The Severity of a Client’s Negative Environmental, Social, and Governance Reputation Affect Audit Effort and Audit Quality

Document Type : Original Article

Authors

• Mahdi Moradi ¹
• Seed Mohsen Salehi Vaziri ²

¹ Ferdowsi University of Mashhad

² PhD Student in Accounting, Ferdowsi University of Mashhad, Mashhad, Iran

10.22067/ijaaf.2023.42357.1142

Abstract

In recent years, investors have evaluated the organizations through environmental, social and governance criteria and assessing firms. However, environmental, social, and governance (ESG) risks affect business processes and controls, increase financial risk, and threaten the firm's survival. This paper examines whether the employer's negative environmental, social, and governance reputation is related to audit effort and quality. For this purpose, data from 107 firms is collected from 2015 to 2020. The analyses show a positive and significant relationship between ESG criteria and delays in the audit report; auditors increase audit efforts by spending long days auditing financial statements in response to poor ESG credits. Because auditors work harder, the financial statements of such firms are less likely to be reviewed. There is a positive and significant relationship between ESG criteria and the restatement of financial statements: the greater the negative reputation resulting from ESG criteria, the greater the likelihood of financial statement restatement and the higher the quality of the audit due to the auditors' scrutiny. Furthermore, there is no significant relationship between ESG criteria and financial statement reform. The paper also studies the interactive effect of the negative clients’ ESG reputation and the delay of the audit report. The results show that delays in the audit report have a significant inverse effect on the relationship between ESG criteria and the presentation of financial statements and adjustment of financial statements.

Keywords

• Amendment to Financial Statements
• Environmental Social and Governance (ESG) Criteria
• Delay
• Restatement of Financial Statements

Main Subjects

• Auditing

---

©2023 The author(s). This is an open access article distributed under Creative Commons Attribution 4.0 International License (CC BY 4.0).

