Institutional Investors, ESG Performance, and Audit Quality

Shuyue Wang

1,* a

, Yajuan Shangguan

and Rong Men

Beijing Jiaotong University, China

China Railway Xi'an Group Co., Ltd., China

Keywords: Institutional Investors, ESG Performance, Audit Quality, Internal Governance.

Abstract: In the process of promoting the high-quality development of China's economy, investors are paying

increasing attention to the ESG performance and audit quality of listed companies. This paper empirically

examines the impact and the mechanisms of institutional investors on audit quality, using Chinese A-share

listed companies from 2015 to 2020 as the research object. The study finds that the higher overall

shareholding of institutional investors, the higher audit quality of listed companies; and that the ESG

performance of firms plays an intermediary role in mediating the influence of institutional investors on audit

quality protocols. The heterogeneity test finds a more significant role of stable institutional investors in

improving audit quality. The research conclusions enrich the relevant literature in the area of institutional

investors and audit quality, and provide empirical evidence for strengthening ESG disclosure regimes.

https://orcid.org/0000-0002-8718-8389

https://orcid.org/0000-0002-7528-9510

https://orcid.org/0000-0002-3580-1938

1 INTRODUCTION

In the process of promoting the high-quality

development of China's economy, enterprises are

improving the quantity and quality of information

disclosure in pursuit of high-quality and sustainable

development. A quality audit by a CPA must have

the ability to distinguish the earnings management

phenomenon of enterprises and alert investors and

stakeholders to the extent of it. Institutional

investors have an incentive to monitor a company's

management's use of manipulable accrued profits for

surplus management and therefore institutional

investors can improve audit quality to some extent.

Enterprises will take the initiative to report to the

community on their own social responsibility and

improve the quality and transparency of disclosure

of information on the three aspects of

environmental, social and governance (referred to as

ESG). More and more investment entities promote

continuous efforts by portfolio companies to

improve their ESG performance, and higher ESG

performance provides auditors with more basis for

audits.

In the above context, this paper empirically

examines the impact of institutional investors on

audit quality and the intermediary role of ESG

performance on the relationship between the two,

using A-share listed companies in China from 2015-

2020. From the perspective of institutional investors,

this paper explores its impact on audit quality. And

this paper provides a basis for how how the capital

market can improve internal corporate governance

and audit quality. Besides, it also provides a

reference for promoting the improvement of ESG

information disclosure by enterprises.

2 LITERATURE REVIEW

2.1 Literature Review

Audit quality, as an important basis for corporate

financial credibility, plays an increasingly important

role in the capital market and has become a hot topic

of research for experts and scholars in the field of

auditing. Li and Li (2008) proposed that institutional

investors should participate in corporate governance,

timely supervise the management behavior, and

Wang, S., Shangguan, Y. and Men, R.

Institutional Investors, ESG Performance, and Audit Quality.

DOI: 10.5220/0012026400003620

In Proceedings of the 4th International Conference on Economic Management and Model Engineering (ICEMME 2022), pages 95-101

ISBN: 978-989-758-636-1

 2023 by SCITEPRESS – Science and Technology Publications, Lda. Under CC license (CC BY-NC-ND 4.0)

promote the normal and good operation of the

enterprise to bring more benefits. Institutional

investors are able to accurately identify the presence

of opportunistic behaviour due to their own

advantages in terms of information, which improves

the transparency of accounting information and the

quality of financial reporting, which in turn

contributes to the improvement of audit quality

(Zhou et al., 2015). There are many academic views

on the results of the impact of institutional investors

on audit quality, but most scholars quite agree that

institutional investors can overall improve the audit

quality of listed companies (Feng, 2014).

In 2021, KPMG published a report on valuing

companies from an ESG perspective, which explains

how to incorporate the internal and external

influence of ESG factors. They suggest that ESG is

also one of the drivers of value that investors and

company management should not ignore, and that

relying solely on traditional financial metrics is an

outdated and one-sided approach to valuation.

According to Huang (2021), ESG is gradually

becoming a core concept and framework system for

evaluating the sustainability of companies. The

existing literature on ESG has focused on examining

ESG performance on financial performance (Wang

et al., 2022), financing constraints (Li et al., 2022),

and firm value (Liu and Tang, 2021), and has not

considered the role of institutional investors in

contributing to ESG performance

This paper introduces the phenomenon of

enterprise ESG performance, link the internal

governance characteristics of institutional investors

and the auditor the external supervision mechanism,

deduce the ESG performance in the bridge in the

process of audit quality.

