۱٫ Introduction

۲٫ Background and hypotheses development

۳٫ Sample and research design

۴٫ Results

۵٫ Conclusion

Appendix A. RepRisk’s 28 ESG issues coverage

Appendix B. Definition of variables

Appendix C. Supplementary material

References

Abstract

In recent years, investors have begun to value companies’ reputations through their environmental, social, and governance (ESG) practices. ESG risk can affect business processes and controls and can heighten financial risk and threaten a firm’s survival. This study examines whether and how the severity of media coverage of a firm’s negative ESG issues (tainted ESG reputation) is associated with audit effort and audit quality. I find that auditors manage the higher expected engagement risk conveyed by tainted ESG reputation by applying higher audit effort. Next, I observe that the increased effort is associated with auditors likely detecting and requiring adjustments for material misstatements and that tainted ESG reputation is associated with fewer misstatements (i.e., reduces poor audit quality). The association between tainted ESG reputation and audit quality is driven primarily by increased audit report lag, not by increased audit fees. Further, I find that tainted ESG reputation is positively associated with audit effort and reduces poor audit quality for up to three years. The results also show that the audit effort and audit quality effect vary across the three components of ESG.

Introduction

Investors have long focused on the reputations of companies (e.g., Demiroglu and James, 2010; Helm, 2007; Shane and Cable, 2002) and, in recent years, have directed their attention to companies’ environmental, social, and governance (ESG) practices (Bernow et al., 2017; Committee of Sponsoring Organizations of the Treadway Commission [COSO], 2018). When a company’s ESG practices falter, the market reacts negatively (e.g., Capelle-Blancard and Petit, 2019; Grewal et al., 2018) The significance of ESG factors to today’s investors is articulated in a January 2018 letter from Laurence Fink, chairman and CEO of BlackRock, to the leadership of the world’s largest companies.2 Fink asserts that addressing ESG-related risks is key to longterm value creation. Consistent with this, growing investor pressure on corporate managers to address ESG risks has driven new regulations mandating ESG disclosures in a number of countries.

The United States has no policy requiring firms to publicly disclose ESG factors. The Securities and Exchange Commission (SEC) retreated from a proposal to implement ESG disclosure after receiving comments on its proposed rules, even though the comments were generally supportive.4 Absent mandatory ESG disclosure, the media disseminates information about companies’ ESG actions to investors. Recent empirical evidence suggests that the intensity and reach of media coverage of a firm’s ESG mistakes can harm investors’ perceptions of a firm and can heighten their assessment of its financial risk (Kölbel et al., 2017).