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The role of the external auditor in managing environmental, social, and governance (ESG) reputation risk

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Abstract

Companies are under increasing pressure to manage their reputation on environmental, social, and governance (ESG) issues. Auditors are a potential source of ESG risk management expertise and assurance due to a deep understanding of their client’s ESG-related reputation risk (“ESG risk”) and their assurance reporting expertise. However, provision of nonaudit services by the external auditor is controversial and public accountants are still defining their role in ESG risk control and reporting. We explore whether auditors help companies manage heightened ESG risk in times of reputation crisis, using abnormal negative ESG-related media coverage as a measure of “tainted reputation.” Findings show a positive association between tainted reputation and nonaudit services and between the interaction of tainted reputation and nonaudit services with future firm value. The positive interaction persists when we consider a proxy for other ESG risk management activities in our analyses and for other measures of ESG risk management effectiveness (future stock returns and future tainted reputation). Subsample analyses indicate that results are driven by companies audited by ESG industry specialist auditors, that the association between tainted reputation and nonaudit services is driven by companies owned by institutional shareholders, and that inferences from our results may not hold when ESG risk is dominated by its social component. Using restatements as a proxy, we find no evidence to suggest that the interaction of tainted reputation and nonaudit services is associated with impaired audit quality. Findings demonstrate an empirical linkage between tainted reputation and nonaudit services that is positively associated with future firm value measures.

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Data availability

All data used in the study are publicly available from sources cited in the text.

Notes

  1. ESG-related reputation differs from corporate social responsibility (CSR) in that CSR describes a company’s commitment to stakeholders for socially responsible practices, while ESG refers to a concept used by market participants for evaluating a company’s practices (regardless of what the company sees as its commitment to stakeholders). See, for example, https://medium.com/@utmccombssii/differences-between-esg-sri-csr-impact-investing-and-philanthropy-4316033e7198 (accessed Nov. 14, 2019).

  2. See, for example, letters dated February 2016 and January 2018 at https://www.blackrock.com/corporate/investor-relations/larry-fink-ceo-letter.

  3. Although BP attributes the increase in nonaudit service fees to work provided by Ernst & Young to “additional work required consequent upon the Gulf of Mexico incident” on page 98 of its 2010 annual report, the increase in fees did not occur until 2011. We discuss these spikes further in Section 2.2.2.

  4. Appendix A provides examples of ESG-related services offered by public accounting firms, which (respectively) fit under categories “Low Carbon Strategy and Carbon Management,” “Social Impact,” and “Sustainable Supply Chain,” such as assurance and auditing of low carbon labeling; identifying, measuring, valuing, monitoring, and reporting the social impacts of projects, programs, and policies; and upholding international human and labor rights.

  5. We develop our abnormal/unexplained tainted ESG reputation measure based on data provided by Zurich-based RepRisk AG (www.reprisk.com). RepRisk aggregates overall negative media sentiment related to a firm’s ESG issues based on over 80,000 media sources into a composite metric. We discuss RepRisk data in more detail in section 3.2.

  6. The SEC requires firms to disaggregate nonaudit service fees into three categories: audit-related, tax-related, and other ( 2003a; b). As we discuss in footnote 18, we expect the majority of ESG-related services offered by audit firms to be classified as audit-related or other. However, to be complete, we also show results for tax-related nonaudit service fees.

  7. More traditional risks include, for example, cyberattacks, Middle East instability, and asset price collapse (WEF 2018).

  8. Examples: Volkswagen paid $14.7 billion in settlement when the company admitted falsifying emissions tests, leading to a worldwide recall of millions of cars; following the revelation that Wells Fargo created as many as two 2 fake consumer accounts, negative perceptions of Wells Fargo dropped from 15% before the scandal to 52% over two months, and high profile customers boycotted the company; Snapchat’s market value dropped $800 million after public outrage in response to an ad that appeared to make light of domestic violence; Facebook’s market value dropped $37 billion after public outrage in response to the news that Cambridge Analytica accessed information from approximately 50 million Facebook users; the Weinstein Company filed for Chapter 11 bankruptcy protection following months of media criticism of sexual misconduct against one of the company’s co-founders. See, for example, http://money.cnn.com/2016/06/28/news/companies/volkswagen-fine/index.html, http://money.cnn.com/2016/10/24/investing/wells-fargo-fake-accounts-angry-customers/, https://www.vanityfair.com/style/2018/03/rihanna-chris-brown-snapchat-ad, http://money.cnn.com/2018/03/19/news/companies/zuckerberg-net-worth/index.html and https://www.nytimes.com/2018/03/19/business/weinstein-company-bankruptcy.html.

  9. For example, Ernst & Young’s “Sustainability Strategy and Integration” category of services features sustainability strategy formulation and integration, ESG management system development, materiality assessment, sustainability review and tailored improvement plans, and a roadmap for corporate sustainability; its “Market Readiness of Emissions Trading Scheme” advertises “establishment of ETS internal controls, accounting treatment of carbon trading, and analytical prediction of ETS; KPMG’s “Stakeholder Communication” category describes ESG service as helping clients “shape the company’s key ESG messages to investors and other stakeholders in the context of strategy and long-term value creation.”

