Businesses that boast strong sustainability practices perform better than their peers when subjected to rigorous auditing standards, a new study by Nagoya University in Japan has found.
The study, Sustainability and financial disclosure: role of ESG in key audit matters adoption, which was published in Managerial Auditing Journal, examined the connection between the implementation of key audit matters, or KAMs, which provide investors with clearer information about the most significant issues identified during an audit, and firms’ sustainability practices.
As it noted, in 2015, the International Auditing and Assurance Standards Board (IAASB) recommended that firms communicate KAMs to better inform investors about potential company risks.
In Japan, publicly-traded companies were permitted to adopt this reporting approach on a voluntary basis in 2019, before it became mandatory in 2020, creating a ‘natural experiment’ that enabled researchers to observe the firms that chose early adoption and how markets responded.
‘Commitment to sustainability’
“You can’t simply buy credibility by paying for expensive audits,” commented report co-author Hu Dan Semba, associate professor at Nagoya University’s Graduate School of Economics. “But if you’ve demonstrated commitment to sustainability practices, then investing in more transparent auditing amplifies that credibility, and markets reward it.”
The research team tracked data from 1,065 Japanese businesses between 2009 and 2023, and found that only a small group of non-financial firms adopted the new audit disclosures voluntarily, before the practice became mandatory.
‘Underlying quality’
As the study found, these early adopters tended to have higher ESG scores, “demonstrating their interest in signalling their underlying quality”, as Semba noted.
In addition, firms with higher ESG scores tended to pay more for audit and consultancy services after adopting KAMs, however, when these became mandatory, their audit and non-audit fees reduced, indicating that early disclosure enabled them to disclose and mitigate audit risks in advance.
“The market appears to view ESG practices and KAMs reporting as a sort of two-factor authentication,” Semba added. “When companies with authentic sustainability practices invest heavily in transparent auditing, investors interpret it as a credible signal of organisational strength.” Read more here.