2.2 Research Hypotheses

An increasing number of institutional investors are

now actively involved in the governance aspects of

their investees, by virtue of exercising their rights to

scrutinise management decisions and participate in

corporate governance, thus greatly enhancing the

quality of audits. This behavior can further

effectively reduce the principal-agent cost and ease

the conflict between the owner and the agent.

Institutional investors are able to collect company

information on their own and use their professional

analytical skills to screen the information in the

market to determine whether there are opportunistic

acts such as false disclosures in the financial reports

of listed companies, and share the results with other

shareholders and investors, alleviating the

information asymmetry. Institutional investors

participate in corporate governance, through field

research, shareholders' proposal activities play its

supervision effect, inhibit the opportunistic behavior,

prompt the information disclosure, reduce the

auditor work intensity and audit risk, which is

conducive to the auditor issued a more fair audit

opinions, and improve the quality of audit.

Institutional investors, who hold a larger stake

than small and medium-sized investors and have

specific criteria for selling their shares, can suffer

significant losses in the event of more serious 'low

audit quality'. For this reason, institutional investors

who recognise that there is a clear 'insider control

problem' in a listed company will put pressure on

management to ensure the auditors' own

independence characteristics.

Therefore, this paper proposes hypothesis 1:

Hypothesis 1(H1): The higher the overall

shareholding ratio of institutional investors, the

higher the audit quality of listed companies

Institutional investors promote truthful

information disclosure by participating in corporate

governance, optimising company operations and

discouraging the occurrence of opportunistic

behaviour. For companies with a higher

shareholding ratio of institutional investors, the

better their ESG performance is, which in turn

makes it easier for problems to be identified and

addressed. Information on corporate governance is

included in ESG disclosures and can reflect the

scientific nature of corporate governance. As

financial information of listed companies is an

important basis for the audit work of CPAs, ESG

performance determines audit quality to a certain

extent.

Therefore, this paper proposes hypothesis 2:

Hypothesis 2(H2): The higher shareholding ratio

of institutional investors, the better ESG

performance of the company, providing auditors

with a more realistic, reliable and relevant audit

basis, thus improving audit quality.

3 RESEARCH DESIGN

3.1 Sample and Data

This paper takes Chinese A-share listed companies

as the research object and selects A-share listed

companies in Shanghai and Shenzhen as the sample

from 2015-2020. After data collection and collation,

the final sample obtained contains 6 years of data

from 2602 listed companies with a total of 11,854

ICEMME 2022 - The International Conference on Economic Management and Model Engineering

observations. The data in this paper mainly comes

from CSMAR database and WIND database.

3.2 Variable Definition

The Explained Variable: Audit Quality (AQ).

Drawing on relevant research on surplus

management, this paper adopts the negative of the

absolute value of manipulated accrued profits

estimated by the modified Jones model by industry

by year as a proxy variable for audit quality, as

follows.

01 2 it

i, 1 i, 1 i, 1 i, 1

tt t t

TA PPE

REVit RECit

AA A A





  



 



(1)

where the subscript i represents the company, t

represents the time.

The Explanatory Variable: Share-holding ratio of

institutional investors (INVH).

The Intermediate Variable: ESG Performance

(ESG). This paper uses the ESG rating data of China

Securities, which is classified into AAA~C from

high to low, and assigns 9~1 respectively. Enterprise

ESG performance depends on the ESG score of the

enterprise in the Wind database. The higher ESG

score is, the better ESG performance of the

enterprise is.

Control Variables. This paper draws on the

studies, adding the following variables to the model:

firm size (SIZE), financial leverage (LEV), firm

growth opportunity (TQ), auditor firm (BIG),

proportion of independent directors (INDEP). In

order to control the impact of year and industry on

audit quality, year, industry virtual variables were

added to the regression model. Variables and their

definitions are detailed in Table 1.

Table 1: Definitions of main study variables.

Type Variable Symbol Calculation Method

Explained variable Audit quality AQ

Negative absolute value of

manipulated accrued profits using

the modified Jones model

Explanatory variable

Share-holding ratio of

institutional investors

INVH

Number of institutional holdings as

a percentage of the total number of

such shares or shares outstanding

Control variables

Firm size SIZE

Natural logarithm of total assets at

the end of the year

Financial leverage LEV

Total liabilities at the end of the

ear / Total assets at the end of t

Firm growth opportunity TQ

(Market value of shares

outstanding + number of non-

marketable shares x net assets per

share + book value of

liabilities

)

/total assets

Auditor firm BIG

Virtual variable, value 1 if the

company is audited by a Big 4

firm; 0 otherwise

Proportion of independent

directors

INDEP

Number of independent directors /

total number of board members

3.3 Model Specification

To test H1, this paper constructs a regression model

(2) for the relationship between institutional investor

shareholding and audit quality:

it 0 1 n

ear+ +

it it

AQ INVH Controls Y Industry



 

    

(2)

where the subscript i represents the company, t

represents the time.

