regulatory settings and subsequent earnings management. Additionally, our analysis echoes Doh et al.’s (2017) explanation that lower regulations lead to difficulty internalizing values, resulting in higher transaction costs. In contexts of low effectiveness and quality, high ESG incurs elevated costs, possibly incentivizing profit manipulation or seeking stakeholder recognition. This aligns with the rationale of our primary testing and the perspective on licensing. Contrasting results in Table 7, Panel C highlight government involvement in regulating ESG reporting, documented in the Principles for Responsible Investment (2016) report. The report identifies that 38 of the world’s 50 largest economies have or are developing government guidelines for ESG disclosure. Under both high and low government involvement, the study demonstrates how ESG affects earnings management, particularly under mandatory regulation, where higher ESG performance leads to significant impact coefficients for earnings manipulation, except for Mdf. Jones. This exploitation of better ESG performance in justifying earnings manipulation resonates with the correlation observed between responsible investment regulations, enhanced ESG risk management, and subsequent economic gains for companies as highlighted by the UN PRI (2016). 7. Conclusion, limitations and recommendation This study examines whether companies’ sustainable performance affects future accrual and real-based earnings management. We used a sample of 47,186 firm-years from 44 countries that met the criteria for the extended periods from 2002 to 2021. The study found evidence that companies with high sustainable performance tend to decrease (increase) accrual-based (real-based) future earnings management, in line with the perspective of moral licensing theory. Separate moral explanations for accrual earnings (as opposed to real earnings) indicate that managers tend to be more conservative, but this does not imply that managers are committed to ethical behavior. Conversely, companies may exhibit aggressiveness in real earnings, reflecting managers’ attempts to surpass targets, responding to pressure, and meeting stakeholder demands. The accruals vs. real earnings explanations indicate that management compensates for excessively high real-based by reducing their accrual-based earnings management. We conducted robust tests to address inefficient estimates with industry-year fixed-effect regression and excluded highly regulated industries. We also test the three pillars of ESG separately; split the sample based on crisis phenomena; industry; and natures of regulation (government effectiveness, regulatory quality standards, and regulatory enforcement). This study concludes that while all pillars of environmental, social, and governance (ESG) have varying impacts on earnings management, the environmental aspect significantly exerts a significant influence, emphasizing its crucial role in driving earnings activities within sustainability contexts. Our analysis also reveals that managerial strategies remain consistent over various economic periods, with companies balancing sustainability efforts and earnings manipulation, although the most significant impact of ESG on earnings management occurred after the 2008 global crisis, characterized by companies using enhanced ESG transparency as a communication tactic amidst recovery efforts. The impact coefficient of ESG’s influence on earnings management is greater and stronger under lower government effectiveness, and lower regulatory quality standards. Conversely, a greater and stronger impact of ESG on earnings manipulation is evident in countries where the government mandates the regulation of ESG. Our overall findings lead to the conclusion that ESG and earnings management are inseparable, and deduced from moral licensing theory, are viewed as unethical behavior in the implementation of sustainability strategies. In this study, we are limited to using ESG scores compiled by Thomson Reuters as the primary database, thus neglecting other measurements of ESG. Another limitation is that this study does not capture the relationship between ESG and earnings with country-fixed effect when testing (due to variable prioritization in the model), which may offer insights into different cultures and characteristics. Future research should consider other measurements of ESG and evaluate the impact and consequences in each country to provide more comprehensive explanations about the ESG and earnings management phenomena. 20 R. R. W. N. SOEPRAJITNO ETAl. This study empirically contributes to literature in the several ways. First, this study applies moral licensing theory adding to predominant theories such as such as agency, legitimacy, or stakeholder theories to explain managerial behavior in ethical strategic decisions concerning sustainability performance and earnings management. We present compelling arguments that shed light on this aspect, filling the gap by incorporating insights from psychological behavior theory to elucidate the effect of sustainability reporting practices on earnings management. Second, recent studies have recommended the expansion of future research, including a focus on the practices of SDG adopters (Sofian et al., 2022), and institutional characteristics and regulatory roles (Santos-Jaén et al., 2021). Building upon these recommendations, this study capitalizes on the research gap to gain insights into the variations in regulatory effectiveness, quality as well as the extent government mandate copanies’ ESG practices. By design this research provides a new perspective through cross-country and long-periods data to analyze the effect regulatory issues on the effect of sustainability performance and earnings management. Third, this study conducts statistical testing to respond Ehsan etal. (2022) recommendations concerning endogeneity issues arising from reverse causality and potential selection bias in the sample that have been overlooked. In addition, robustness tests and model sensitivity, as well as the separate utilization of ESG measurement components, offer a more detailed