Negative ESG Reputation and Financial Reporting Quality: The Effect of the Introduction of Stewardship Code in Korea

This study examines whether negative ESG (Environment, Social, and Governance) reputation affects corporate financial reporting quality after the introduction of stewardship code and how institutional investors' monitoring influences the relationship. Since the stewardship code focuses on improving long-term shareholder value by considering non-financial factors, we predict that the monitoring role of institutional investors is strengthened in companies with increased ESG risks after the introduction of the code. To measure the ESG risks, we select 18 keywords related to MSCI ESG key issues and collect negative ESG news using these keywords. Utilizing the news and C-score(Khan and Watts 2009), we find that conditional conservatism in corporate financial reporting of companies with negative ESG reputation has weakened, while the negative correlation between conditional conservatism in financial reporting and tainted ESG reputation was alleviated after the introduction of the stewardship code. This suggests that the potential losses that may be caused by negative ESG news are conservatively reflected in financial reporting because the stewardship code aims at long-term sustainable growth. Moreover, the higher the stake of institutional investors, the stronger demand for conservative financial reporting, indicating that institutional investors pay more attention to ESG risks after the introduction of the stewardship code.