Sustainability and financial disclosure: role of ESG in key audit matters adoption

Abstract

Purpose – This study aims to examine the relationship between environmental, social and governance (ESG) and the adoption of key audit matters (KAMs) in Japan. It also investigates the implications of KAMs on audit and nonaudit fees, firms’ subsequent performance and the effect of ESG on these relationships. Design/methodology/approach – Using probit and logit regressions, this study investigates whether ESG plays a significant role in the likelihood of firms adopting KAMs early (early adopters). Using ordinary least squares (OLS), propensity score matching (PSM), fixed effects and random effects, this study examines the effect of ESG on the number of KAMs items disclosed in audit reports and the relationships between KAMs and audit fees, nonaudit fees and subsequent performance after KAMs become mandatory (post-KAMs). Findings – This study found a positive relationship between firms’ ESG, the likelihood of firms participating in early KAMs adoption and the number of KAMs items disclosed in the audit report. Moreover, audit and nonaudit fees were higher during the post-KAMs period for firms with higher ESG scores. Mandatory KAMs are associated with greater subsequent accounting and market performance for firms with higher ESG scores. Practical implications – Firms with greater sustainability practices adopt greater financial disclosure (i.e. voluntarily adopting KAMs one year before mandatory KAM disclosure) to send a positive signal to stakeholders to protect their reputational capital. While KAMs increase audit and nonaudit fees for firms with higher ESG scores, these firms are rewarded with greater accounting and market performance during the post-KAMs period and when they disclose more KAMs items in their audit reports. Social implications – Firms’ sustainability and financial disclosure practices are related. Firms with greater sustainability objectives are more willing to adopt new regulatory disclosure requirements for financial reporting. Originality/value – This study provides new insights into the role of firms’ sustainability (ESG) in KAMs adoption and disclosure as signals of their commitment to provide greater transparency to stakeholders. It also presents evidence of the interrelationships between ESG and the voluntary adoption of KAMs, firms’ audit and nonaudit fees and subsequent performance during the post-KAMs period.