Socially Responsible Firms Demand High-Quality Audits

Socially responsible firms pay more for the external audits of their financial statements, thereby lowering risks to investors. But those lower risks also mean lower returns for investors.

The increased popularity of sustainable investment strategies has led to changes in cash flows – raising the cost of capital of companies with poor environmental, social and governance (ESG) scores and lowering it for companies with good ESG scores. That has led to changes in the behavior of corporations, increasing their engagement in corporate social responsibility (CSR) as they seek lower costs of capital or face a competitive disadvantage. In addition, companies are seeking to reduce the risks of negative events that lead to heightened risks of lawsuits (e.g., over environmental incidents and discrimination) and consumer boycotts. Companies have also recognized that “doing good” not only improves their reputation but leads to attracting employees who desire to work for companies acting responsibly, enhancing employee satisfaction and, in turn, productivity – and the profitability of the company. Those behaviors are leading to positive feedback loops.

The increased popularity of sustainable investing has also been accompanied by a rise in research into the subject. Asif Saeed, Ammar Ali Gull, Asad Ali Rind, Muhammad Shujaat Mubarik and Muhammad Shahbaz, authors of the study, “Do Socially Responsible Firms Demand High-Quality Audits? An International Evidence,” published in the October 2020 issue of the International Journal of Finance and Economics, investigated whether CSR performance influences the demand for high-quality audits (which reduce the risks to shareholders of earnings management) in terms of audit effort measured by audit fees.

They began by noting that audit quality is one of the most important aspects of financial reporting quality, so “it is presumed that socially responsible managers will demand high-quality audits from external auditors to ensure the quality of financial statements. If this is not the case, then the managers may be using CSR as a cover to hide their financial misconduct.” This is an important issue, as earnings management creates risks to investors.

Their data sample included 20,891 firm-year observations on listed firms from 20 developed countries across three regions – the United States (54%), the United Kingdom (18%) and Europe (28%) – and different measures of CSR performance (environmental and social) over the period 2002-2016. They used Thomson Reuters’ ASSET4 ESG rating as a proxy for CSR measure. They controlled for variables that might influence the demand for high-quality audits, including firm size, return on assets, book-to-market value, free cash flow, financial loss, financial leverage, corporate complexity, inventory-to-total assets ratio and non-audit fees. Following is a summary of their findings: