Corporate social responsibility risk and auditor–client retention

• Author: Li (Lily) Zheng Brooks,Bernard Wong‐On‐Wing,Sue Gill
• DOI: http://doi.org/10.1111/ijau.12148
• Published date: 01 March 2019
• Date: 01 March 2019

ORIGINAL ARTICLE

Corporate social responsibility risk and auditor–client retention

Li (Lily) Zheng Brooks

1

|Sue Gill

2

|Bernard Wong‐On‐Wing

2

1

Department of Accounting Division of

International Banking and Financial Studies,

Texas A & M International University, Laredo,

Texas, USA

2

Department of Accounting College of

Business, Washington State University,

Pullman, Washington, USA

Correspondence

Li (Lily) Zheng Brooks, Department of

Accounting Division of International Banking

and Financial Studies Texas A & M

International University, Laredo, TX 78041,

USA.

Email: lily.brooks@tamiu.com

Literature suggests that firms engaging in irresponsible corporate social responsibility

(CSR) activities are more likely to increase auditor's engagement risk. Using audit firm

tenure as a continuous measure for retention decisions made by either auditors or

client firms, we find a significant and negative association between CSR risk and

auditor tenure. Moreover, when the continuous variable audit tenure is replaced with

a dichotomous variable auditor change, the likelihood of auditor change intensifies

with increases in CSR risk. These results suggest that both clients and auditors are

more likely to sever relationships when client firms exhibit high CSR risk than low

CSR risk. This study has implications for future research on audit firm tenure and audit

outcomes.

KEYWORDS

audit firm tenure, audit risk, auditor choice,business risk (auditing), client retention, corporate

social responsibility, CSR risk, engagement risk, mandatory auditor rotation, sustainability

1|INTRODUCTION

According to recent surveys conducted by the international public

accounting firm KPMG, approximately 83% in 2011 and 86% in 2013

of US top 100 firms provide corporate social responsibility (CSR) infor-

mation in stand‐alone reports or integrated with annual financial

reports (KPMG, 2011, 2013). As the reporting and assurance of CSR

information have become mainstream among the world's largest com-

panies, a body of research has examined the impact of CSR on firms.

A number of theories posit benefits to firms undertaking positive CSR

activities (Carroll, 1979; Freeman, 1984; Jones, 1995; Kreps, 1990;

Van der Laan Smith, Adhikari, & Tondkar, 2005), whereas empirical

studies examine relationships between CSR and other corporate deci-

sions. Socially responsible firms are shown to be less likely to engage

in earnings management (Kim, Park, & Benson, 2012), more likely to

demonstrate transparent financial reporting quality (Dhaliwal, Li, Tsang,

& Yang, 2011; Dhaliwal, Radhakrishnan, Tsang, & Yang, 2012), and less

likely to pursue aggressive tax positions (Hoi, Wu, & Zhang, 2013; Lanis

& Richardson, 2012) than their less socially responsible counterparts.

CSR studies in the audit area provide evidence that irresponsible

social activities impose threats to auditors' engagement risk, resulting

in changes in auditors' actions. Specifically, studies document

relationships between irresponsible social activities and increased

audit fees (Koh & Tong, 2013). However, it is currently unclear

whether the risk related to irresponsible social activities (hereafter

referred to as CSR risk) is related to auditor–client retention deci-

sions.

1

This study examines the existence and nature of any significant

association between auditor tenure and CSR risk.

Understanding whether CSR risk is related to auditor–client reten-

tion (also referred to as auditor tenure) is important for the following

reasons. First, the nature of any significant association between auditor

tenure and CSR risk would have implications for research on the asso-

ciation between auditor tenure and audit opinions. On the one hand,

as high CSR risk has been shown to be related to lower quality financial

reporting (Dhaliwal et al., 2011; Dhaliwal et al., 2012; Kim et al., 2012)

and a greater likelihood of modified audit opinions (Koh & Tong, 2013),

to the extent that high‐CSR‐risk firms dismiss auditors or auditors

resign from such risky clients, there would exist a mechanical positive

relationship between auditor tenure and unmodified audit opinions.

On the other hand, a mechanical negative association would be found

if high‐CSR‐risk clients, particularly those who are more likely to man-

age earnings to meet or beat financial analyst forecasts, remain with

auditors for a longer period of time (e.g., Davis, Soo, & Trompeter,

2009). Essentially, in these scenarios, auditor tenure serves as a proxy

for earnings quality (Myers, Myers, & Omer, 2003).

Second, and related to the foregoing, understanding the sensitiv-

ity of auditor–client retention to CSR risk can help regulators and

Data Availability: Data used in this study are available from public sources iden-

tified in the article.

Received: 10 August 2015 Revised: 5 November 2018 Accepted: 6 November 2018

DOI: 10.1111/ijau.12148

Int J Audit. 2019;23:95–111. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/ijau 95

standard‐setters evaluate the necessity of mandatory auditor rotation

and the important factor to consider when evaluating the association

between audit firm tenure and audit outcomes. Although in the USA

the Public Company Accounting Oversight Board (PCAOB) is not cur-

rently pursuing mandatory auditor rotation at the firm level, it is an

issue that may resurface in the future, particularly as other countries

(e.g., the European Union) are still moving forward with mandating

audit firm rotation. As such, this remains a relevant issue for audit

researchers. Finally, a relationship between CSR risk and auditor ten-

ure would provide evidence of an additional factor related to

auditor–client retention decisions and the trade‐offs associated with

making this type of rational decision.