  10. For example, British Petroleum experienced four years of reductions in fees for nonaudit services up to fiscal year 2010. According to Audit Analytics data, following the Deepwater Horizon drilling rig explosion in the Gulf of Mexico in 2010, fees for nonaudit services increased from approximately $8 million per year in 2009 and 2010 to approximately $11 million in 2011 (a 37.5% increase) and $21 million in 2012 (over 200% increase). The increase in fees for nonaudit services (pre- versus post-scandal periods) is largely driven by increases in audit-related and other nonaudit services fees, while average audit fees remained stable or decreased after the oil spill. We note similar spikes in nonaudit service fees for the following examples: Alphabet following the antitrust violation scandals in 2017 and 2018 (a 48% increase for 2017 and 2018, on average, compared to 2016); Facebook following consumer data breaches in 2018 (an 8% increase in 2018 compared to 2017); and Wells Fargo following the consumer accounts scandal in 2016 and 2017 (a 14% increase for 2016 to 2018, on average, compared to 2015).

  11. Frankel et al. (2002) find that the association between nonaudit service fees and market reaction is small in economic terms, and Ashbaugh et al. (2003) find no evidence of significant market reaction to disclosures of higher nonaudit service fees.

  12. In this report, the CAQ provides three examples that demonstrate flexibility and variability in the type of reports and pre-assurance services an auditor can offer to their audit clients: a 2019 standalone ESG examination and review report for Vornado Realty Trust, a 2019 standalone sustainability review report for Guess?, and a separate review report that relates to information provided as part of the 2019 annual 10-K report for Etsy.

  13. See www.RepRisk.com. RepRisk corporate reputation data is publicly accessible via a subscription on the Wharton Research platform.

  14. The UN Global Compact is a voluntary initiative based on CEO commitments to implement universal sustainability principles and to undertake partnerships in support of UN goals. See https://www.unglobalcompact.org/.

  15. Using the annual average of monthly data is consistent with the approach used for similar measures, such as credit risk (e.g., Ham and Koharki 2016). In section 5.5.1, we consider an alternative measure of RRI. This alternative measure captures year-to-year variations in RRI.

  16. Minimum and maximum within firm changes in unadjusted average current RRI are −20.83 to 32.33 (untabulated), and year-to-year minimum/maximum changes in unadjusted average current RRI from the prior year for 2008, 2009, 2010, 2011, 2012, 2013, and 2014 are −14.50/31.00, −20.83/25.92, −17.58/29.50, −18.17/27.17, −17.25/27.50, −16.08/25.75, and − 17.83/32.33, respectively (untabulated), suggesting that average current RRI is not static. At the firm level, average current RRI for General Motors (for example) jumped 32.3% from 36.5 in 2013 to 68.8 in 2014 when the company faced an uproar in 2014 over its handling of a defective ignition switch in some of its cars, leading to recall of 2.6 million cars.

  17. In Section 5.5.2, we consider the robustness of our results to excluding LIT and ESG_IND and including both year and firm fixed-effects in Equation (1).

  18. Public accounting firms do not disclose specific information regarding how they classify nonaudit services. Per informal discussion with audit partners, fees related to providing assurance for ESG-related reports and pre-assurance fees might be categorized as “audit-related” or “other,” depending on the nature of the client and services.

  19. In Section 4.2.5, we employ three-year out stock returns as a measure of firm value as an additional analysis.

  20. Except firm size (SIZE) and audit fees (AUFEE), all correlations (for variables included in the same regression) are below the 0.80 multicollinearity threat threshold (Kennedy 2008) and the highest untabulated variance-inflation factor from all of our analyses is 4.66, well below the recommended threshold of 10 (Kennedy 2008). The high correlation between SIZE and AUFEE is consistent with theory and auditor fee research.

  21. We exclude 47 singleton observations (i.e., firms with only one firm-year observation in the sample) from the nonaudit service fee models, as including them in regressions that control for firm fixed effects can overstate statistical significance and lead to incorrect inferences (Correia 2015; deHaan 2021).

  22. We use the margins function in Stata to estimate the adjusted predicted AUNAS, TAXNAS, and OTHNAS, at the first and third quartiles of the independent variable, TAINTREP, while holding all other variables at their mean values (Williams 2012). The Stata margins estimate of adjusted predicted values at the first and third quartiles of TAINTREP are 8.210356 and 9.0443204 for AUNAS. The change in predicted values equates to an increase of 10.16%. We use the margins function in Stata to compute economic significance throughout this paper. We do not compute the marginal effect of TAINTREP with respect to TAXNAS because TAINTREP is not significantly associated with TAXNAS.