References

1. Ahmadi, M. (2015). Investigating the relationship between abnormal delays in the audit report and restatement of financial statements on the Tehran Stock Exchange. Master Thesis, Azad University, Isfahan, Iran (In Persian).
2. Anvarkhatibi, S., Baradaran Hassan Zadeh, R., Mottaghi, A. and Taghizadeh, H. (2019). Review the Effect of audit quality from the perspective of different groups on financial reporting quality. Journal of Management Accounting and Auditing Knowledge, 8(31), pp. 245-260 (In Persian).
3. Bernardi, C. and Stark, A. W. (2018). On the value relevance of information on environmental and social activities and performance–Some evidence from the UK stock market. Journal of Accounting and Public Policy, 37(4), pp. 282-299.
https://doi.org/10.1016/j.jaccpubpol.2018.07.001
4. Bernow, S., Klempner, B., Magnin, C., 2017. From ‘why’ to ‘why not’: Sustainable investing as the new normal. McKinsey & Company. (Accessed on March 2018). www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/from-why-to-why-not-sustainable investing-as-the-new-normal
5. Blankley, A. I., Hurtt, D. N. and MacGregor, J. E. (2012). Abnormal audit fees and restatements. Auditing: a journal of practice & theory, 31(1), pp. 79-96. https://doi.org/10.2308/ajpt-10210
6. Blankley, A. I., Hurtt, D. N. and MacGregor, J. E. (2014). The relationship between audit report lags and future restatements. Auditing: A Journal of Practice & Theory, 33(2), pp. 27-57. https://doi.org/10.2308/ajpt-50667
7. Bozorg Asl, M., Dori, R. and Khormin. H. (2018). Investigate the factors affecting publication at the time of the audit report. Journal of Accounting Knowledge, 9 (1), pp. 115-146. https://doi.org/10.22103/jak.2018.10944.2503.(In Persian).
8. Burke, J. J., Hoitash, R. and Hoitash, U. (2019). Auditor response to negative media coverage of client environmental, social, and governance practices. Accounting Horizons, 33(3), pp. 1-23. https://doi.org/10.2308/acch-52450
9. Cao, Y., Myers, L. A. and Omer, T. C. (2012). Does company reputation matter for financial reporting quality? Evidence from restatements. Contemporary Accounting Research, 29(3), pp.956-990. https://doi.org/10.1111/j.1911-3846.2011.01137.x
10. Capelle-Blancard, G. and Petit, A. (2019). Every little helps? ESG news and stock market reaction. Journal of Business Ethics, 157(2), pp. 543-565. https://doi.org/10.1007/s10551-017-3667-3
11. Chan, K. H., Luo, V. W. and Mo, P. L. (2016). Determinants and implications of long audit reporting lags: evidence from China. Accounting and Business Research, 46(2), pp. 145-166. https://doi.org/10.1080/00014788.2015.1039475
12. COSO, W. (2018). Enterprise risk management: Applying enterprise risk management to environmental, social and governance-related risks by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the World Business Council for Sustainable Development (WBCSD). Geneva, Switzerland
13. DeFond, M. and Zhang, J. (2014). A review of archival auditing research. Journal of accounting and economics, 58(2-3), pp. 275-326. https://doi.org/10.1016/j.jacceco.2014.09.002
14. Demiroglu, C. and James, C. M. (2010). The role of private equity group reputation in LBO financing. Journal of Financial Economics, 96(2), pp. 306-330. https://doi.org/10.1016/j.jfineco.2010.02.001
15. Dittenhofer, M. (1995). Environmental accounting and auditing. Managerial Auditing Journal. 10(8), pp. 40–51. https://doi.org/10.1108/02686909510093615
16. Fang, L. and Yasuda, A. (2009). The effectiveness of reputation as a disciplinary mechanism in sell-side research. The Review of Financial Studies, 22(9), pp. 3735-3777. https://doi.org/10.1093/rfs/hhn116
17. Grewal, J., Riedl, E. J. and Serafeim, G. (2019). Market reaction to mandatory nonfinancial disclosure. Management Science, 65(7), pp. 3061-3084. https://doi.org/10.1287/mnsc.2018.3099
18. Helm, S. (2007). The role of corporate reputation in determining investor satisfaction and loyalty. Corporate Reputation Review, 10(1), pp. 22-37. https://doi.org/10.1057/palgrave.crr.1550036
19. Hillegeist, S. A. (1999). Financial reporting and auditing under alternative damage apportionment rules. The Accounting Review, 74(3), pp. 347-369. https://doi.org/10.2308/accr.1999.74.3.347
20. Jackson, A. R. (2005). Trade generation, reputation, and sell‐side analysts. The Journal of Finance, 60(2), pp. 673-717. https://doi.org/10.1111/j.1540-6261.2005.00743.x
21. Khan, A. and Subramaniam, N. (2012). Family firm, audit fee and auditor choice: Australian evidence. In Financial Markets & Corporate Governance Conference. Geelong, Australia. http://ssrn.com/abstract=1985776
22. Knechel, W. R. and Payne, J. L. (2001). Additional evidence on audit report lag. Auditing: A Journal of Practice & Theory, 20(1), pp. 137-146. https://doi.org/10.2308/aud.2001.20.1.137
23. Knechel, W. R. and Sharma, D. S. (2012). Auditor-provided nonaudit services and audit effectiveness and efficiency: Evidence from pre-and post-SOX audit report lags. Auditing: A Journal of Practice & Theory, 31(4), pp. 85-114. https://doi.org/10.2308/ajpt-10298
24. Knechel, W. R., Rouse, P. and Schelleman, C. (2009). A modified audit production framework: Evaluating the relative efficiency of audit engagements. The Accounting Review, 84(5), pp. 1607-1638. https://doi.org/10.2308/accr.2009.84.5.1607
25. Kölbel, J. F., Busch, T. and Jancso, L. M. (2017). How media coverage of corporate social irresponsibility increases financial risk. Strategic Management Journal, 38(11), pp. 2266-2284. https://doi.org/10.1002/smj.2647
26. Lobo, G. J. and Zhao, Y. (2013). Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), pp. 1385-1412. https://doi.org/10.2308/accr-50440
27. LópezPuertas‐Lamy, M., Desender, K. and Epure, M. (2017). Corporate social responsibility and the assessment by auditors of the risk of material misstatement. Journal of Business Finance & Accounting, 44(9-10), pp. 1276-1314. https://doi.org/10.1111/jbfa.12268
28. MohammadRezaei, F. and Mohd‐Saleh, N. (2018). Audit report lag: the role of auditor type and increased competition in the audit market. Accounting & Finance, 58(3), pp. 885-920. https://doi.org/10.1111/acfi.12237
29. Rahmani, H .; Bakhrdi Nasab, (2016). Investigating the effect of normal and abnormal delays in the publishing and presentation process; The auditor's report on the auditor's independence. Auditing knowledge, 67(29), pp. 265-286 (In Persian).
30. Safari Grayley, M. (2017). Abnormal reporting of audit reports and criticism of future financial statement presentation: the moderating role of economic dependence and auditor industry expertise, Quarterly Scientific Research Journal of Management Accounting and Auditing Knowledge, 6(23), pp. 155-168 (In Persian).
31. Sharma, D. S., Sharma, V. D. and Litt, B. A. (2018). Environmental responsibility, external assurance, and firm valuation. Auditing: A Journal of Practice & Theory, 37(4), pp. 207-233. https://doi.org/10.2308/ajpt-51940
32. Shibano, T. (1990). Assessing audit risk from errors and irregularities. Journal of Accounting Research, 28(31), pp. 110-140. https://doi.org/10.2307/2491251
33. Vafaeipour, R. and Ghasemi, M. (2020). Provide a model based on the financial crisis, investment opportunities, and its impact on audit quality. Journal of New Research Approaches in Management and Accounting, 4(31), pp. 1-16 (In Persian).
34. Xiao, T., Geng, C. and Yuan, C. (2020). How audit effort affects audit quality: An audit process and audit output perspective. China Journal of Accounting Research, 13(1), pp. 109-127. https://doi.org/10.1016/j.cjar.2020.02.002