Using a panel data fixed‐effects model to control for time‐

invariant firm characteristics that may jointly affect CSR activities

and auditor–client retention decisions and to measure auditor tenure

as the number of years the auditor has served the same client, the

natural logarithm of the number of years the auditor has served the

same client, and the annual decile rank of audit firm tenure, we find

a significant negative association between CSR risk and auditor

tenure for the sample period of 2004–2013. In terms of the economic

significance of our results, we find that the average auditor–client

retention year under the current voluntary regime is around 16 years

when CSR risk is at its sample median and that a one standard

deviation increase in CSR risk decreases auditor tenure by approxi-

mately 1–4 months.

We employ a series of robustness checks to solidify our main

results. First, we test our hypothesis using auditor turnover, rather

than length of auditor tenure. Controlling for documented determi-

nants of auditor changes, we provide evidence that the likelihood of

auditor changes increases with CSR risk when compared with firms

that do not undergo auditor switches. Thus, our initial results are also

supported when using this alternate measure of auditor–client

retention.

We also demonstrate that our results are robust to a constant

sample analysis, ruling out the possibility that the results may be an

artifact of our sample composition. Finally, we decompose CSR risk

into three of its individual components: social, environmental, and

governance, as determined by a principal component analysis on the

seven CSR dimensions. Our conclusion persists across these three fac-

tors, suggesting that the negative association between CSR risk and

auditor tenure is not driven by a single dimension of CSR.

This study's contribution to the literature is threefold. First,

evidence as to how firms' CSR risk affects auditor tenure extends

the current literature on the impact of clients' CSR activities on

auditor–client decisions in general (e.g., Koh & Tong, 2013). As such,

we complement recent studies examining auditors' behaviors related

to mitigating CSR risk through the manipulation of auditor activities

(Kim & Park, 2014) and perceptions of audit quality (Butcher, Harrison,

& Ross, 2013) on auditor tenure. Second, our results suggest that it

is important to consider CSR risk when assessing audit outcomes

(e.g., modified versus unmodified opinions) associated with auditor

tenure when interpreting results of existing US studies that investigate

the association between audit firm tenure and audit quality (Gul, Fung,

& Jaggi, 2009; Johnson, Khurana, & Reynolds, 2002; Myers et al.,

2003). Additionally, this study facilitates the identification of an

additional factor related to auditor tenure as well as highlights the

importance of considering CSR risk when conducting research on

the economic consequences and/or financial reporting outcomes of

an extended auditor–client relationship.

2|RELATED LITERATURE AND

HYPOTHESIS DEVELOPMENT

Following McWilliams and Siegel (2001), we consider positive CSR

activities to be actions on the part of firms that appear to advance

the promotion of some social good beyond the immediate interests

of the firm/shareholders and beyond legal requirements. Theories

such as stakeholder, ethical, and corporate culture posit relationships

between positive CSR activities and enhanced firm value. Stakeholder

theory explains that a firm needs the support of all of its stakeholders

in order to sustain long‐term survival and success (Freeman, 1984;

Van der Laan Smith et al., 2005). Under this theory, positive CSR

activities can improve firm performance and enhance firm value (e.g.,

Mackey, Mackey, & Barney, 2007) by allowing a firm to differentiate

its products in the market (McWilliams & Siegel, 2001; Waddock &

Graves, 1997), build stronger customer relationships (Mescon &

Tilson, 1987; Varadarajan & Menon, 1988), and improve employee

productivity through improved working conditions, increased intrinsic

motivation, and employee identification with firm goals (Bewley,

1999; Campbell & Kamlani, 1997). Consequently, firms undertaking

irresponsible CSR activities may display deteriorating performance

and financial health, increasing a client firm's business risk and limiting

an auditor's future business opportunities with the client.

•Ethical and corporate culture theories are similar, in that they focus

on the benefits of the “right”thing to do and shared beliefs related

to doing the right thing respectively. For example, ethical theories

suggest that positive CSR activities reflect higher social conscious-

ness and better business ethics based on the aforementioned right

thing to do and/or the “necessity to contribute to the good of soci-

ety by doing what is ethically correct”(Carroll, 1979; Jones, 1995).

Along the same lines, corporate culture theories (e.g., Kreps, 1990)

promote the benefits of corporate responsibility as a shared belief

within a firm—the belief about the “right”courses of actions that

take into account not only economic but also social, environmen-

tal, and other externalized impacts of company actions.

Empirical studies support the notion that socially responsible firms

also behave in a more responsible manner with regard to other corpo-

rate decisions. For example, according to Kim et al. (2012), firms

engaged in positive CSR activities are less likely to engage in earnings

management than firms that are not, thus decreasing audit risk. These

socially responsible firms are therefore less likely to be subject to

Security and Exchange Commission investigations and enforcement

actions (Kim et al., 2012), which assists firms in avoiding costly

government‐imposed fines (Belkaoui, 1976; Bragdon & Marlin, 1972;

Freedman & Stagliano, 1991; Shane & Spicer, 1983; Spicer, 1978).

Consequently, auditors' exposure to risk is decreased (Godfrey,

2005; Kim, 2010). Firms undertaking positive CSR activities are also

96 BROOKS ET AL.