  23. See Online Appendix A. Panels A, B, and C present results for AUNAS, TAXNAS, and OTHNAS, respectively. In each panel, Columns 1, 2, 3, and 4 document results for the design choices as described above. Results are consistent with those we present throughout this section for all four models.

  24. We lose 1137 observations for this analysis because we drop the base year from the changes regressions.

  25. We exclude 66 singleton observations (i.e., firms with only one firm-year observation in the sample) from the firm value models, as including them in regressions that control for firm fixed effects can overstate statistical significance and lead to incorrect inferences (Correia 2015; deHaan 2021).

  26. We compute economic significance for H2a and H2b (discussed shortly) using the methodology described in footnote 21. The Stata margins estimate of adjusted predicted values at the first and third quartiles of TAINTREP x AUNAS are 0.032361 and 0.039531 for 3YRROA. The change in predicted values equates to an increase of 22.16%. We do not compute the marginal effect of TAINTREP x TAXNAS with respect to 3YRROA because TAINTREP x TAXNAS is not significantly associated with 3YRROA.

  27. From Online Appendix C, the significance levels of the 3YRROA and 3YRTOBIN results are robust (i.e., significant results remain significant at p = 0.10 or below) to the following alternative designs: (1) including only firm fixed effects and clustering by industry and year, (2) including year and industry fixed effects and clustering by industry and year, (3) including year and firm fixed effects and clustering by firm and year, and (4) including year and firm fixed effects and clustering by industry only. Panels A, B, and C present results for AUNAS, TAXNAS, and OTHNAS, respectively. In each panel, Columns 1, 2, 3, and 4 present results of designs (1), (2), (3), and (4), respectively, for 3YRROA. Columns 5, 6, 7, and 8 present results of designs (1), (2), (3), and (4) for 3YRTOBIN.

  28. We exclude all fees (audit and nonaudit services) paid to the external auditor to develop a proxy for fees paid to other consultants or additional internal cost incurred in periods of tainted ESG reputation.

  29. The audit literature defines an auditor as an industry specialist if the auditor commands 10%–30% of audit market share (based on audit revenues) (Neal and Riley Jr. 2004; DeFond and Zhang 2014). We follow the literature to derive the measure of office-level expertise (Ferguson et al. 2003; Whitworth and Lambert 2014). First, we use our measure of ESG industry firms (ESG_IND) to derive total annual audit fees paid by ESG industry firms to all auditors, measured at the city level (i.e., total ESG city-level fees). Second, we derive audit fees paid by ESG industry firms to a particular office within each city, less fees paid by the observation firm (i.e., total ESG office-level fees). Third, we calculate ESG industry market share by dividing total ESG city-level fees by total ESG office-level fees. Finally, we derive ESG_SPE_AUD as equal to 1 if the firm is audited by an auditor with 30% or more of the ESG audit market share and zero otherwise. Since our measure is restricted to expertise derived from ESG industry firms only, the percentage of observations with ESG_SPE_AUD = 1 is lower than percentages frequently found in the audit office level expertise literature (usually approximately 15%) that examines expertise deriving from all industries.

  30. Nonreliance restatements, also known as Item 4.02 restatements, are material or egregious restatements of previously published financial statements because they can no longer be relied upon due to significant accounting errors. We include the following control variables in the REST model: SIZE, FOROPS, GROWTH, BUSEG, LEV, ROA, RESTR, MERGER, BIG4, AUDTEN, AUFEE, INSIDE, INSTMAJ, BIND, ACEXPRT, restatement announcement in year t (MISST), and internal control weakness (ICW).

  31. The environmental score (E_score), for example, is the percentage of environmental links in proportion to the total number of links that make up the RRI score. According to RepRisk, if one company has a higher environmental than another it is not necessarily worse on the environmental dimension, but rather the score reflects a different composition of news.

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Acknowledgements

We thank Lakshmanan Shivakumar (the editor), the anonymous reviewers, Raluca Chiorean, Jeffrey Hales, Rani Hoitash, Jae B. Kim, Marietta Peytcheva, Divesh Sharma, Matthew Sherwood, Mike Wilkins, and workshop participants at the 25th Symposium on Audit Research at the University of Illinois at Urbana-Champaign and the University of Massachusetts, Amherst for their helpful comments.

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  1. Department of Accounting, College of Business, Lehigh University, Lehigh, PA, 18015, USA

    Bright Asante-Appiah & Tamara A. Lambert

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  1. Bright Asante-Appiah
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Correspondence to Tamara A. Lambert.

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Appendices

Appendix A

Table 11 Examples of ESG-related services offered by public accounting firms
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Appendix B

Table 12 RepRisk’s 28 ESG issues coverage
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Appendix C

Table 13 Variable definitions
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Asante-Appiah, B., Lambert, T.A. The role of the external auditor in managing environmental, social, and governance (ESG) reputation risk. Rev Account Stud 28, 2589–2641 (2023). https://doi.org/10.1007/s11142-022-09706-z

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