2.1. Environment, Social, and Governance, and Audit Complexity
Sustainable development (SD) is strongly prioritized nowadays, and we can see this in policies such as the 2030 Agenda for Sustainable Development; these primary sustainable development goals (SDGs) address how SD progress can be measured. The concept of CSR, which was formed in response to the challenge of global sustainability, is one of the most significant actors in the promotion of SD [
13]. Because of the significance of CSR, other organizations have begun implementing various strategies to promote CSR within their organizations.
For example, the B Corporation certification now incorporates societal and environmental concerns when evaluating a company’s overall business model and strategy. Also, compared to simple charitable donations in the past, B corporation certification now involves a more extensive set of requirements. Also, ESG, which is an acronym for Environmental, Social, and Governance, is emphasized.
ESG, which is a non-financial metric, is perceived as the evaluation indicator that investors utilize when making investment decisions [
14] and is considered a key to investment success [
15]. The demands for ESG information by investors and information intermediaries are increasing as a result of their efforts to apply this information to their valuation models [
16]. In other words, a firm’s participation in ESG is recognized as an indicator of positive financial performance in the future. Similarly, the B Corporation certification, which evaluates the total company operation and is positively associated with firm performance, promotes transparency as well as sustainability [
17].
Previous studies corroborate the hypothesis that firms with higher ESG ratings are more productive and financially secure because of their ability to generate more value [
18]. Jeong and Shim (2019) [
19] highlight the relationship between corporate social activities and a positive market reaction. Kim and Kim (2018) [
20] suggest that ESG activities have a comparatively positive effect on a firm’s sustainable development compared to firms that do not partake in ESG activities. Thus, the degree of revealing that firms are dedicated to ESG is an effective mechanism to secure stakeholders’ interests and is crucial in their decision-making [
21]. The information that firms disclose about their ESG activities can help improve the transparency of their financial statements and enable them to obtain further access to financial resources [
22,
23]. Also, revealing environmental information reduces the overall information asymmetry embedded between managers and outside stakeholders [
24]. This is valuable information for stakeholders that raises awareness of the firm’s ethics; the firm’s CSR may even lead to accounting transparency by influencing the management’s attitude towards financial reporting.
The existing literature has primarily focused on the relationship between ESG and economic outcomes. However, in this study, we viewed ESG activities from the perspective of the audit. A firm’s participation in ESG gives rise to complex financial issues and requires additional accounting disclosure. The International Sustainability Standards Board mandates corporations to comply with sustainability disclosure standards, which may be onerous for a business. Furthermore, the ESG disclosure needs to comply with specific criteria; for instance, the disclosure must prove that the scenario analysis assumptions are valid [
4]. Also, as Owen et al. (2001) [
25] emphasized in their study, social and ethical accounting auditing and reporting involve the development of standards to create fundamental principles to assure both the quality of external reporting and the resilience of the underlying management system involved. Thus, the process of preparing ESG disclosures entails additional work that must be completed. Collectively, participating in ESG activities increases audit complexity, as investments in ESG activities trigger complex economic activities that increase the volume and variety of the accounting information that is processed.
Hay et al. (2006) [
26] detail the most common aspects that lead to a complex audit: foreign subsidiaries, percentage of international assets, and industry characteristics. What these elements have in common are the metrics of complexity underpinning the auditee’s operating environment. Bonner (1994) [
27] supports that the complexity of an audit stems from the various tasks that the auditor must complete to perform their duties effectively. Pirson and Turnbull (2018) [
28] define the complexity encompassing financial and non-financial goals. Compared to simple donations and services in the past, ESG calls for a specific action within society. For example, for the E in ESG, which stands for environment, a revaluation of eco-friendly financing for aspects such as green bonds and assets exposed to climate risk should be factored in. For the banks whose lending portfolio is heavily exposed to carbon-intensive industries, credit risk increases when strict regulations are enforced to reduce greenhouse gas emissions. For the S category, securing adequate wages for workers should be considered (Korea Corporate Governance Service). At the same time, ESG incorporates issues related to sustainability such as environment-related opportunities, crises, and countermeasures; at the same time, sustainability also includes aspects such as efforts to improve social issues such as labor-management relations. High scores for ESG activities are achieved through positive investments in ESG, as McWilliams et al. (2006) [
29] and Tsoutsora (2004) [
30] suggest, which can lead to complex financial reporting issues and the need for additional accounting disclosure.