If the



is positive, which proves that the higher

institutional investor shareholding ratio, the higher

audit quality, then H1 is true.

In order to investigate the intermediary role of

ESG in institutional investors and audit quality,

draw on the research results of Wen et al. (2004),

use the intermediary effect test procedure, and

construct the three-step regression model using the

gradual regression method based on model (2):

it 0 1 nit it

ESG INVH Controls Year Insustry



 



 

(3)

it 0 1 2 nit it it

AQ INVH ESG Controls Year Industry



  



     

(4)

Institutional Investors, ESG Performance, and Audit Quality

where the subscript i represents the company, t

represents the time.

If the



is positive, the higher institutional

investor shareholding ratio, the better corporate ESG

performs; if both



and



are positive,

assumption 2 holds.

4 EMPIRICAL ANALYSIS

4.1 Descriptive Statistics

Table 2 presents the full sample descriptive statistics

for the main variables. The minimum value of audit

quality (AQ) is -0.28 and the maximum value is -

0.0007, indicating a large degree of variation in

audit quality between different listed companies.

The average shareholding ratio of institutional

investors (INVH) is 0.45, indicating that the average

shareholding of institutional investors in listed

companies in the sample amounted to 45%.

The average ESG performance of the sample

companies is 6.54, indicating that the ESG

performance ratings of listed companies in the

sample are relatively good, which is mainly because

since 2018, the SSE and SZSE have taken

corresponding initiatives for listed companies to

monitor the disclosure of CSR information and set

mandatory information disclosure requirements for

some industries; the standard deviation is 1.22,

indicating the large gap in the ESG information

disclosure rating of the sample company.

Table 2: Descriptive Statistical Analysis.

Variable N Mean Min P50 Max SD

AQ 11854 -0.05 -0.0 -0.04 -0.28 0.05

INVH 11854 0.44 0 0.45 1.01 0.24

ESG 11854 6.54 1 6 9 1.22

SIZE 11854 22.6 20.2 22.41 26.4 1.26

LEV 11854 0.44 0.07 0.43 0.87 0.20

TQ 11854 2.04 0.83 1.61 8.48 1.34

BIG 11854 0.06 0 0 1 0.25

INDEP 11854 0.38 0.33 0.36 0.57 0.05

4.2 Baseline Regression Results

Table 3 presents the results of the baseline

regression. As can be seen from the regression

results of model (2), the more institutional investors

hold shares, the higher audit quality. Hypothesis 1 is

verified. According to the regression results of the

model (3), the more institutional investors hold their

shares, the better corporate ESG performance is.

According to the regression results of model (4),

institutional investors play a partially mediating role

through corporate ESG performance, thereby

improving audit quality.

Institutional investors have a positive role in

ESG performance, and the audit quality of listed

companies will improve as institutional investors

exert corporate governance effects and improve

information transparency, namely institutional

investors exert monitoring and governance effects

through participation in corporate governance,

curbing the occurrence of opportunistic behaviours,

while alleviating the degree of information

asymmetry and improving corporate ESG

performance, which in turn facilitates the audit work

of CPAs and contributes to the improvement of audit

quality.

Table 3: Baseline Regression Results.

Model(2) Model(3) Model(4)

AQESGAQ

INVH 0.0078

***

0.3887

***

0.0064

***

(

3.18

)

(

7.62

)

(

2.60

)

ESG 0.0036

***

(7.62)

SIZE 0.0053

***

0.4282

***

0.0037

***

(9.05) (38.37) (6.13)

LEV -0.0426

***

-1.0224

***

-0.0389

***

(

-11.70

)

(

-15.89

)

(

-10.69

)

TQ -0.0025

***

0.0420

***

-0.0027

***

(-5.15) (4.90) (-5.49)

ICEMME 2022 - The International Conference on Economic Management and Model Engineering

BIG 0.0042

0.1323

***

0.0038

(2.38) (3.55) (2.12)

INDEP -0.0213

0.0623 -0.0216

(

-2.35

)

(

0.36

)

(

-2.37

)

cons -0.1419

***

-3.2965

***

-0.1300

***

(

-10.44

)

(

-12.35

)

(

-9.58

)

Industry Effect yes yes yes

Year Effect yes yes yes

Observations 11854 11854 11854

Adj R

0.0550 0.2490 0.0600

Note: * p < 0.1, ** p < 0.05, *** p < 0.01

4.3 Heterogeneity Analysis

According to the characteristics of institutional

investors, they can be divided into transactional

institutional investors and stable institutional

investors.

