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The Role of Audit Quality in the ESG-Corporate Financial Performance Nexus:

Empirical Evidence from Western European Companies

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Full Length Article

The role of audit quality in the ESG-corporate financial performance nexus:

Empirical evidence from Western European companies
R.M. Ammar Zahid a, Muhammad Kaleem Khan b,*, Waseem Anwar c, Umer Sahil Maqsood d
a
School of Accounting, Yunnan Technology and Business University, Kunming, Yunnan, PR China
b
Asia-Australia Business College, Liaoning University, PR China
c
Department of Management Sciences, COMSATS University Islamabad (Lahore Campus), Pakistan
d
School of Economics and Finance, Xi'an Jiaotong University, Xi'an, PR China
Received 25 April 2022; revised 28 August 2022; accepted 28 August 2022
Available online ▪ ▪ ▪

Abstract

The study explores the moderating role of audit quality in the relationship between environmental, social, and governance (ESG) factors and
corporate financial performance (CFP) in Western European countries. The research sample includes 620 firms headquartered in Western Europe,
including Austria, Belgium, France, Germany, Luxembourg, Monaco, the Netherlands, and Switzerland from 2010 to 2019. Panel data estimations
are used to examine the direct and moderating effects. The results show that ESG has a significantly negative effect on a firm's financial per-
formance as measured by the return on assets (ROA), supporting the trade-off hypothesis in which investing in ESG activities increases the cost of
business. Additionally, we find that ESG's adverse influence on CFP is more evident at enterprises that are certified by Big Four accounting firms.
However, ESG has a significantly positive effect on revenue, suggesting that customers are more attracted to firms that invest in ESG. The analysis
of the subcomponents of ESG supports the main results. The results are robust to alternative model specifications and alternative measures of CFP
and audit quality and are free of endogeneity issues. The findings contribute to the existing knowledge on ESG by elucidating the effect of external
auditor quality on the ESG-CFP relationship. We also examine overall ESG scores as well as individual ESG characteristics (environmental,
social, and governance).
Copyright © 2022 Borsa İstanbul Anonim Şirketi. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license
([Link]

Keywords: Audit quality; Environment; ESG; Financial performance; Governance; Social; Western Europe

1. Introduction environment, social, and governance activities. Corporations

use ESG disclosure as a voluntary practice. Despite a few at-
Globally, corporations recognize that a short-term emphasis tempts at standardizing reporting procedures for ESG activities
on merely financial objectives is no longer adequate. The (e.g., the Global Reporting Initiative's [GRI] Sustainability
rationale is that stakeholders have developed interest in sus- Reporting Guidelines or the EU legislation on nonfinancial
tainability performance. However, the European Union (EU) is reporting), ESG disclosure practices vary significantly between
truly leading the charge, having launched a series of reforms in organizations. Supporters of standardization argue that stan-
the sustainable finance arena, transforming how financial and dards ensure uniformity in reporting (Zahid & Simga-Mugan,
nonfinancial corporations operate in this paced development of 2019) and allow comparisons of firms' ESG performance, at
least within sectors. An independent audit firm can be relied
upon to ensure that a company's sustainability reporting is
* Corresponding author. truthful. A key stumbling block for the ESG movement is that
E-mail addresses: amrzahid@[Link] (R.M.A. Zahid), most firms publish sustainability reports separately from their
[Link]@[Link] (M.K. Khan), wasyhcc@[Link]
(W. Anwar), omersahil@[Link] (U.S. Maqsood).
financial reports, making it challenging to identify the
Peer review under responsibility of Borsa İstanbul Anonim Şirketi. connection between financial performance and sustainability

