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:
- Socially responsible firms demand high-quality audits from external auditors – there was a positive and statistically significant (at the 1% confidence level) relation between CSR and the demand for high-quality audits.
- The average audit fee for firms in the lowest CSR decile was about $1.2 million, while the average for the top decile of CSR firms was almost six times higher – suggesting a positive association between CSR and demand for high-quality audits as proxied by audit fees.
- Measures of both environmental and social performance were positively linked with the demand for high-quality audits.
- Irrespective of the firm-level corporate governance strength, there was a significant positive impact of CSR on the demand for high-quality audits. However, the existence of strong governance structure at the firm level amplified the relation between CSR and the demand for high-quality audits.
- Firms operating in Europe demanded more intensive audits than the firms in the U.S. and the U.K.
- The results were robust to the use of alternate samples, country and firm-level governance systems, and endogeneity concerns.
Their findings led Saeed, Gull, Rind, Mubarik and Shahbaz to conclude: “Socially responsible attributes of being ethical, honest, trustworthy, and transparent while reporting financial results motivate firms to demand high-quality audits in order to preserve their reputation or socially responsible image. The main implication of our findings is that the stakeholders may place greater confidence in the financial reports of socially responsible firms as they are likely to demand high-quality audits.” They added: “CSR acts as a proxy for ethical management that promote higher ethical standards in financial reporting by inducing managers to demand high-quality-audit services from external auditors.”
Their findings are consistent with prior research that had found: Employees of firms with higher ethical standards exhibit a greater tendency to act as whistleblowers when they witness acts of wrongdoing; there is a positive association between socially irresponsible firms and unethical behavior proxied by tax avoidance; firms with higher ethical culture are less likely to be involved in corporate frauds; and socially responsible firms adhere to higher standards of financial transparency and prefer to build long-term relationships with stakeholders by providing detailed disclosures.
Investor takeaways
Investors can reasonably assume that socially responsible firms/managers have higher ethical standards – socially responsible firms provide more extensive disclosures and are more transparent in their financial reporting than socially irresponsible firms. Those higher standards result in reduced economic risks to shareholders. For example, Guido Giese, Linda-Eling Lee, Dimitris Melas, Zoltán Nagy and Laura Nishikawa, authors of the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” found that firms with high ESG scores had better risk management and better compliance standards, leading to fewer extreme events such as fraud, corruption and litigation (and their negative consequences). The result was a reduction in tail risk in high-ESG-scoring firms relative to the lowest ESG-scoring firms. The highest scoring ESG firms also had lower idiosyncratic risk.
They also found that high-ESG-scoring firms had less exposure to market shocks and exhibited lower recent five-year volatility of earnings when compared to low-scoring firms. Thus, they had lower betas. The lower betas resulted in higher valuations (such as lower book-to-market and higher price-to-earnings ratios), producing lower costs of capital and ultimately lower expected returns. Their findings provide a clear risk-based rationale for why “green” stocks should have lower expected returns than “brown,” or “sin,” stocks. A taste-based explanation is provided by the screening process employed by sustainable investors that drives green stocks to have higher valuations and thus lower expected returns.
Larry Swedroe is the chief research officer of Buckingham Wealth Partners and Buckingham Strategic Wealth.
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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.