Corporate social responsibility and the assessment by auditors of the risk of material misstatement

• Author: Kurt Desender,Mónica LópezPuertas‐Lamy,Mircea Epure
• Date: 01 October 2017
• DOI: http://doi.org/10.1111/jbfa.12268
• Published date: 01 October 2017

DOI: 10.1111/jbfa.12268

Corporate social responsibility and the assessment

by auditors of the risk of material misstatement

Mónica LópezPuertas-Lamy1Kurt Desender1Mircea Epure2

1Departmentof Business Economics,

UniversidadCarlos III, Getafe (Madrid), Spain

2Departmentof Economics and Business,

UniversitatPompeu Fabra, Barcelona, Spain

Correspondence

MónicaLópezPuertas-Lamy, Department of

BusinessEconomics, Universidad Carlos III, Calle

deMadrid, 126, E-28903 Getafe (Madrid), Spain.

Email:mlopezpu@emp.uc3m.es

Abstract

This paper investigates whether, and how, firms’ corporate social

responsibility (CSR) performance influences the auditor's assess-

ment of the risk of material misstatement, whether due to fraud or

error,at the financial statement level by analysing their pricing deci-

sion (i.e., audit fees). Using a panel data set of 12,330 firms from

28 countries over the period 2003–2012 and different measures of

CSR performance, we find a U-shaped relationship between firms’

CSR performance and audit fees. This result suggests that there is

an optimal level of CSR performance that minimizes the auditor's

assessment of the risk of material misstatement, which in turn low-

ers the need for greater auditor effort; that is why auditors charge

firms significantly less when their CSR performance is at the optimal

level.Finally, we also show that the optimal level of CSR performance

varies with the degree of environmental dynamism, ownership con-

centration and leverage.

KEYWORDS

audit fees, corporate social responsibility (CSR), CSR performance,

risk of material misstatement

1INTRODUCTION

The past two decades havewitnessed a dramatic increase in firms’ engagement in corporate social responsibility (CSR)

in response to the needs and expectations of a wide range of stakeholders (Campbell, 2007; Hoepner, Oikonomou,

Scholtens, & Schröder,2016; Waddock, 2008).1Meanwhile, numerous information intermediaries have emerged, rat-

ing firms across several dimensions of environmental and social performance, to provide credible CSR ratings and

scores in a standardized and comparable way.The increasing interest in CSR, as well as the availability of CSR scores,

1Increasingly, customers, investors,employees and other stakeholders are considering firms’ CSR in their decisions. To illustrate, a large number of insti-

tutional investors are signatories to the United Nations’ ‘Principles for Responsible Investment’ (UNPRI). The most recent UNPRI website reports 1,718

investmentinstitutions as signatories, representing 59 trillion of assets under management. Moreover, the socially responsible investing (SRI) movement has

gainedimportance and professionally managed US assets tied to SRI accounted for more than US$3 trillion in 2010 (Di Giuli & Kostovetsky, 2014). In addition,

Nielsen's(2014, 2015) Global Survey on CSR shows that 67% of the 30,000 participant in 60 countries prefer to work for socially responsible companies, while

60%indicate that they are willing to pay more for products and services from companies that are committed to positive social and environmental actions(up

from50% in 2013).

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has led to a proliferation of academic studies seeking to better understand its determinants and consequences (Huang

& Watson,2015).

Much of the existingliterature on the consequences of CSR has focused on analysing the impact of CSR on different

measures of firm performance (e.g., Di Giuli & Kostovetsky,2014; Eccles, Ioannou, & Serafeim, 2014; Flammer, 2015;

Lys, Naughton, & Wang, 2015; Margolis, Elfenbein, & Walsh,2007), on firm value (e.g., Gregory & Whittaker, 2013;

Gregory, Whittaker, & Yan, 2016; Renneboog, Ter Horst, & Zhan, 2008), on access to finance (e.g., Cheng, Ioannou,

& Serafeim, 2014; El Ghoul, Guedhami, Kwok, & Mishra, 2011; Goss & Roberts, 2011; Hoepner et al., 2016), and on

(post-audit) financial reporting quality2(e.g., Chih, Shen, & Kang, 2007; Kim, Park,& Wier, 2012; Petrovits, 2006; Prior,