[Link]
2214-8450/Copyright © 2022 Borsa İstanbul Anonim Şirketi. Published by Elsevier B.V. This is an open access article under the CC BY-NC-ND license (http://
[Link]/licenses/by-nc-nd/4.0/).
Please cite this article as: R.M.A. Zahid, M.K. Khan, W. Anwar et al., The role of audit quality in the ESG-corporate financial performance nexus: Empirical
evidence from Western European companies, Borsa İstanbul Review, [Link]
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performance. Additionally, the outbreak of COVID-19 and the The study sample includes 620 nonfinancial listed com-
accompanying lockdowns sowed uncertainty and had far- panies headquartered in Western Europe, with 6195 firm-year
reaching consequences, disrupting commonality and observations from 2010 to 2019. The ESG overall score and
imposing numerous adjustments in the ESG policies. This subcomponents are used as independent variables, and the
study connects ESG and corporate financial performance (CFP) ROA and revenue assess financial performance as the depen-
in Western European markets. Moreover, this study explores dent variable. The interaction term Big4 × ESG is used as a
how audit quality moderates the nexus between ESG and CFP. moderator for audit quality. We base our analysis on the
Earlier studies about ESG initiatives examined its de- Thomson–ESG Eikon ratings, data that also provide informa-
terminants and economic consequences. However, recent tion on the use of auditing techniques for nonfinancial infor-
corporate finance research has shifted its focus to financial and mation. The study also includes control factors such as firm
accounting aspects of the company's ESG initiatives in terms of size, financial leverage, dividends paid, and the price-to-book
governance, external stakeholders (David et al., 2007), society ratio. Our results show that ESG has a negative impact on
(Matten & Moon, 2008), and institutional pressure (Bondy past financial performance as assessed by ROA, validating the
et al., 2012; Matten & Moon, 2008). Meanwhile, the key trade-off theory or traditional perspective that ESG increases
question for companies and shareholders is whether ESG costs and diminishes profitability (Galant & Cadez, 2017;
disclosure policies can improve a company's financial perfor- Saygili et al., 2022). However, ESG benefits the organization's
mance. Environmental and social disclosure are the two most revenues/sales, as customers tend to reward good ESG strate-
commonly studied ESG topics in past studies (Barnett & gies (Okafor et al., 2021). The subcomponents of ESG
Salomon, 2012). Because ESG disclosure concerns are inter- corroborate the main findings. In the second phase of the
related, focusing exclusively on one facet might pose diffi- research, we examine the moderating effect of audit quality on
culties. Only a few ESG studies have examined all three ESG the ESG-CFP nexus. The findings show that ESG and incre-
aspects and their influence on CFP in a single scenario (Nollet mental audit quality judged by Big Four auditors negatively
et al., 2016; Tarmuji et al., 2016). Moreover, distinct view- affect historical financial performance. At the same time, ESG's
points and ambiguous results make this discussion inconclu- positive impact on revenue is more evident at Big
sive. Considering these diverse findings, the ESG-CFP nexus Four–certified companies.
should be re-examined to obtain a new understanding. It is Thus this paper contributes (theoretically and practically) to
imperative to include all ESG aspects when measuring their the existing literature not only by adding to the vast literature
impact on CFP. So, this study goes beyond these extant studies on the sustainability-financial performance nexus but also by
because of its multifaceted contributions. deviating from extant studies as follows. First, this study covers
Additionally, recent research relies on oversimplified all aspects of sustainability (i.e., environment, social, and
models that focus exclusively on the direct association between governance), so our findings offer a complete picture. Until
CSR and financial performance (Cho et al., 2019; McGuire now, most ESG research has focused on the total ESG score,
et al., 1988), ignoring alternative moderating factors. Organi- whereas the influence of the constituents CSR have been
zational behavior is moderated by certain corporate governance studied infrequently (Liu et al., 2021). Second, the study looks
systems, which they fail to consider (Rodriguez-Fernandez, at the intersection of ESG, CFP, and auditing. No other study
2016). Thus, it is worthwhile to investigate areas that previ- has examined these three aspects together in a single analysis.
ous studies have mostly overlooked to gain more nuanced Audit quality is a critical governance characteristic that is likely
knowledge about the ESG-CFP relationship, such as audit to prevent management opportunism. In conjunction with ESG
quality. Adding the importance of audit quality helps shed light performance, audit quality is correlated with improved finan-
on the relationship between ESG and CFP, in addition to cial success for businesses (Alareeni & Hamdan, 2020).
looking beyond the obvious connection. Recent empirical in- Therefore, the study answers a very important question: Does
vestigations indicate that, even when the ESG-CFP relationship audit quality make a difference in the relationship between
is positive, the relationship might be influenced by a variety of ESG rating and CFP? Third, we present a more complete
situational (moderating or mediating) variables (Busch & picture by examining the influence of different ESG compo-
Friede, 2018; Liu et al., 2021). In that light, a specialized nents, alternative financial performance measures, critical
governance mechanism, such as audit quality, might be critical control variables, the robustness of estimation techniques, and
for improving the quality of strategic choices and ensuring the a longer period (2010–2019). Finally, this study empirically
effective implementation of new initiatives. Audit quality is a explores this phenomenon in Western European markets,
critical governance technique for resolving agency issues considered pioneers in sustainability practices and the world's
(Watkins et al., 2004). Information asymmetry between loudest voice in advocacy of sustainable development.
stakeholders and management generates agency costs in an The rest of the article is organized as follows. Section 2
agency environment. Thus firms should use independent au- reviews the ESG-CFP literature and formulates hypotheses.
ditors to help them avoid opportunistic conduct (Buchanan Section 3 discusses the methodology used in the research,
et al., 2021). Thus, this article examines the correlation be- whereas Section 4 discusses the empirical findings and further
tween ESG and financial performance and emphasize the tests. Finally, Section 5 summarizes the findings and their
moderating role of audit quality. practical consequences, acknowledges the study's significant

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limitations, suggests further research, and offers management gain their support and approval (or to distract their opposition
and regulatory implications. and disapproval)” (Huang & Kung, 2010, p. 449). Employee,
customer, and stakeholder (including local governments and
2. Relevant literature and development of our hypotheses banks) interests have been promoted as long-term key strate-
gies in ESG (McWilliams & Siegel, 2001), with corporations
2.1. ESG and CFP that have social responsibility (Hussainey & Achek, 2015).
Socially responsible firms have conflicts with society, which
The CSR and CG concepts emerged in the setting of major coincides with a decrease in the cost of conflict and hence
listed corporations in highly industrialized countries, which increases shareholder value (Heal, 2005). According to mana-
sparked a boom in sustainable business and investment gerial myopia, managers tend to favor actions with short-term
(Alareeni & Hamdan, 2020). The relationship between ESG profit above those that optimize long-term shareholder value.
and various firm-level components has been extensively In contrast, investors with a short-term focus tend to under-
researched over the past few decades. The ESG literature could value long-term advantages. Because the expenses of socially
be divided into two streams, of which the first is the de- responsible acts are incurred immediately, their benefits are
terminants of CSR disclosure, and the second is the impact of realized in the long run. Therefore, the accompanying gains are
ESG on firm-level economic outcomes. The determinants of more difficult to foresee and less enticing to investors with a
CSR disclosure include company size, profitability, financial short-term focus.
leverage, industry environmental sensitivity, board size, In contrast, the neoclassical approach of Friedman (2007)
women members of the board, internationalization, and repu- emphasized profit maximization and value creation for share-
tation (Dyduch & Krasodomska, 2017). Second, a large corpus holders and management. Accordingly, corporate performance
of research examines how ESG affects different firm-level can be harmed by appeasing other stakeholder groups (Brown
outcomes. Research shows that ESG improves a company's & Caylor, 2006). Increasing costs, decreasing profitability, and
public image, which leads to an increase in sales and revenue reducing competitive advantage are the consequences of
(Nyame-Asiamah & Ghulam, 2019). Risk-related studies find a investing resources in achieving social and environmental ob-
negative impact of ESG on the financial leverage and overall jectives (e.g., reducing pollution, increasing employee
risk profile of the firm (Harjoto, 2017). Although company compensation and benefits, and supporting the community
image, leverage, and risk are some of the most important in- through donations and sponsorships) (Galant & Cadez, 2017;
dicators of firm performance, do these factors lead to better Zahid et al., 2022). According to Barnea and Rubin (2010),
financial performance? Managers are more concerned about the socially responsible activities that represent extravagant ex-
financial performance of the firm, as it is directly related to firm penditures by managers motivated by personal benefits, such as
value (Hill & Snell, 1988; Saygili et al., 2022). public appreciation, as opposed to the idealistic intent of
The nexus between ESG and CFP has been extensively nonfinancial value, result in a significant decrease in share-
researched in terms of the theoretical and applied aspects. One holder value and inferior financial performance. Therefore, an
established notion holds that no single theory can encompass agency issue arises. According to Krüger (2015), investors
the sustainability-related phenomenon (Khan et al., 2022; respond adversely (positively) to the announcement of socially
Zahid & Simga-Mugan, 2022). The current study incorporates responsible actions by enterprises with a high (low) liquidity
insights mainly from stakeholder theory (Freeman et al., 2010), position, and these investments are seen as inefficient. Agency
managerial myopia theory (Stein, 1988), trade-off theory theory is employed to support H1 and H2. Agency theory
(Aupperle et al., 1985), and agency theory (Jensen & captures attention in ESG-related studies because of the
Meckling, 1976). Two contradictory theoretical approaches governance aspect of ESG.
explain the ESG-CFP nexus; the trade-off hypothesis and the Many earlier investigations came to different conclusions
social effects (doing well while doing good) hypothesis show a about the ESG-CFP relationship. Some discovered a neutral,
negative and positive association between ESG and CFP, negative, or positive connection, while others reported a U-
respectively. The social effects hypothesis holds if the costs of shaped or inverted U-shaped ESG-CFP link. For instance,
socially responsible operations surpass the benefits. ESG has Shahzad et al. (2022) find a positive influence of ESG on a
some hidden value that converges with stakeholder and social firm's financial performance. Surroca et al. (2010) see no sig-
impact theories (Freeman et al., 2010). Freeman (2010) sup- nificant relation between ESG on a firm's financials. In com-
ports the engagement of management in ESG activities and parison, Wang and Bansal (2012) suggest that the adoption and
states that corporations can use ESG activities to resolve con- application of ESG inflate its cost, adversely affecting the firm's
flicts among stakeholders, such as managers, shareholders, financial performance. Gilley et al. (2000) demonstrate that, as
employees, and customers (Khan et al., 2021; Zahid et al., the positive effects of the implementation of ESG offset the
2022). ESG reporting is a tool used by an organization to adverse effects, the relation between ESG and financial per-
control, manage, influence, or even manipulate various stake- formance becomes U-shaped. Barnett and Salomon (2012)
holders. “Information—including financial accounting and so- confirm the existence of this U-shaped curve in their study.
cial accounting—is a major element that can be deployed by This U-shaped relationship is also supported by Nollet et al.
the organization to manage (or manipulate) the stakeholder to (2016) in the context of US firms. Han et al. (2016) find

