Current Issues in Auditing: A Foundation for ESG Research Free

Disclosing environmental, social, and governance (ESG) matters is a top priority of international and U.S. corporate regulators. For example, the Companies Act and its related Regulations require that U.K. companies listed on the London Stock Exchange, among others, annually report their global energy use and greenhouse gas (GHG) emissions. China’s Securities Regulatory Commission and related Rules of the Ministry of Ecology and Environment require that domestic entities disclose a range of environmental information annually. In March 2022, the U.S. Securities and Exchange Commission (SEC) issued its proposal to adopt rules to enhance and standardize climate-related disclosures (Release Nos. 33-11042 and 34-94478). New rules typically generate new research questions.

One overarching question is whether ESG disclosures are, or will be, associated with improvements in ESG-related outcomes. For example, the SEC’s proposal would require that companies quantitatively report their GHG emissions. If the proposal is adopted, should we expect GHG emissions to decline? Observations from periods following historical mandates to disclose other matters, like executive compensation, may be informative.

In 1992, the SEC passed a rule mandating that companies tabulate (versus narrate) the compensation of their most highly paid executives (Release 33-6962, Tabulation Rule), and in 2017, companies began having to report the ratio of their CEO’s compensation to that of the company’s average worker (Release 34-95607, Pay Ratio Disclosure). These expanded disclosures were largely based on calls from investors to increase transparency to allow them to better monitor the activities of corporate boards and management.

Since the Tabulation Rule was enacted, the median CEO compensation of “top-500” companies outpaced inflation, increasing from $2.2 million in 1990 to $14.3 million in 2021; and since the Pay Ratio Disclosure was enacted, the median CEO pay ratio rose from 181:1 in 2018 to 245:1 in 2021.¹ A possible explanation for these increases is the trend of making stock-based compensation a larger part of total executive compensation (Rappaport 1999; Anderson 2016). Another possibility is that compensation committees of companies with CEO pay that falls below the median use these data to justify CEO pay increases. Unless the pay of CEOs with above-the-median pay is reduced, the median continues to climb, and compensation committees continuously play catch-up. Although there may be more incentives to reduce GHG emissions than there are to moderate CEO compensation, the trend in CEO pay demonstrates that additional disclosure is not always associated with corporate behavior that we might expect.

This issue of Current Issues in Auditing includes a Special Forum of studies that address auditing-related ESG questions that we hope will serve as a foundation for future practice-relevant academic research. For example, in “Accountants’ Views on Sustainability Reporting: A Generational Divide,” Bakarich, Hoffmann, Marcy, and O'Brien (2023) discover that most U.S. accountants lack experience in sustainability reporting, and enthusiasm for sustainability reporting is greatest among younger accountants. Given the enthusiasm of younger accountants, irrespective of regulatory mandates, the frequency and type of ESG-related disclosures may increase in the future. Future research might investigate: Beyond disclosures that are mandated, which ESG matters are the most frequently reported, and are disclosures both qualitative and quantitative?

ESG disclosures can be produced using a variety of frameworks (e.g., the EU’s Corporate Sustainability Reporting Directive, which, in 2023, replaces the EU’s Non-Financial Reporting Directive; Task Force on Climate-related Financial Disclosures; IFRS Sustainability Disclosure Standards; Global Reporting Initiative Standards; Sustainability Accounting Standards Board nonfinancial ESG reporting standards). Bakarich et al. (2023) also find that, on average, U.S. accountants have no or only slight familiarity with ESG disclosure frameworks. Future research might investigate: Does the ESG reporting framework matter to investors and other stakeholders, and does the “quality” of ESG disclosures vary with the framework used?

Research on the relationship between companies’ ESG-related activities and reporting and business outcomes is in its infancy. LaTorre, Mango, Cafaro, and Leo (2020) find mixed evidence concerning ESG-related activities and reporting and stock price, whereas Whelan, Atz, Van Holt, and Clark (2021) find that the relationship between ESG-related activities and reporting and financial performance is generally positive. In “The Influence of Corporate Social Responsibility Disclosures and Assurance on Jurors’ Judgments,” Stuart (2023) finds that when jurors perceive management’s motives in producing ESG-related disclosures as altruistic, negligence and punitive damage assessments are less than when ESG-related disclosures are perceived as self-serving. Stuart (2023) also finds that in the presence of ESG assurance, there is no difference in negligence and punitive damage assessments attributed to motives.

Despite the possible benefits of ESG assurance, in “The Current State and Future Implications of Environmental, Social, and Governance Assurance,” Bakarich, Baranek, and O’Brien (2023) find that fewer than 60 percent of the world’s “most sustainable” companies have at least some of their sustainability disclosures assured. Future research might investigate: Do ESG disclosures influence investors differently when the disclosures are assured, and does the impact of ESG assurance on stakeholder actions vary based on the type of disclosure (e.g., energy use versus GHG, qualitative versus quantitative)?

Both accountants and nonaccountants can provide ESG assurance. Bakarich et al. (2023) find that Big 4 auditors perform the majority of ESG assurance work internationally, but nonaccountants dominate the U.S. ESG assurance market. It may be that U.S. assurance standards for publicly traded companies are not sufficiently developed to address ESG-related disclosures, or independence considerations may vary across jurisdictions in a manner that impacts the extent of ESG assurance in the U.S. Given declining trends in U.S. accounting-degree program enrollments (American Institute of Certified Public Accountants (AICPA) 2021; Dawkins 2023), it is unclear whether there would be enough accountants to provide ESG assurance services should the demand for their services increase. It is also unclear whether U.S. accounting firms employ individuals with the prerequisite skills needed to perform ESG assurance (Knechel 2021). Future research might investigate: Do investors and other stakeholders care who performs ESG assurance? Do ESG disclosures affect stakeholders differently dependent on who performs the assurance service? Do the skills needed to provide assurance vary dependent upon the type of ESG disclosure?

The extent of assurance can vary. International Standards on Assurance Engagements describe reasonable and limited assurance engagements. The U.S. Statements on Standards for Attestation Engagements describe examinations and reviews. AccountAbility’s Standard AA1000AS describes high and moderate assurance. Bakarich et al. (2023) also discover that, of their sample companies that obtain assurance, 88 percent obtain only limited forms of assurance. Future research might investigate: Do investors and other stakeholders care about the extent of assurance? Do the impacts of ESG disclosures on stakeholder actions vary depending on the extent of assurance?

Regardless of the extent of assurance provided, all assurance providers conclude whether ESG disclosures are materially misstated. Under U.S. Securities Laws, the concept of materiality has long been tied to financial decisions, which may or may not be appropriate measures when evaluating ESG disclosures. In “Expanding the Concept of Materiality to ESG: Audit Issues and Implications,” Turner and Weirich (2023) provide a history of the concept of materiality and a primer on “double materiality” that includes the assurance provider’s consideration of financial materiality and environmental and social materiality. Future research might investigate: How do materiality judgments of quantitative and qualitative ESG disclosures vary comparing financial, and environmental and social criteria?

For our practitioner audience, we hope you that find this issue of CIIA enlightening. For our academic audience, we hope that the articles in this issue prompt additional research questions and investigations of ESG matters that include collaborations with practitioners.