Environmental, social, and governance controversies and earnings quality

The paper examines the association between environmental, social, and governance (ESG) controversies and earnings quality. Prior studies have adduced evidence that ESG controversies significantly influence the cost of equity, audit pricing, firm value, and analyst following. However, the mechanism by which these relationships result has remained an open question. Using publicly available data from multiple sources, the paper constructs a sample of 2,629 firm-year observations. Then the author tests three hypotheses, contending that firms with high ESG controversies are more likely to be associated with low earnings quality. The fourth hypothesis is that these effects are more likely to be elevated in firms operating in environmentally sensitive industries. The author uses abnormal discretionary accruals, and measures of real activities, earnings management, and restatements as proxies of earnings quality. It was found that decreasing ESG controversies score (more controversies) is significantly associated with decreasing earnings quality. Moreover, this effect is more significant in firms operating in environmentally sensitive industries. These results are replicated in additional analyses. Hence, the underlying earnings quality associated with ESG controversies may be one of the links between ESG performance and the factors identified in the research. The author argues that the findings associated with higher ESG performance are better explained by the opportunistic reporting hypothesis rather than the transparent hypothesis. The findings provide a significant addition to the existing literature as they explain the mechanism in support of results documented in prior studies that ESG controversies affect firm value (Aouadi & Marsat, 2018), relate to more gender diversity on the board (Issa & Hanaysha, 2023) and affect firm cost of equity (La Rosa & Bernini, 2022). Moreover, these findings extend prior research to show that the components of ESG performance (rather than the combined score) can provide a better understanding of how firm executives behave considering emerging controversies as argued by Kolsi et al. (2023). The paper argues on the significance of the findings, and the accompanying limitations, and suggest future research.