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convexity in the ESG and financial performance of firms in Hypothesis 1. ESG and its components have a negative
Korea. Friede et al. (2015) compares the nonlinearity of the impact on corporate financial performance.
ESG-CFP relationship in developed and emerging markets.
They highlight the role of moderating variables and institu-
tional settings in changing the course of the ESG-CFP curve. 2.2. Moderating effect of audit quality and audit cost in
The trade-off argument supports studies that show negative ESG-CFP nexus
relationships in which ESG raises business costs and adversely
affects CFP (Wang & Bansal, 2012). At the same time, a According to the agency theory by Jensen and Meckling
positive association shows that being socially responsible firms (1976), auditing is a vital method for reducing information
boosts profits (Lee & Choi, 2021; Shahzad et al., 2022). inequality, restraining opportunistic conduct, and enhancing
However, studies that show a neutral connection reveal that ESG performance (Agyei-Mensah, 2018; Habbash &
being socially responsible does not influence profitability Alghamdi, 2017). Angelo (1988) defines audit quality as the
because the good impacts outweigh the negative ones (Gilley auditors' capacity to discover and disclose serious errors. A low
et al., 2000; Surroca et al., 2010). Then, studies with U-sha- probability of misinterpretation of financial statements,
ped or inverted U-shaped links imply that the ESG-CFP nexus including errors or misconduct, is a sign of high audit quality.
is influenced by the degree of ESG investment (Brammer & The extent to which an auditor renders an appropriate audit
Millington, 2008). Barnett and Salomon (2012) demonstrate opinion is what we refer to as the “quality” of an audit,
a U-shaped link. At the beginning, ESG activity harms CFP explained by Dewi and Monalisa (2016). Better auditing results
because costs outweigh benefits, but later on, the connection is in more accurate financial reporting, greater trustworthiness,
reversed and becomes positive. and less self-serving behavior (Watkins et al., 2004).
Researchers have also examined the impact of ESG on According to audit theory, the efficacy of external auditing
various corporate performance measures in a European context. is contingent on audit quality (Kausar et al., 2016; Knechel
For instance, Nirino et al. (2021) consider the moderating ef- et al., 2013). Various characteristics are proposed in prior
fect of ESG on the impact of corporate controversies on research to evaluate auditors' competency, including audit firm
financial performance. By employing linear regression models size. Along these lines, Angelo (1988) asserts that audit quality
on 365 European companies, they could not confirm the pos- rises with an audit firm's size or brand. Well-known auditors
itive impact of ESG on the financial performance of the Eu- produce higher-quality audits to protect their reputational
ropean firms engaged in corporate controversies. Rahi et al. capital and remain independent from their customers (Bacha
(2021) employ static and dynamic estimators on financial et al., 2020). Customers of the Big Four accounting firms
sector corporations in the Nordic countries and find a negative appear to be better off financially, according to recent studies
relationship between ESG and return on equity (ROE) and (Phan et al., 2020). Accredited audit firms help ensure that
earnings per share (EPS). Looking at 200 French enterprises audited companies' financial statements are reliable, trans-
listed from 2007 to 2018, Dakhli (2021) discover a significant parent, and valuable because they adhere to high-quality
positive correlation between CSR and financial performance. auditing standards. Aside from supporting good corporate
The proxies used to measure financial performance were ROA, governance and internal control, rigorous audits can help
ROE, and Tobin's Q. Dakhli also considers the moderating improve financial performance. It may be difficult to persuade
effect of audit quality and finds that the positive impact of the Big Four firms to breach established auditing norms because of
CSR is greater at French firms that are audited by Big Four the need to preserve their reputation (Ado et al., 2020). Large
auditors. audit firms always have higher audit quality, which infers that
More than a simple cause-and-effect relationship exists be- high audit quality can help corporations perform better finan-
tween ESG and CFP. Some experts argue that ESG policies are cially. Customers of Big Four firms, according to past studies,
nothing more than a cost to a company, resulting in a decrease demonstrate exceptional social performance (Agyei-Mensah,
in profitability (Kim & Lyon, 2015). Others show that CFP and 2018). CSR information may be more credible because of the
ESG components are positively related (Shahzad et al., 2022). investment in human capital and technology made by the Big
In short, the evidence in the literature linking ESG and the Four firms.
firm's financial performance is not conclusive. The literature Auditing cost is generally associated with audit quality.
above shows that the direction of the relationship between ESG Audit firms, known for their audit quality, tend to charge a
and CFP varies, depending on the market in which the research higher audit cost. Stakeholders link the audit cost and audit
was conducted and the profitability indexes that are used. The quality with the notion that corporate social governance en-
unavailability of a conclusive relation creates an opportunity hances firm value and image. The voluntary disclosure of more
for future research, and our research fill this gap, in particular reliable nonfinancial information and more accurate ESG
regarding Western Europe markets. scores can be ensured by setting up good-quality, cost-effective
Based on the preceding theoretical explanations and audits. For example, Ali and Lesage (2013) and Griffin et al.
empirical evidence, we expect to see a negative influence of (2010) show that audit pricing takes into account the charac-
ESG ratings and its components on CFP in Western European teristics of the clients and any potential agency issues. If au-
markets. The following hypothesis is proposed: ditors are implicated in a company controversy, they risk losing