Surroca, & Tribó,2008), with the general conclusion that CSR affects all these dimensions but with mixed results. How-

ever,to the best of our knowledge, the relationship between CSR performance and the auditor's assessment of the risk

of material misstatement, whether due to fraud or errors, at the financial statement level(i.e., the auditor's assessment

of the risk that the financial report contains material misstatements before the audit is conducted, hereafter,the audi-

tor's assessment of the risk of material misstatement3) is still far from known, and has received little attention from

academics and policy makers.4

The current paper addresses this issue and investigates whether,and how, a firm's CSR performance influences the

auditor's assessment of the risk of material misstatement, by analysing their pricing decision (i.e., audit fees). With this

aim, we follow Mackey,Mackey, and Barney (2007) and the European Commission (2001) and consider CSR practices

as the voluntary firm actions designed to improvesocial or environmental conditions. This concept of CSR corresponds

to what Baron (2006) calls corporate social performance (orCSR performance).

Understanding the implications of CSR performance on the auditor's assessment of the risk of material misstate-

ment is important for academics and policy makers,because this assessment affects the auditors’ effort and evaluation

of evidence (Hammersley,Bamber, & Carpenter,2010) and ultimately the (post-audit) firms’ financial reporting quality.

In this sense, theory predicts that higher audit effort increases the likelihood of detected errors and reduces the like-

lihood of undetected errors at the financial statement level (Dye, 1993; Hribar,Kravet, & Wilson, 2014; Matsumura &

Tucker, 1992; Shibano, 1990), implying a positive relation between the audit effort and (post-audit) financial report-

ing quality.Empirically, Lobo and Zhao (2013) provide support for this prediction, finding a robust negative association

between audit effort (measured by audit fees) and annual report restatements. Therefore, our analysis may help to

understand whether the audit effort is one mechanism through which CSR performance influences the (post-audit)

financial reporting quality of firms and hence, whether it is an important omitted variable of prior studies that examine

the effect of CSR performance on (post-audit) financial reporting quality (Chih et al., 2007; Kim et al., 2012; Petrovits,

2006; Prior et al., 2008).

We extract the auditor's assessment of the risk of material misstatement from the audit fees, as they reflect the

amount of effort that the auditors are expected to expend in the audit to fulfil its purpose (Ghosh & Tang, 2015; Rice

& Weber,2012; Srinidhi & Gul, 2007), and auditors respond to increases in misstatement risk by increasing their audit

efforts (ISAs 330). The purpose of an audit is to obtain reasonable assurance on whether the financial statements as a

whole are free from material misstatement. Toobtain reasonable assurance, the auditor should gain sufficient appro-

priate audit evidence to reduce the risk of issuing an incorrect opinion on the financial statements (i.e., the audit risk)

2Theexisting literature on the link between CSR and financial reporting quality (Chih et al., 2007; Kim et al., 2012; Petrovits, 2006; Prior et al., 2008) analyses

thelink between CSR and earnings quality constructs that are computed based on financial reports that are issued, not before, but after the completion of the

audit.We therefore refer to this stream of literature as linking CSR to (post-audit) financial reporting quality.

3Misstatements in the financial statements can arise from either fraud or error.In this paper, we focus on both types of misstatements. The distinguishing

factor between fraud and error is whether the underlying action that results in the misstatement of the financial statements is intentional or unintentional.

The International Standards on Auditing (ISAs) establish that two types of intentional misstatements are relevant to the auditor: misstatements resulting

from fraudulent financial reporting and misstatements resulting from misappropriation of assets (ISA 240). Given the relevanceof fraud, greater responses

andprocedures should be implemented when the auditor believes that there is risk of material misstatement due to fraud rather than to error (ISA 240).

4Anecdotal evidence reiteratesthe increasing role of CSR information in auditing. For example, the KPMG managing director, Eric Israel, noted at the 2010

Amsterdam Global Conference on Sustainability and Transparencythat they have begun to better understand the implication of this information for their

auditsbut that more work is needed. However, as far as we know,t here isno empirical evidence on whether and how CSR performance influences the auditor's

assessmentof the risk of material misstatement and hence the audit fees.