2.2. Audit Risk and Audit Hours
An auditor is a person who carries out an audit, according to ISO 9001:2015 [
31]. As auditors perform an audit, they are expected to have an adequate level of understanding and knowledge of auditees to verify that the financial statements are in conformity with the generally accepted accounting principles and to discover fraudulent accounting. ISO 19011:2018 offers a formal framework for professional auditors and focuses on processes that are used to acquire evidence and evaluate it objectively to assess the degree to which the audit criteria are satisfied [
32]. For instance, auditors need to identify changing environments and develop a framework to elaborate the audit procedures based on ISO 19011:2018.
At the same time, when auditors plan for an audit, according to the audit risk model, auditors should determine the desirable level of detection risk that they can reasonably assess to avoid material misstatement [
33]. The audit risk model is a joint probability of risk of material misstatement in the financial statement and detection risk. The risk of material misstatement in the financial statements exists due to the auditee’s inherent characteristics and its operating system. However, detection risk is under auditors’ control and they can adjust the audit risk to an acceptable or desirable level. For instance, when the auditors assess a high chance of material misstatement, they should hold the detection risk at a lower level to maintain an acceptable level of risk.
International Standard on Auditing (ISA) 330 suggests that auditors increase their efforts when conducting audits in response to increased risks [
34]. Audit efforts are related to the possibility of uncovering corporate issues [
35], and audit hours will be the most relevant factor. There is prior literature measuring audit efforts based on audit fees; however, audit fees are embedded with various factors such as the risk premium, legal liability costs, and the external and internal environment of the audit market [
36,
37]. Thus, we focus on the audit hours as a direct measurement of audit efforts [
38].
Studies on the determinants of audit hours have shown that auditors assess corporate complexity and inherent risk to determine audit efforts [
39,
40]. Previous studies on audit hours mainly focused on understanding the factors that determine audit hours. The variables such as total assets of the auditee, listing status, the ratio of accounts receivables and inventories in total assets, debt ratio, auditor size, and inherent risks, are the main determinants of audit hour increases [
40,
41,
42].
Bell et al. (2001) [
43] confirm that high audit hours positively correlate with high audit risk, implying that increased audit hours offset the high audit risk. Ji and Moon (2006) [
44] regard reporting loss and the uncertainty of going concern as business failure. They report that firms with litigation risk due to business failure show high audit hours. Woo and Lee (2009) [
45] consider the payment guarantee, equivalent to contingent liabilities, as a factor that increases audit risk, which in turn, increases audit hours. According to their analysis, it was confirmed that higher audit hours are required to have more payment guarantees provided by the auditee. In addition, the result suggests that the higher the debt ratio, the significantly longer the audit hours. Ma and Kwon (2010) [
46] show the negative relationship between abnormal audit hours and income from the prior period’s error corrections, implying that the quality of audit and financial reporting improves as audit hours increase. Park et al. (2010) [
47] investigate increases in total auditing hours. The result indicates that auditors exert more effort when facing audit risk, but it does not lead to higher audit fees in a competitive audit market. Overall, in the process of understanding the auditee’s objectives and strategies, auditors dedicate more time to firms with high risk.
2.3. Hypothesis Development
ESG refers to non-financial information that is nevertheless a crucial component of a company’s continued existence. Distinguished from simple donations made by companies, ESG is comprised of corporate policies that will be acted upon that are a critical aspect of a company’s management and a metric that is closely paid attention to and followed by investors.
Given that ESG is derived from CSR, we follow CSR’s line of reasoning as it pertains to how ESG impacts the company overall. For instance, according to Waddock and Graves (1998) [
48], actively participating in CSR leads to greater financial performance, increased employee satisfaction, and increased business value. In addition to this, engaging in ESG allows for the monitoring of management, which helps decrease the risk of bankruptcy, agency expenses, and information asymmetry. Choi and Moon (2013) [
49] contend that companies that engage in CSR activities have lower levels of earnings management and greater levels of earnings persistence compared to companies that do not engage in CSR activities.
Regardless of the beneficial effects, participating in ESG includes complex operating, accounting, and disclosure procedures [
28], owing to the increased volume of data in the course of corporate operations [
50]. Shin and An (2011) [
51] investigated the association between corporate ethical management and auditing factors and found that firms focusing on ethical management are operated in a complicated manner. Pirson and Turnbuall (2018) [
28] demonstrated that participation in ESG also leads to an increase in the procedures that organizations go through, which in turn increases the volume and diversity of information that an auditor is required to deal with. Since firms have the same end goal as various stakeholders to maximize profits, starting or continuing to engage in ESG builds stronger relationships with a wide range of stakeholders [
52]; this further complicates the accounting process.