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their reputation and incurring legal fees. High-risk clients are firms is in Germany (27.55%, 171 firms), with 1707 firm-year
charged a higher audit fee to offset anticipated losses (Simunic, observations, followed by France with a total of (23.41%, 145
1980). firms), and the fewest firms were selected from Monaco
As discussed in the preceding section, literature on ESG and (0.64%, 4 firms), with 40 firm-year observations.
firm performance demonstrates negative, positive, neutral, and
U-shaped results. This shows a need for further investigation of 3.2. Variable measurements
this relationship to improve understanding. To fill this gap, we
introduce audit quality in this model. Moreover, despite the 3.2.1. Dependent variable
plethora of research on the relationship between ESG and CFP, We use two different parameters—namely, return on assets
none of the studies has incorporated the moderating impact of (ROA) and sales revenue (Rev(ln)) of the firms—to measure
audit quality underlying the ESG-CFP nexus. The present corporate financial performance (CFP), the dependent variable.
study also fills this gap. Following prior research, we propose ROA is the ratio of net earnings to total assets, and sales
that a contingency approach is necessary for understanding revenue is the natural logarithm of net sales for a year. They are
ESG's influence on CFP. Accordingly, this study examines some of the most popular measures used in the literature
how audit quality and cost influence the link between ESG and (Chakroun & Amar, 2021; Cho et al., 2019).
the financial performance of companies. Accordingly, higher
audit quality contributes to both ESG and corporate financial 3.2.2. Independent variables
performance (by restraining opportunistic behavior and We use the ESG score and its components (environmental,
lowering agency conflict concerns); therefore, audit quality is social, and governance) scores as independent variables. The
expected to moderate the ESG-CFP relationship positively: ESG score is a multidimensional index based on several
financial and nonfinancial indicators. In particular, Thomson
Hypothesis 2. Audit quality positively moderates the ESG-
Reuters obtains and processes more than 400 ESG measures in
CFP relationship.
the public domain to construct the 178 most comparable
measures, which are then grouped into ten categories, that
range on a scale of 0–100, with a higher score showing better
3. Data and methodology ESG accomplishment. ESG scores are constructed from the
outputs of environmental, social, and governance disclosures. It
3.1. Data description and sample selection is beneficial to have independent data accessible for each
component to avoid the potential for one dimension to influ-
The ESG and the firm performance have become the need of ence another, which can cancel out the overall impact (Buallay
the hour in the context of sustainability. In this regard, the et al., 2020). This categorization enables us to determine which
disclosure of these practices varies by countries and companies. component of the ESG score is the primary driver of CFP and
The Eikon Refinitiv database is used to identify the firms that which variable has the most significant impact on CFP.
practice ESG reporting. Initially, the data were gathered from
651 nonfinancial listed companies headquartered in Western 3.2.3. Moderating variables
countries, including Austria, Belgium, France, Germany,
Luxembourg, Monaco, the Netherlands, and Switzerland, from Audit quality is used as a moderating variable in the study.
2010 to 2019. Because ESG is a voluntary disclosure, most Based on prior research, audit quality is proxied by the Big Four,
firms do not report it. In 2014, the EU approved a regulation on the world's four largest accounting firms (Deloitte, Ernst &
nonfinancial reporting, pursuant to which major public firms Young, KPMG, and PriceWaterhouseCoopers). Because of their
(those employing more than 500 people) were required to well-established brand names, Big Four companies are more
provide information about their operations concerning the motivated to provide higher-quality auditing services in order to
environment, social, and governance issues (European preserve their reputation (Angelo, 1988; Watkins et al., 2004). It is
Parliament, 2014). Moreover, the EU released the “European a dummy variable, which takes a value of 1 if a Big Four com-
Green Deal” initiative in December 2019, an action plan to panies audits the company's financial statements; otherwise, 0.
make Europe a climate-neutral continent by 2050 (European
Commission, 2019). We selected Western European countries 3.2.4. Control variables
because they focus on ESG-related reporting and data avail-
ability. Another reason for selecting this sample is that Europe Several factors are involved in determining the firm's per-
is a pioneer in raising its voice against environmental harm by formance. In order to examine the impact of ESG on CFP, we
industry and is among the regions where firms started to consider some control variables based on prior literature,
disclose ESG-related practices. In fact, the 651 firms comprise including size, financial leverage, dividends paid, and the
all the nonfinancial firms in these countries that reported ESG price-to-book value in order to capture the impact of size,
data in the database. After scrutiny, 620 companies, with 6195 flexibility, profitability, and firm growth, respectively. The
firm-year observations, were chosen because of the unavail- literature shows a positive relation between firm size and a
ability of data on some companies. The highest number of firm's financial performance, so firm size is considered as a

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control variable, measured as the natural log of total assets Table 1