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to an acceptably low level (ISA 200). This audit risk is a function of the risk of material misstatement and the detection

risk such that:

Audit risk =Risk of material misstatement in the final statements ×Detection risk.

The risk of material misstatement is the entity's risk and is outside the direct control of the auditor (it exists inde-

pendently of the audit of the financial statements). In contrast, the detection risk is under the control of the auditor

since it constitutes the risk that the procedures performed by the auditor to reduce the audit risk to an acceptably low

level will not detect a misstatement that existsand that could be material either individually or when aggregated with

other misstatements (ISA 200).

According to the audit risk model, auditors choose an acceptable level of audit risk and then assess the risk of mate-

rial misstatement, which leads to the desirable levelof detection risk (Houston, Peters, & Pratt, 1999). When the audi-

tor's assessment of the risk of material misstatement is high, the detection risk needs to be held at a lower level to

keep the audit risk at an acceptable level. Lower detection risk can be achieved by increasing the nature, timing and

extent of the audit procedures. These actions in turn increase the cost of the audit, as they require more effort and/or

the involvement of personnel with more overall or industry-specific experience5(Bedard & Biggs, 1991; Johnstone

& Bedard, 2003; Solomon, Shields, & Whittington, 1999). Thus, auditors charge higher audit fees on engagements in

which they assess the risk of material misstatement to be high. Conversely,when the auditor believes that the risk of

material misstatement is low, the detection risk can be set at a relatively higher level, reducing the audit effort or the

specific experience of the engagement team and, hence, the audit fees (ISA 200).6

Auditors assess the risk of material misstatement by gaining an understanding of the entity and its envi-

ronment, including the entity's internal control (ISA 315) and the incentives/pressures, opportunities, and atti-

tudes/rationalizations that managers or employees may have to commit fraud (ISA 240). In doing so, the auditor

obtains, among other things, an understanding of the entity's objectives and strategies, and of those related business

risks7that may result in risks of material misstatement. The business risk is broader than the risk of material misstate-

ment, though it includes the latter as most business risks will eventually have financial consequences and, therefore,

an effect on the financial statements (ISA 315). For example,the business risk arising from a decreasing customer base

may increase the risk of material misstatement associated with the valuation of receivables or mayincrease manager 's

incentives/pressuresto engage in fraudulent financial reporting. Thus, an increase in the firm's business risk should lead

to an increase in the auditor's assessment of the risks of material misstatement. In this line, Johnstone (2000), Lyonand

Maher (2005), O'Keefe, Simunic, and Stein (1994) and Pratt and Stice (1994) show that audit partners recommend

higher audit effort and fees in response to higher business risk.

Building on resource dependence and agency theory, we claim that within certain limits, an increase in the firm's

CSR performance is likelyto reduce the auditor's assessment of the risk of material misstatement and, hence, the audit

fees, by reducing the firm's business risk. As CSR performance continues to increase, however, this positiveeffect of

CSR performance on the reduction of the auditor's assessment of the risk of material misstatement is likely to level

off and eventually turn into a negative effect because of increasing business risk and auditor's concerns related to the

opportunistic use of CSR. Therefore, we posit that the CSR performance–audit fee relationship may be described as

U-shaped, such that there is an optimal level of CSR performance that minimizes the assessed risk of material mis-

statement and, as a result, the audit fees.

5Professionalguidance suggests that the risk of material misstatement should leadthe auditor to plan more hours (ISA 330). In addition, the positive linkage

between the risk of material misstatement and audit work has been documented in prior studies (e.g., Bell, Landsman, & Shackelford,2001; Hackenbrack&

Knechel,1997; Johnstone & Bedard, 2001).

6We restrictour sample to firms with Big-4 auditors. Similar to Ghosh and Tang(2015), we assume similar quality among the Big-4 auditors (i.e., we assume

that they choose the same level of audit risk). Thus, for a given levelof audit risk, higher levels of audit fees should reflect higher assessment of the risk of

materialmisstatement by the auditor.

7Weadopt the definition of business risk provided by ISA 315 which defines it as ‘a risk resulting from significant conditions, events, circumstances, actions or

inactions that could adversely affect an entity's ability to achieveits objectives and execute its strategies, or from the setting of inappropriate objectives and

strategies’.