Do Auditors Understand the Implications of ESG Issues for Their Audits? Evidence From Financially Material Negative ESG Incidents

Abstract

We exploit a unique dataset and test how well auditors integrate financially material ESG issues into their audits. Such issues may have implications about the effectiveness of clients’ internal controls over financial reporting (ICFR). We find that auditors fail to detect material weaknesses in ICFR when clients experience financially material negative ESG incidents, which eventually lead clients to restate their financial statements. Our results are strongest among the Big 4 auditors, when the PCAOB identifies more deficiencies in their audits of ICFR, when ESG incidents occurred sufficiently before the client’s fiscal year end or violated the law, and begin once the Sustainability Accounting Standards Board released standards that provided disclosure guidance on financial materiality of ESG issues. Overall, these results suggest that auditors overweigh their clients’ attempts at improving their internal controls following the revelation of material ESG incidents.

Keywords: Audit; ESG; Auditor; ICFR; ESG Risk