(Zhu et al., 2014). Financial leverage has a negative relation to Descriptive statistics.
the firm's financial performance (Naseem et al., 2020), so it is Variable Obs. Mean Std. Dev. Min. Max.
included as a control variable, measured as the ratio of total ROA 5723 .036 .127 −3.813 .623
liabilities to total assets. Firms with high dividend payments are Rev(ln) 5385 2.122 .205 .6934 2.6876
seen as having healthy financial performance; we measure it as ESG 3562 52.995 21.075 2.25 94.117
Environment 3562 51.951 28.163 0 99.1
the ratio of dividends paid to total assets (Benlemlih, 2019). Social 3562 57.682 24.287 .122 98.249
Finally, the price-to-book value is measured as the ratio of the Governance 3562 49.352 23.057 .495 97.76
market value of shares of a company to its book value of eq- Big4_Auditor 5509 .785 .411 0 1
uity, which shows the firm's opportunities for growth. Audit fee 4842 14.119 1.482 7.185 18.231
ROE 5379 −.021 8.889 −650.6 14.316
Size 5851 22.001 1.925 13.008 28.044
3.2.5. Empirical models
FL 5849 .548 13.545 −877.372 169.566
Dividend Paid (ln) 4595 18.156 1.845 7.601 23.475
The following multivariate regression model is estimated to Price-to-Book 5427 2.587 19.032 −783.876 764.776
test the hypothesized relationships between ESG and CFP. Notes: ROA = return on assets, Rev(ln) = natural logarithm of revenue/sales,
ESG = Environmental, Social and Governance score (Thomson Reuters Eikon
Fin Perf = α + β1 ESGit + β2 Sizeit + β3 FLit + β4 Div payoutit Refinitiv), Big4_Auditor = audited by a Big Four firm, ROE = return on assets,
n size = natural logarithm of total assets, FL = debt to assets ratio.
+ β5 PTBit + ∑ βn Country Dummiesit
i=1
n
4. Results and discussions
+ ∑ βn Industry Dummiesit
i=1 4.1. Descriptive statistics and correlation analysis
n
+ ∑ βn Year Dummiesit + εit Table 1 contains descriptive data for the variables used in the
i=1
study. The mean value is 0.036 for ROA and 2.122 for Rev(ln),
(1) with standard deviations of 0.127 and 0.205, respectively. The
In Equation (1), i is the firm, and t is the time in years. mean value of the ESG score is 52.99, with the highest score
Fin_Perf is the financial performance, measured by ROA and (57.68) in the social component, whereas the standard deviation
sales revenue (Rev(ln)); ESG refers to the environment, social, of ESG ratings is 21.7, with a higher standard deviation (28.16)
and governance scores; Size is the log of the total assets of the in the environmental component. Financial leverage and price-
firm; financial leverage (FL) is measured as the ratio of total to-book ratios have higher standard deviations than size and
debt to total assets; dividend payout (DP) is the measured as dividends payable, showing that the enterprises have a range of
the dividend paid divided by total assets, and PTB is the price- indebtedness risk and profitability characteristics.
to-book ratio. We include country, industry, and year dummies
to avoid common endogeneity issues that arise over time across 4.2. ESG and corporate financial performance
industries and countries. Ɛ is the error term.
Further, to examine the moderating role of audit quality and Table 2 summarizes the results of the ESG and CFP rela-
the cost of audits in the ESG-CFP nexus, we introduced an tionship based on the estimation of Equation (1). We use a
interaction term, Big4 × ESG, that is, the interaction effect panel ordinary least squares (OLS) regression with fixed effects
between being audited by Big Four accounting firms and ESG for the year, company, and country (the Hausman tests also
and its components. Equation (2) shows the model in detail. suggest a preference for the fixed-effect [FE] model). Table 2,
panels A and B, illustrates the effect of ESG factors and its
Fin Perf = α + β1 ESGit + β2 Big4it + β3 Big4it × ESGit components on ROA and Rev(ln), respectively. Models 1, 2, 3,
+ β4 Div Payoutit + β3 FLit + β4 ROAit + β5 PTBit and 4 illustrate the impact of the ESG, Environment, Social,
n and Governance ratings on CFP.
+ ∑ βn Country Dummiesit The findings indicate that the ESG score and its components
i=1 have a statistically significantly negative effect on ROA. The
n
social and governance scores have a significantly positive
+ ∑ βn Industry Dummiesit impact on revenue, whereas the overall ESG and environ-
i=1
n mental components are not significantly related to revenue.
+ ∑ βn Year Dummiesit εit ESG and its components have a negative effect on ROA,
i=1 showing that the expense of ESG practices becomes a cost to
(2) shareholders, limiting investment opportunities and overall
performance (Kim & Lyon, 2015). Therefore, our findings are
where all the variables are the same as in Equation (1), except consistent with H1 and support the trade-off hypothesis or
the interaction term, Big4 × ESG, to capture the moderating traditionalist perspective of a negative relationship between
impact of audit quality. ESG and CFP. Spending money on environmental and social
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Table 2
ESG and corporate financial performance.
Variables Panel A: ROA Panel B: Rev(ln)
1 2 3 4 1 2 3 4
ESG −0.388*** 0.293
(0.0925) (0.557)
Environment −0.264*** 0.642
(0.0750) (0.467)
Social −0.227*** −0.849**
(0.0683) (0.406)
Governance −0.187*** 0.836**
(0.0683) (0.407)
Size −6.690* −7.926** −8.082** −9.582*** 0.610*** 0.606*** 0.625*** 0.606***
(3.775) (3.740) (3.742) (3.673) (0.0222) (0.0219) (0.0219) (0.0215)
FL 1.101*** 1.112*** 1.108*** 1.128*** −0.0139 −0.0110 −0.0282 −0.0122
(0.308) (0.309) (0.309) (0.309) (0.177) (0.176) (0.176) (0.176)
Dividend Paid (ln) 5.625*** 5.361*** 5.394*** 5.371*** 0.098*** 0.195*** 0.215*** 0.188***
(1.068) (1.064) (1.065) (1.068) (0.0624) (0.0621) (0.0621) (0.0622)
Price-to-Book 0.0781 0.0766 0.0804 0.0760 0.0254 0.0255 0.0267 0.0260
(0.0590) (0.0591) (0.0591) (0.0591) (0.0336) (0.0336) (0.0335) (0.0335)
Constant 120.0 146.6* 148.6* 179.5** 7.938*** 8.022*** 7.618*** 8.028***
(83.66) (82.93) (83.07) (81.75) (0.486) (0.481) (0.482) (0.473)
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Observations 3011 3011 3011 3011 2705 2705 2705 2705
Number of Firms 520 520 520 520 477 477 477 477
Notes: See notes to Table 1. Equation (1) is the model estimated. Standard errors in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.