explanation to sustainability performance and earnings management issues. These methodological approaches enhance the reliability and validity of our findings, thereby strengthening the overall contribution of this research to the literature on sustainability reporting and earnings management practices. Finally, our findings have crucial practical implications. We underscore the role of the government as a provider of ESG-related policies that may be challenging to internalize due to regulatory uniformity. Our recommendations differ from those of Bermejo Climent etal. (2021), who emphasize the importance of homogeneous ESG standards in portfolio performance contexts. However, we agree with Tran, Beddewela, and Ntim (2021), who question the effectiveness of legislative approaches in corporate reporting engagement. We express concerns that standardized regulations could lead to resource damage, decreased industry competitiveness, and reduced stakeholders’ information capacity. Moreover, the high implementation costs may burden companies in developing countries. We advocate for policymakers to adopt a gradual and tailored approach before moving toward standardization. Researchers believe that companies practicing corporate social responsibility (CSR) may be less inclined to engage in earnings manipulation because they prioritize the long-term needs of stakeholders (Ahmad, Subhan, et al. 2023). This study provides different explanation that managers inclined to manage earnings. This difference may occur due to regulatory environment and stakeholder pressure on management to achieve profit targets, compensation, and efforts to maintain company reputation are done by relying on excessive disclosure of environmental, social, and governance. Our findings also highlight a similar issue regarding the importance of holistic management strategies in facing regulatory and policy challenges, as discussed in Ahmad etal. (2024). These findings also hold practical implications for company management strategies. Managers must conduct thorough assessments of the financial implications of adhering to such regulations and plan their financial resources accordingly. Moreover, they may need to explore alternative, cost-effective implementation methods while ensuring adherence to regulatory standards. Our findings also highlight a similar issue regarding the importance of holistic management strategies in facing regulatory and policy challenges, as discussed in Ahmad etal. (2024). The results of the study may also provide information for investors in resource allocation decisions based on earnings information. Since earnings are managed, in this case as part of companies’ sustainability strategy, investors need to consider the quality of (managed) earnings information in determining the value of the firms for investment decisions. Author contributions Conceptualization and idea, RRWNS and AN; Methodology, RRWNS, IKW, FR, AN; running and analysis data, RRWNS and FR; Writing and original Draft Preparation, RRWNS; Writing – review and editing, AN, IKW, FR; Supervisor, AN. All authors have read and agreed to the published version of the manuscript. COGENT BUSINESS & MANAGEMENT 21 Disclosure statement No potential conflict of interest was reported by the author(s). About the authors Raden Roro Widya Ningtyas Soeprajitno holds a Bachelor of Accountancy (2020) from Universitas Airlangga, Indonesia. She is currently a doctoral student in accounting at Universitas Gadjah Mada, enrolled in the Master’s Education Program leading to a Doctorate for Outstanding Undergraduates (PMDSU). Her research interests include management accounting, corporate reporting, textual analysis, governance, and government regulation. Ainun Na’im is a Professor of Accounting at the Department of Accounting Universitas Gadjah Mada. He has extensive experiences as a financial executive and currently sits as member of supervisory board of Indonesian Institute of Chartered Accountant. He does research in the area of sustainability, decision making, governance and management control. Indra Wijaya Kusuma is a professor in accounting at Universitas Gadjah Mada. He earned his PhD in Accounting from Kent State University (1998). His current research interests are Financial Accounting and Capital Markets, Sustainability Reports, and International Accounting. Fuad Rakhman is an Associate Professor at the Department of Accounting, Universitas Gadjah Mada. He earned his PhD in Accounting from Oklahoma State University, USA. Currently, his work primarily focuses on the public sector. For example, he investigates the determinants of financial reporting quality in the public sector and how human capital affects the quality of financial reporting among local governments in Indonesia. He also examines the effect of term limits on elected government offices on the behavior of mayors (i.e., local government leaders), especially on how they allocate and implement budgets. Funding This study was supported and funded by the Ministry of Education, Culture, Research and Technology; the Republic of Indonesia under the scheme of PMDSU, contract number: 2179/UN1/DITlIT/Dit-lit/PT.01.03/2023; 3843/UN1/ DITlIT/Dit-lit/PT.01.03/2023. ORCID Raden Roro Widya Ningtyas Soeprajitno http://orcid.org/0000-0001-5003-1030 Ainun Na’im http://orcid.org/0009-0008-0772-8826 Indra Wijaya Kusuma http://orcid.org/0000-0003-3360-8007 Fuad Rakhman http://orcid.org/0000-0003-4813-2689 Data availability statement The data supporting this study’s findings are available on request from the first author [RRWNS] or Correspondance author [AN]. References Abdelfattah, T., & Elfeky, M. (2021). Earnings management, corporate social responsibility and governance structure: Further evidence from Egypt. International Journal of Accounting, Auditing and Performance Evaluation, 17(1/2), 173. https://doi.org/10.1504/IJAAPE.2021.117576 Abdul-Rashid, S. H., Sakundarini, N., Raja Ghazilla, R. A., & Thurasamy, R. (2017). The impact of sustainable manufacturing practices on sustainability performance: Empirical evidence from Malaysia. 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