In recent decades, the business world has undergone a significant paradigm shift. What began as largely voluntary corporate social responsibility (CSR) initiatives has evolved into a comprehensive framework of environmental, social, and governance (ESG) metrics. As demand for these metrics has increased, rating agencies now routinely assign ESG scores intended to capture firms’ ESG performance.
ESG policies are currently under fire from lawmakers, but ESG ratings have long attracted skepticism. Do high ESG scores reflect high-quality, reliable financial reporting, or do they function as a smokescreen that diverts attention from weak business performance?
In a new article, we explore this question and investigate whether companies use ESG ratings strategically to mask subpar financial performance. The concern is twofold: first, that “bad” companies might over-invest in ESG activities to conceal business failures; and second, that an excessive focus on ESG might drain resources from financial reporting and internal audits.
To address these concerns, we examine the relationship between a firm’s ESG ratings and the quality of its financial reporting. Our study encompasses U.S.-listed firms from 2012 to 2022, using MSCI ESG ratings. The final sample comprises 2,807 firms and 16,191 firm-year observations.
To measure financial reporting quality, we use two widely recognized proxies:
- Earnings Persistence: the extent to which current earnings predict future earnings.
- Earnings Predictability of Future Cash Flows: the ability of earnings to predict future cash flows.
Our findings are clear. High ESG ratings do not come at the expense of financial reporting quality. On the contrary, we observe a significant positive relationship between higher ESG scores, earnings persistence, and the ability of earnings to predict cash flows. In other words, firms with robust ESG performance tend to report their financial results more reliably. ESG performance appears to signal a management culture that values transparency and financial accountability.
The Social Pillar Effect
Most studies treat ESG as a monolithic score. Our article contributes to the literature by disaggregating the ESG rating into its three pillars – environmental (E), social (S), and governance (G) – to examine their individual effects on financial reporting quality. The results are surprising.
While all three pillars are positively related to financial reporting quality, the social pillar exhibits the strongest and most consistent relationship. This result challenges the conventional assumption that the governance pillar should be the primary driver of reporting quality, given its focus on compliance and formal internal controls.
We also examine the impact of the 2019 Business Roundtable Statement on the Purpose of a Corporation, which marked a shift from shareholder primacy toward a broader stakeholder-oriented approach. We find that the positive relationship between each of the ESG pillars and reporting quality strengthened following the statement, with the social pillar showing the most pronounced improvement. This suggests that as ESG considerations became more salient in corporate discourse, they also became more tightly integrated into the company processes that improve financial reporting.
The explanation lies in what the social pillar actually measures. Social performance captures human capital management, employee relations, workplace practices, and corporate culture. These factors directly influence the people and processes responsible for producing, reviewing, and validating financial information. In this sense, the social pillar reflects not abstract values, but the everyday company behaviors that sustain reliable financial reporting.
This finding has important implications for institutional investors that tend to down play the social pillar despite the centrality of reporting quality to investment decisions. A recent study on investment considerations found that only 2% of institutional investors viewed the social pillar as the most important ESG component. Simultaneously, however, 57% of these same investors prioritize financial reporting quality in their decision-making. Our results suggest a clear mismatch: Investors who care about reporting reliability should attribute significantly more weight to the social pillar, as it appears to be a key predictor of that very reliability.
Conclusion
The key takeaway is that ESG rating should not be treated as a black box. Aggregated ESG scores risk obscuring the component most closely associated with financial reporting reliability. Our findings support a disaggregated, pillar-specific approach to ESG analysis, especially one that takes social performance seriously.
The public debate surrounding ESG has become increasingly politicized, yet our empirical evidence tells a different story. Companies with higher ESG ratings do not exploit these ratings to divert attention from subpar financial performance. Investing in environmental, social, and governance activities is not only a public relations tool aimed at attracting conscientious investors, but also part of a broader management approach that fosters financial transparency and accountability. In an era of growing global uncertainty, ESG ratings, especially the social pillar, offer investors a valuable tool for risk management and assessing a firm’s financial reporting reliability.
Dov Solomon is a professor of law at the College of Law and Business; Rimona Palas is an associate professor and head of the Accounting Department at the College of Law and Business; Dalit Gafni is an associate professor and Dean of the School of Economics at the College of Management; and Ido Baum is an associate professor of law at the College of Management. This post is based on their recent article, “ESG Ratings and Financial Reporting Quality: Why Social Performance Matters,” available here.