goals (e.g., pollution control, higher salaries and benefits, and term profit. Acts of social responsibility have a short-term
community donations and sponsorships) increases expenditure, financial cost but a long-term financial reward. Thus it is diffi-
lowers profitability, and diminishes competitive advantage cult to predict the associated benefits of ESG firms and less
(Galant & Cadez, 2017). appealing to investors with a focus on the short term (Stein,
However, the positive impact of the social and governance 1988).
components of ESG on CFP shows that investment in social Corporate size negatively influences ROA, but financial
initiatives enables businesses to develop a positive brand image leverage and dividend payout have a positive effect. These
and reputation (Bahta et al., 2021) and attract a diverse range of findings corroborate earlier research indicating that larger en-
creditors and investors (Barnett & Salomon, 2012). Social ini- terprises generate more competition than smaller competitors.
tiatives and better governance signal the market and attract more This advantage enables businesses to obtain economies of scale
customers than revenue increases. According to McGuire et al. and consolidate their market position (Chakroun & Amar,
(1988) and (Bacha et al., 2020), enterprises with better ESG 2021; Cho et al., 2019).
performance are less risky than their counterparts. As a result,
socially responsible businesses are related to greater investor 4.3. ESG and CFP nexus: the moderating role of audit
preference (Bacha et al., 2020). These findings corroborate those quality
of Rodriguez-Fernandez (2016), Okafor et al. (2021), and
Shahzad et al. (2022), who all say that enterprises with a stronger Table 3 states that the audit quality (i.e., Big Four auditor) of
social mission achieve superior performance. They contend that financial statements has a significantly positive influence on the
a company's image can be enhanced through social programs. effect on ROA. At the same time, the interaction term (i.e.,
Our results show that customers feel gratified when they pur- Big4 × ESG and its components, respectively) have a signifi-
chase products or services from firms that participate in social cantly negative moderating impact on the ESG-ROA relation-
initiatives (Phan et al., 2020); as a result, corporate sales grow. ship. In other words, ESG policies, when combined with
However, excessive spending by managers in ESG activities is improved audit quality as demonstrated by Big Four certification
driven by self-interest, rather than the idealistic purpose of of company financial reports, result in a decline in historical
nonfinancial value. Consequently, agency problems can emerge, financial performance during the period studied. The effect is
which increase the overall cost of doing business, thus share- consistent with that for the subcomponents of environment, so-
holder value and financial performance are significantly cial, and governance. Further, the financial audit quality (Big4
decreased (Barnea & Rubin, 2010). Short-term profits are Auditor) strongly moderates the relation between ESG and
prioritized by management, while long-term benefits are corporate performance indicators. A comparison of the results of
undervalued in the minds of investors, who are focused on short- Table 3 with those in Table 2 reveals that including the Big Four

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Table 3
Moderating role of Audit Quality (Big4) in the ESG-CFP nexus.
Variables Panel A: ROA Panel B: Rev(ln)
1 2 3 4 1 2 3 4
ESG −0.404** 0.0588
(0.159) (0.0973)
Environment −0.309** 0.0116
(0.123) (0.0770)
Social −0.210* 0.166**
(0.123) (0.0748)
Governance −0.176 0.0757
(0.122) (0.0751)
Big4_Auditor 3.280* 1.378** 3.594* 4.061 −0.0478* −0.0303* −0.0520 0.0128*
(9.008) (7.331) (7.766) (6.839) (0.0552) (0.0460) (0.0473) (0.0418)
Big4 × ESG −0.0343* 0.119*
(0.151) (0.0926)
Big4 × Environment −0.0397* 0.0835*
(0.114) (0.0710)
Big4 × Social −0.0320* 0.123**
(0.122) (0.0744)
Big4 × Governance −0.0535** 0.0138*
(0.119) (0.0737)
Size −6.530* −7.695** −8.380** −9.706*** 0.615*** 0.613*** 0.631*** 0.612***
(3.863) (3.829) (3.835) (3.759) (0.0235) (0.0232) (0.0232) (0.0227)
FL 1.631*** 1.644*** 1.644*** 1.672*** 0.0508 0.0519 0.0298 0.0498
(0.370) (0.370) (0.371) (0.371) (0.220) (0.220) (0.220) (0.219)
Dividend Paid (ln) 6.297*** 5.998*** 6.002*** 6.019*** 0.216*** 0.216*** 0.234*** 0.205***
(1.099) (1.094) (1.097) (1.098) (0.0663) (0.0660) (0.0660) (0.0661)
Price-to-Book 0.0674 0.0655 0.0699 0.0661 0.0248 0.0253 0.0254 0.000252
(0.0581) (0.0581) (0.0582) (0.0582) (0.0341) (0.0341) (0.0341) (0.0341)
Constant 103.3 130.5 141.5* 168.4** 7.801*** 7.838*** 7.480*** 7.832***
(85.79) (85.05) (85.12) (83.81) (0.516) (0.510) (0.511) (0.503)
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
\Observations 2808 2808 2808 2808 2527 2527 2527 2527
R-squared 0.310 0.297 0.278 0.279 0.302 0.302 0.303 0.303
Number of Firms 516 516 516 516 473 473 473 473
Notes: See notes to Table 1. Equation (2) is the model estimated. Standard errors in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.

