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

Abstract

We exploit a unique dataset to examine how effectively auditors integrate financially material environmental, social, and governance (ESG) issues into their audits, particularly following the introduction of the Sustainability Accounting Standards Board (SASB) and the 2013 Committee of Sponsoring Organizations (COSO) frameworks, which highlighted the link between ESG and clients’ internal control over financial reporting (ICFR). We find that auditors tend to exhibit excessive optimism when evaluating ICFR effectiveness in the presence of material ESG incidents. Specifically, auditors often fail to detect material weaknesses in ICFR when clients experience negative ESG incidents, which leads clients to restate their financial statements. These results are driven by the post-SASB and 2013 COSO period, and are the strongest when ESG incidents are severe, illegal, repetitive, and occur well before the fiscal year-end. Furthermore, the results are amplified when client firms are perceived to have strong ESG expertise and auditors face business growth pressure and heightened competition. Overall, audit firms do not seem to fully understand the implications of material ESG issues from an ICFR standpoint and make incorrect assessments.

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