The Role of the External Auditor in Managing Environmental, Social, and Governance Reputation Risk

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 (NAS) by the external auditor is controversial and public accountants are still defining their role in ESG risk control and reporting. We explore whether auditors effectively 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 NAS, and a positive association between the interaction of tainted reputation and NAS 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 results are driven by companies audited by ESG industry specialist auditors, and that the association between NAS and tainted reputation is driven by companies owned by institutional shareholders. Using restatements as a proxy, we find no evidence to suggest that the interaction of NAS and tainted reputation is associated with impaired audit quality. Findings demonstrate an empirical linkage between tainted reputation and NAS, support the importance of managing ESG risk, and suggest auditors effectively help their clients respond to heightened ESG risk.