The Institutional Investor Heterogeneity

Identifier Variable (INVW) indicator is obtained by

drawing on Niu et al. (2013) and Li et al. (2014),

which use two dimensions of time and industry to

study the heterogeneity of institutional investors.

The formula is as follows:

,3 ,2 ,1

(, ,)

1, ( )

it it it

it t j

INVH

STD INVH INVH INVH

SD MEDIAN SDt

INVW

























其他

(5)

where the subscript i represents the company, t

represents the time, and j represents the industry.

The results of the institutional investor

heterogeneity regressions are presented in Table 4.

As can be seen from column (1), there is a positive

correlation between stable institutional investors and

audit quality. According to column (2), stable

institutional investors are conducive to improving

corporate ESG performance. As can be seen from

the column (3), the stable institutional investors play

some intermediary role through the enterprise ESG

performance, so as to improve the audit quality. The

regression results show that stable institutional

investors are more likely to exert corporate

governance effects through monitoring than

transactional institutional investors, resulting in

sound corporate ESG disclosure and providing more

information for auditors to refer to, thereby

improving audit quality.

Table 4: Institutional Investor Heterogeneity Regression Results.

(1) (2) (3)

AQ ESG AQ

INVW 0.0027

***

0.2019

***

0.0020

(2.76) (9.93) (2.01)

ESG 0.0036

***

(7.60)

Controls yes yes yes

_cons -0.1510

***

-3.6421

***

-0.1379

***

(-11.54) (-14.30) (-10.54)

Industry Effect yes yes yes

Year Effect yes yes yes

N 11854 11854 11854

r2_a 0.0548 0.2516 0.0598

Note: * p < 0.1, ** p < 0.05, *** p < 0.01

4.4 Robustness Tests

Substitution of explanatory variables. In this paper,

audit opinion (OPIN: if the company's financial

report is issued a standard opinion, the value is 1,

otherwise 0) is used as a replacement variable for

audit quality and is used in the regression as an

alternative to model (2).

Replacement of the ESG performance metric.

Drawing on the replacement method of Gao et al.

(2021), a more straightforward and simple

assignment method is used to construct the

mediating variable ESG_R, which is constructed

Institutional Investors, ESG Performance, and Audit Quality

directly based on the broad categories (A, B and C)

of the ESG rating, with an assignment of 3 to 1.

Table 5 shows the results. The regression results

are significant and prove that the baseline regression

of this paper is robust.

Table 5: Robustness Tests Regression Results.

(1) (2) (3)

OPIN ESG_R AQ

INVH 0.0175

0.1434

***

0.0069

***

(2.35) (6.36) (2.81)

ESG_R 0.0062

***

(5.90)

Controls yes yes yes

_cons 0.6663

***

-1.3449

***

-0.1336

***

(14.55) (-12.24) (-9.82)

Industry Effect yes yes yes

Year Effect yes yes yes

N 11854 11854 11854

r2_a 0.0276 0.2230 0.0577

Note: * p < 0.1, ** p < 0.05, *** p < 0.01

5 CONCLUSIONS

This paper examines the relationship between

institutional investors and audit quality, as well as

the mediating role of ESG performance on the

relationship between the two, using a sample of A-

share listed municipal companies in Shanghai and

Shenzhen in China for the period 2015-2020, and

draws the following key conclusions: the higher

shareholding of institutional investors, the higher

audit quality; and ESG performance plays a partial

intermediary effect in the role of institutional

investors on audit quality; stable institutional

investors are more helpful in improving ESG

performance and audit quality of listed companies.

The entire impact path is that institutional

investors actively participate in the governance

aspects of their investees, by virtue of exercising

their rights, to strictly monitor management

decisions, participate in corporate governance and

play a controlling role in their falsification, surplus

manipulation, profit falsification and statement

embellishment, thus greatly enhancing audit quality.

By improving the ESG performance of companies,

institutional investors provide auditors with a more

truthful, reliable and relevant basis for audits, thus

improving audit quality.

In order to promote the improvement of audit

quality of listed companies in China, this paper puts

forward relevant policy recommendations. Firstly,

the governance effect of institutional investors

should be strengthened. Secondly, the development

of institutional investors with stable shareholdings is

a big step forward. Thirdly, strengthen the ESG

information disclosure system and improve the ESG

performance of listed companies.

The study in this paper only selected that ESG

acted as the mediating variable, which found that

ESG acted as a partial mediator, and proved that

other variables will also mediate the role in this path

of influence. In future research, other intermediary

variables in the impact of institutional investors on

audit quality can be studied to further broaden the

research on audit quality.

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