More Than Values: The Link Between ESG Ratings and Financial Reporting Quality

In recent decades, the business world has shifted from voluntary CSR to a complex system of ESG (Environmental, Social, and Governance) metrics. While agencies like MSCI and S&P provide scores reflecting corporate performance, skepticism remains: is a high ESG score evidence of reliable reporting, or merely a "smoke screen" to distract from poor business results?

In two new articles published in Finance Research Letters, Prof. Dov Solomon and his colleagues (Dr. Rimona Palas, Dr. Ido Baum, and Dr. Dalit Gafni) examined this tension. Based on a wide sample of U.S. companies, the research refutes the fear that ESG masks financial failures, proving instead that high ESG performance is a clear indicator of superior financial reporting quality.

The Link Between ESG Ratings and Financial Reporting Quality

In the study ESG Regulation and Financial Reporting Quality: Friends or Foes?, we analyzed 3,907 U.S. companies (2012–2022). Using metrics such as Earnings Persistence, Cash Flow Predictability, and Restatements, the findings were unequivocal:

• Positive Correlation: High ESG ratings are directly linked to more reliable and predictable financial data, not at the expense of reporting quality.

• Lower Risk: Companies with strong ESG performance show a lower frequency of financial restatements.

• The BRT Effect: Following the 2019 Business Roundtable statement - shifting focus from "Shareholder Primacy" to "Stakeholders" - this positive link to transparency has only strengthened.

The Impact of the Social (S) Component on Reporting Quality

In the study ESG Ratings and Financial Reporting Quality: Why Social Performance Matters, we deconstructed ESG into its three components to test their individual impact:

• The "Social" Factor: While many assume Governance (G) is the primary driver, the research reveals that the Social (S) component actually has the strongest link to reporting quality.

• The Investor Gap: A major disconnect exists: while 57% of institutional investors prioritize reporting quality, only 2% consider the Social component significant in their decisions.

• The Takeaway: Investors seeking reporting reliability should attribute much greater weight to the Social component, as it most closely reflects internal integrity.

Not Just an Expression of Values: ESG Rating as a Reflection of Organizational Culture

The Social component - encompassing organizational culture and human capital - directly impacts the people and systems responsible for financial oversight. These findings show that ESG investment is not just about "conscience"; it is a core management strategy that builds market trust and serves as a vital tool for risk management in an uncertain world.

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Prof. Dov Solomon, Head of the LL.M. Program, Academic Center of Law and Business