The Role of the External Auditor in Managing Environmental, Social, and Governance Reputation Risk

Companies are under increasing pressure to manage their reputations on environmental, social, and governance (ESG) issues. Some companies have lost revenue, gone bankrupt, been boycotted by customers, or otherwise suffered a decline in value because of a negative reputation on ESG. We refer to the risk of this decline in value as ESG risk. Managing ESG risk, adequately informing investors of ESG risk, and increasing financial support for sustainable activities are primary concerns of public companies and their regulators. The U.S. Securities and Exchange Commission (SEC) and the European Commission recently issued public statements and taken actions toward achieving these goals. Our study asks whether external auditors (i.e., certified public accountants who attest to the reliability of a company’s financial statements) effectively help their clients manage ESG risk.

We expect auditors to help companies managing ESG risk. Auditors develop a deep understanding of their clients’ business risks, including ESG risk, as part of the financial statement audit. As public accountants, auditors have decades of theoretical and practical expertise and experience evaluating systems of internal control, qualifying them for a role even when non-audit firms provide some ESG-related advisory services. External auditors  are prohibited from providing advisory services to their audit clients because it would violate the independence rules in their profession’s code of conduct, but they can provide other pre-assurance and assurance work on ESG and sustainability reports issued by their audit clients.

Fees for this ESG-related work would be classified as non-audit services (NAS) on a company’s financial statements, but not all NAS fees relate to ESG work. So, to test whether companies are turning to their external auditors for help on  ESG risk, we develop a measure of heightened ESG risk based on negative ESG-related media coverage. As expected. we find a positive association between heightened ESG risk and NAS fees, after controlling for audit and other consulting fees and other potentially correlated variables.

To test whether external auditors are effective in managing ESG risk, we look at the interaction of heightened ESG risk and NAS fees on evidence of ESG risk-management effectiveness. We find ESG risk to be negatively associated with measures such as future (three-years out) operating performance, market value, and future ESG risk. Of primary interest to the study, however, is that the interaction of ESG risk and NAS fees is positive. That is, heightened ESG risk is associated with less negative firm outcomes when it occurs in conjunction with increased NAS fees, suggesting external auditors effectively help their clients manage ESG risk.

We are limited in our ability to establish causation due to the nature of archival data. However, we run robustness tests and additional analyses to try to rule out alternative explanations for our results, which we believe suggest an important pre-assurance or assurance role for the external auditor in enhancing the management of ESG risk.

In addition, we run subsample analyses to test whether our results vary in predictable ways. For example, if our association is driven by auditor expertise, then our results should be stronger for auditors with experience auditing companies in ESG-sensitive industries (e.g., oil and gas, cigarettes and tobacco products). As expected, we find that our results remain significant for the subsample of companies with office-level ESG-specialist auditors, but not for the subsample of non-specialists. Thus, the results appear to be driven primarily by external auditors with ESG industry expertise. Similarly, if auditors effectively help company management manage ESG risk, it is likely that active investors are aware of this. So, we look to see if our results are stronger for companies with a higher percentage of institutional shareholder ownership. We find that they are. Thus, the results appear to be driven primarily by those companies.

Finally, using financial statement restatements as a measure of audit quality, we find no evidence that the interaction of ESG risk and NAS fees impairs audit quality, suggesting auditors have been maintaining their independence while helping their clients manage ESG risk.

Our study shows further evidence supporting the importance of managing ESG risk. More research is needed to fully understand the role of the external auditor in managing and reporting on ESG risk, but our early (sample period of 2007-2014) evidence is consistent with the notion that auditors have developed expertise to help their clients respond to ESG risk in a way that positively effects firm value and other ESG risk management goals.

This post comes to us from professors Tamara A. Lambert and Bright Asante-Appiah at Lehigh University. It is based on their recent article, “The Role of the External Auditor in Managing Environmental, Social, and Governance Reputation Risk,” available here.

Leave a Reply

Your email address will not be published. Required fields are marked *