ESG Regulation and Financial Reporting Quality: Friends or Foes?

In recent decades, investors and regulators have focused more on companies’ role in advancing long-term, sustainable, global goals. This focus has led to a significant rise in demand for corporate social responsibility (CSR) that reflects a commitment to balance shareholder value with environmental, social, and governance (ESG) considerations. ESG information has become an important consideration for investors who want to invest in companies that prioritize sustainability and ethical practices. As interest in ESG performance increases, so too does the demand for information about firms’ ESG behavior. Given the significance of ESG performance for investors, global rating agencies began rating it to provide investors with comparable ESG metrics.

However, concerns exist that companies may employ nonfinancial ESG reporting as a diversion from subpar financial reporting. Specifically, one major concern is that “bad” companies will try to mask their poor performance, as reflected in the low quality of their financial reporting, by pumping up their ESG activities to achieve better ESG ratings. Another concern is that overinvesting in ESG activities may lead to underinvestment in financial reporting quality.

In ESG Regulation and Financial Reporting Quality: Friends or Foes?, forthcoming in Finance Research Letters, we investigate whether companies use high ESG ratings to divert attention from poor performance, which is hidden by their low financial reporting quality. We examine the relationship between ESG ratings and the quality of financial reporting in a comprehensive dataset of U.S. publicly traded companies from 2012 to 2022. Our study reveals that high ESG ratings do not come at the expense of financial reporting quality.

To measure financial reporting quality, we use three well-known proxies: two financial statement indicators, persistence and predictability, and an external indicator, financial statement restatements. We observe a significant positive relation between higher ESG scores, earnings persistence, and the ability of earnings to predict cash flows, indicating that companies with strong ESG performance have a higher quality of financial reporting. Additionally, these companies demonstrate a negative association with the number of financial statement restatements, implying a lower likelihood of having to revise their financial information.

Major companies adopted socially responsible policies decades ago, but the watershed moment for CSR was the 2019 statement by the Business Roundtable (BRT) regarding the corporate purpose, calling on companies to abandon shareholder primacy and adopt a broader stakeholder-oriented perspective. We find that the heightened focus on companies’ ESG performance following the BRT statement has had a favorable impact on the observed relationships between ESG scores and key indicators of financial reporting quality. In other words, the increased attention to ESG reporting spurred by the BRT statement positively affects the quality of financial reporting.

These findings contribute to the ongoing regulatory discourse on the advantages and drawbacks of enforcing ESG disclosure. They provide empirical evidence that companies with higher ESG ratings do not exploit these ratings to divert attention from inadequate financial information, thereby lending support to the case for ESG reporting requirements.

Our findings suggest that investors as well as enforcement agencies might consider ESG scores as indicators of a company’s financial reporting reliability. Rather than serving as a smokescreen for financial inadequacies, robust ESG practices may be indicative of superior financial reporting standards. At the company level, management could focus on improving ESG performance not only to appeal to conscientious investors but also as a strategy to boost investor confidence and enhance the company’s reputation for financial transparency and reliability.

The complete paper is available for download here.