auditor in the model increases the negative impact of ESG on the company is more likely to achieve success in terms of
financial performance (ROA) from −0.388 to −0.404. Thus, growth. Thus, our findings lend credence to the agency theory
improved audit quality, as evidenced by Big Four certification of (Jensen & Meckling, 1976), which identifies auditing as a
company financial reports, negatively affects the link between critical monitoring tool for mitigating information asymmetry,
ESG practices and historical financial performance in Western constraining opportunistic behavior, and enhancing ESG per-
European countries in the period investigated. However, panel 2 formance and disclosure (Agyei-Mensah, 2018; Cho et al.,
of Table 3 reveals that audit quality has a significantly positive 2019; Habbash & Alghamdi, 2017). According to Ado et al.
relation to revenue. This means that auditing by Big Four audi- (2020), Big 4 auditors are seen as more trustworthy because
tors increases the firm's overall revenue. These findings they devote significant resources to improving audit quality and
corroborate earlier empirical findings (Phan et al., 2020), facilitating the spread and implementation of best practices,
showing that customers of Big 4 firms achieve superior financial such as ESG (Bacha et al., 2020). By retaining Big 4 auditors,
performance. They suggest that rigorous audits can help firms socially conscious businesses commit to ethical standards,
strengthen their corporate governance and internal control sys- openness, and trustworthiness.
tems, improving their financial performance. Additionally, Overall, the results indicate that adding audit quality to ESG
stakeholders believe that organizations audited by the Big 4 are practices improves business revenues because Big 4 auditors
free of significant misstatements, promoting and strengthening give creditors and customers additional confidence regarding
their trust in these firms to invest more. the success of the firm's strategy and the legitimacy of ESG
Further, the coefficients of the interaction term (Big4 data. However, ESG's negative influence on company financial
auditor × ESG) are all positive and significant. When a Big 4 performance is more evident at enterprises certified by the Big
firm audits a socially responsible business (high ESG scores), 4 accounting firms.

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Table 4
ESG-CFP nexus-Alternative dependent variable (ROE).
Variables ROE
1 2 3 4 5 6 7 8
ESG −0.296** −0.0833*
(0.408) (0.719)
Environment −0.392* −0.598*
(0.339) (0.568)
Social −0.354* −0.109*
(0.297) (0.554)
Governance 0.186 0.579
(0.297) (0.553)
Big4_Auditor 3.842** 9.899 4.065* 4.701*
(4.044) (3.390) (3.462) (3.071)
Big4 × ESG −0.293*
(0.677)
Big4 × Environment 0.198
(0.521)
Big4 × Social −0.312*
(0.547)
Big4 × Governance −0.488*
(0.541)
Size −62.31*** −60.89*** −60.84*** −67.19*** −66.54*** −65.06*** −65.46*** −71.60***
(16.13) (15.99) (15.97) (15.65) (17.21) (17.05) (17.05) (16.67)
FL −5.071*** −5.094*** −5.102*** −5.050*** −4.931*** −4.963*** −4.969*** −4.910***
(1.432) (1.432) (1.432) (1.432) (1.870) (1.870) (1.870) (1.869)
Dividend paid (ln) 13.35*** 13.35*** 13.56*** 12.34** 13.73*** 13.84*** 13.86*** 12.74**
(5.060) (5.019) (5.038) (5.036) (5.260) (5.215) (5.238) (5.233)
Price-to-Book −2.486*** −2.487*** −2.481*** −2.485*** −2.464*** −2.465*** −2.459*** −2.462***
(0.251) (0.251) (0.251) (0.251) (0.258) (0.258) (0.258) (0.258)
Constant 1336*** 1309*** 1304*** 1441*** 1395*** 1389*** 1371*** 1496***
(355.5) (351.9) (352.4) (345.7) (379.9) (376.0) (376.1) (369.2)
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Observations 2806 2806 2806 2806 2623 2623 2623 2623
Number of Firms 492 492 492 492 488 488 488 488
Notes: See notes to Table 1. Standard errors in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.

4.4. Robustness analysis audit fees to calculate audit fees in the manner described by
Bacha et al. (2020) and Garcia et al. (2018). The audit fee
4.4.1. Alternative dependent variable multiplied by ESG (Audit_fee × ESG) denotes the impact of
We replaced the primary dependent variables with an auditing quality in ESG (its components) and the CFP
alternate measure of CFP, that is, ROE, and calculated our relationship.
main and moderating models to confirm their robustness. Table Equation (2) is re-estimated using audit fees (Audit_fee) as a
4 summarizes the findings in detail. Models 1–4 show that the proxy for audit quality. Table 5 demonstrates that our findings
signs and significance levels of the main explanatory variables are similar to those in Table 3. The interaction term
remain unchanged following the substitution. Models 5–8 give Audit_fee × ESG has a significantly negative effect on the
the findings for the moderating variable (i.e., audit quality), financial performance of Western European enterprises. How-
demonstrating that the coefficient of the Big Four auditor ever, although the impacts are identical in direction (all are
interaction term significantly negatively affects the ESG-CFP positive), their magnitudes vary.
nexus. The robustness tests, on the whole, confirm the main
results of the primary model. 4.4.3. Endogeneity issue

4.4.2. Alternative moderating variable of audit quality We used the conventional endogeneity procedure to confirm
To ensure the robustness of our main findings, we next that our findings are free of any endogeneity biasness, con-
examine whether the moderating effect of audit quality remains sisting of a two-stage least squares regression (2SLS). We
intact after the measure of audit quality is changed. So, audit employ an instrumental variable for ESG (i.e., change in ESG
quality (AQ) is quantified in terms of audit fees (Audit_fee) as (ΔESG)), which is likely to satisfy the criterion of correlation
an alternative to Big Four auditors. We use the logarithm of with ESG but not CFP. 2SLS is preferred over OLS because of