During the auditing process, the auditors must obtain an understanding of the company and its environment to identify events, business conditions, and activities that may have a significant impact on the risk of material misstatement [
53]. Therefore, increased complexity as a consequence of ESG elevates the cognitive demands placed on auditors, which has a positive effect on the auditor’s ability to carry out the audits in an appropriate manner [
26]. For instance, the high level of complexity caused by an auditee’s business environment requires the evaluation of any potential errors. The International Standard on Auditing recommends that auditors gather enough evidence to provide a reasonable level of certainty about the financial statements of the auditee [
54]. In other words, if the firm carries a higher audit risk as a result of any additional or otherwise complicated tasks, the auditors will adjust the nature, timing, and extent of audit procedures, which in turn requires more effort and hours. Therefore, we set up the first hypothesis.
Hypothesis 1: There is a positive relationship between the level of ESG activities and audit hours.
Recently, academic research has focused on the role of the top manager in understanding CSR [
4]. According to the upper echelons theory, managers make strategic choices and have risk preferences depending on their psychological and cognitive characteristics [
55]. Therefore, to investigate the manager’s substantial impact on ESG, the effects of cognitive and psychological characteristics that are directly connected to the manager’s decision-making capabilities should be empirically verified.
At the same time, the ISO 31000 standard provides a more comprehensive and strategic perspective to managers by outlining the ideas and practices employed in risk management. The ISO 31000:2018—Risk Management standard emphasizes the development of strategies, the accomplishment of goals, and the making of well-informed decisions to manage the effects of uncertainty on the firm’s objectives [
56]. In other words, ISO 31000:2018 assists the manager in making decisions and achieving strategic goals [
57].
Previous studies have shown that managerial characteristics influence a firm’s economic outcome, such as financing, operating, investment, and business practices [
58,
59,
60]. Demerjian et al. (2012) [
8] suggest that highly competent managers are likely to report precise and useful information since they understand the firms’ macroeconomics. Ban and Jeong (2018) [
61] examine the impact of the managers’ ability as applied to accounting fraud, using the prediction model of accounting fraud risk, the F-score. The analysis result suggests that the manager’s competency lowers the F-score, leading to a low accounting fraud risk. Andreou et al. (2013) [
62] confirm that highly competent managers make bold investments, report high performance, and reduce information asymmetry. At the same time, managerial ability plays a significant role in accounting procedures and their quality as well [
63,
64]. Krishnan and Wang (2015) [
65] examined the impact of managers’ competence on audit fees and going concern statements. The result of the empirical analysis shows that the audit fee decreases as the competency of the manager increases. It is interpreted that the competency of the manager’s ability can reduce the likelihood of the company receiving a low possibility of going concern opinion. Specifically, auditors who have a strong preference in favor of competent managers will also have a positive prejudice that impacts the audit process [
29,
66]. Given the theories of a manager’s impact on a firm’s overall financial outcomes, managerial ability is one of the most important intangible assets that should be considered [
8].
The auditors express the audit opinion based on whether the financial statements of companies comply with generally accepted accounting principles. The audit risk perceived by auditors varies depending on the adequacy of the financial statements. In other words, the higher the quality of accounting information, the easier it is for the auditor to judge the appropriateness of financial statements, all of which will affect audit efforts. The financial statements prepared by highly competent managers are expected to be transparent in delivering the financial messages.
Therefore, auditors need to consider the impact of tone at the top due to its prevalent impact on the auditee’s financial reporting processes [
67,
68]. Tone at the top affects accrual quality [
69], cost of equity [
70], and the forecasting by equity analysts [
71]. Auditors have preferences for certain types of managers. Specifically, auditors who have a strong preference in favor of competent managers will also have a positive prejudice that impacts the audit process [
72].
Based on this reasoning, firms that participate in ESG activities are perceived as more complicated by auditors than those firms that do not. Though ESG firms generally have more data [
50], as well as more complex operating and business processes [
28], auditors may recognize firms with competent managers as transparent and reliable in financial accounting and procedures. Therefore, the risks perceived by the auditors are expected to vary depending on the adequacy of financial statements. As both the quality and quantity of accounting information increase, it becomes easier for auditors to judge the appropriateness of financial statements, making disparate audit efforts. With this background, we set up the second hypothesis.
Hypothesis 2: Highly competent managers positively affect the relationship between the level of ESG and audit hours.