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Table 5
ESG-CFP nexus Alternative Audit Quality (Audit fee) moderating variable.
Variables Panel A: ROA Panel B: Rev(ln)
1 2 3 4 1 2 3 4
ESG −1.248* 0.186***
(0.970) (0.0623)
Environment −0.348* 0.0954*
(0.737) (0.0503)
Social −0.409* 0.104**
(0.760) (0.0471)
Governance −1.708** 0.134***
(0.763) (0.0481)
Size −3.723 −5.806 −5.275 −6.868 0.583*** 0.579*** 0.601*** 0.576***
(4.296) (4.261) (4.258) (4.207) (0.0254) (0.0251) (0.0251) (0.0248)
FL 1.598*** 1.617*** 1.604*** 1.637*** 0.0653 0.0706 0.0380 0.0787
(0.385) (0.386) (0.386) (0.386) (0.223) (0.223) (0.223) (0.223)
Dividend paid (ln) 5.721*** 5.349*** 5.490*** 5.509*** 0.198*** 0.195*** 0.219*** 0.181**
(1.216) (1.214) (1.214) (1.218) (0.0718) (0.0715) (0.0716) (0.0717)
Price-to-Book 0.0666 0.0644 0.0693 0.0658 0.0169 0.0182 0.0184 0.0188
(0.0605) (0.0607) (0.0606) (0.0607) (0.0347) (0.0347) (0.0347) (0.0347)
Audit fee −8.857** −6.132* −6.269* −11.60*** 0.119*** 0.0829*** 0.0936*** 0.101***
(4.365) (3.658) (3.792) (3.847) (0.0274) (0.0232) (0.0230) (0.0238)
ESG × Audit fee 0.515* −0.126***
(0.658) (0.0426)
Environment × Audit fee 0.0265 −0.0603*
(0.500) (0.0348)
Social × Audit fee 0.0607* −0.0777**
(0.516) (0.0321)
Governance × Audit fee 0.995* −0.0859***
(0.512) (0.0325)
Constant 184.9* 190.4* 179.7* 286.6*** 6.833*** 7.419*** 6.796*** 7.244***
(103.0) (97.91) (99.32) (96.06) (0.618) (0.587) (0.588) (0.567)
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Observations 2667 2667 2667 2667 2396 2396 2396 2396
R-squared 0.032 0.027 0.029 0.027 0.293 0.292 0.294 0.294
Number of Firms 496 496 496 496 454 454 454 454
Notes: See notes to Table 1. Standard errors in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.

its ability to mitigate endogeneity issues. Table 6 details the boosting short-run performance. ESG disclosure and strate-
2SLS regression results on the ESG-CFP nexus. The overall gies can add value to a company's products and boost buyers
results of 2SLS confirm the main regression findings, indi- and investors' desire to buy, resulting in increased business
cating that the results are consistent after accounting for revenue. ESG activities boost corporate image and revenue.
possible endogeneity. We address our second objective by investigating the
moderating influence of audit quality on the ESG-CFP nexus.
5. Conclusions and policy implications The findings indicate that incremental audit quality, measured
by Big 4 auditors, when combined with ESG, adversely af-
This study examines the effect of ESG on CFP and the fects a firm's historical financial performance. However,
moderating role of audit quality in this relationship. The ESG's beneficial influence on performance, measured as
regression models show that ESG has a negative effect on a revenue, is more evident at enterprises certified by the Big 4
firm's historical financial performance, measured by ROA, accounting firms.
corroborating the trade-off hypothesis or traditional perspec- The findings of this study have significant implications for
tive that spending on environmental, social, and sustainable managers and policy makers in European countries and other
activities increases costs and decreases profitability. This advanced economies. Our results suggest that ESG is advanta-
might be because socially responsible businesses incur more geous to shareholders in the long run, so substantial resources
financial expenses, resulting in worse operational and finan- should be allocated to this area. In addition, authorities such as
cial performance. However, ESG positively affects firm rev- central banks, auditors, and stock market organizers are
enue because customers reward good ESG strategies, encouraged to examine ESG as a source of accurate financial

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Table 6
Robustness test: ESG-CFP relationship 2SLS estimation.
Variables Panel A: ROA Panel B: Rev(ln)
1 2 3 4 1 2 3 4
ESG −0.303** 0.0721*
(0.249) (0.159)
Environment −0.379* 0.0958
(0.311) (0.212)
Social 0.315* 0.0756*
(0.258) (0.168)
Governance 0.245* 0.0557
(0.201) (0.123)
Size −8.693* −8.793 −8.765* −8.572* 0.588*** 0.586*** 0.586*** 0.591***
(4.937) (5.443) (5.291) (4.459) (0.0305) (0.0339) (0.0336) (0.0272)
FL 1.132*** 1.133*** 1.134*** 1.131*** 0.000800 0.000807 0.000834 0.000772
(0.412) (0.413) (0.413) (0.412) (0.00247) (0.00247) (0.00248) (0.00246)
Dividend paid (ln) 3.668*** 3.668*** 3.667*** 3.669*** 0.0189** 0.0189** 0.0189** 0.0190**
(1.231) (1.232) (1.233) (1.228) (0.0748) (0.0750) (0.0752) (0.0744)
Price-to-Book 0.213** 0.213** 0.212** 0.213** 0.0527 0.0538 0.0501 0.0538
(0.0961) (0.0961) (0.0966) (0.0961) (0.0568) (0.0569) (0.0573) (0.0568)
Country FE Yes Yes Yes Yes Yes Yes Yes Yes
Industry FE Yes Yes Yes Yes Yes Yes Yes Yes
Year FE Yes Yes Yes Yes Yes Yes Yes Yes
Instrumental variable ESG Env Soc Gov ESG Env Soc Gov
Observations 2405 2405 2405 2405 2151 2151 2151 2151
Number of Firms 338 338 338 338 308 308 308 308
Notes: See notes to Table 1. Instrumental variable: ΔESG. Standard errors in parentheses. ***p < 0.01, **p < 0.05, *p < 0.1.

data. Moreover, stakeholders, such as investors, advocate greater design but in different institutional settings? We leave this
understanding of ESG and its significance to businesses to question to future research.
enable them to make more informed investment decisions. The
findings show investors that business performance can be Declaration of competing interest
improved not only through social initiatives but also through the
hiring of a competent auditor. Audits conducted by the Big Four The authors have no relevant financial or non-financial in-
auditors improve the financial performance of businesses with a terests to disclose.
social conscience. The benefit is evident from a boost in short-
run revenue. With respect to the efficacy of CG code application Acknowledgments
in Europe and other developed countries, regulators of CG codes
can use the findings of this study to develop new rules and We are thankful to Dr. Alina Taran and Dr. Shoaib Irshad in
amendments and implement critical corrective measures. helping data extraction; and Debra Soled for language editing.
One of the study's major shortcomings is that the ESG rat- We are grateful to the editor, Professor Ali Kutan, and anon-
ings do not consider the type of ESG disclosure used by a firm. ymous referees for their valuable comments. All remaining
Additionally, when many types of ESG disclosures are merged errors are our own.
into a single score, the associated impacts might cancel each
other out when the actual effect is calculated. Other research References
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