chung - 2004 - selective mandatory auditor rotation and audit quality - an empirical investigation of auditor designation policy in korea [mar]

Revised 6/03PURDUE UNIVERSITY GRADUATE SCHOOL Thesis Acceptance This is to certify that the thesis prepared Entitled SELECTIVE MANDATORY AUDITOR ROTATION AND AUDIT QUALITY: AN EMPIRICAL

(Revised 6/03)

PURDUE UNIVERSITY

GRADUATE SCHOOL Thesis Acceptance

This is to certify that the thesis prepared

Entitled

SELECTIVE MANDATORY AUDITOR ROTATION AND AUDIT QUALITY: AN EMPIRICAL INVESTIGATION OF AUDITOR DESIGNATION POLICY IN KOREA

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SELECTIVE MANDATORY AUDITOR ROTATION AND

AUDIT QUALITY:

AN EMPIRICAL INVESTIGATION OF AUDITOR DESIGNATION POLICY IN KOREA

A Thesis Submitted to the Faculty

of Purdue University

by Hyeesoo Hyun Chung

In Partial Fulfillment of the Requirements for the Degree

of Doctor o f Philosophy

August 2004

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To Chaebung, Soyoung, and Shinyoung.

I am deeply grateful for the opportunity to study at the graduate level at Purdue University with a research assistantship My five years here have been among the most rewarding periods o f my life, thanks both to the faculty at the Krannert School of Management, and to my fellow graduate students, many o f whom will be deeply missed when we part after graduation.

A special acknowledgement goes to my major professor and committee chair, Dr Sanjay Kallapur, for his ability to put me back on track whenever I got lost in my

research, and for his patience and time spent training me and reviewing early drafts o f this thesis I also want to express my gratitude to my committee members, Drs William Kross, Byung Ro, and Susan Watts, for their contribution to my scholastic progress and

my thesis research.

Finally, my husband deserves a special gratitude for encouraging me to take on the challenge o f a graduate study and looking after my daughter and son while pursuing his own doctoral degree Without his love and support, I would not be what I am today.

TABLE OF CONTENTS

Page

LIST OF TABLES vi

ABSTRACT vii

CHAPTER 1 INTRODUCTION 1

CHAPTER 2 BACKGROUND AND HYPOTHESIS DEVELOPMENT Mandatory Auditor Rotation 7

Auditor Designation Policy in Korea 10

Hypothesis Development 13

CHAPTER 3 RESEARCH DESIGN Identifying Treatment and Control Samples 15

Discretionary Accruals as Proxy for Audit Quality 16

CHAPTER 4 DATA AND DESCRIPTIVE STATISTICS Sample Description 19

Descriptive Statistics 22

CHAPTER 5 EMPIRICAL TESTS AND RESULTS Mean Difference Test o f Discretionary Accruals 24

Multivariate Results 27

Sensitivity Analysis 30

CHAPTER 6 CONCLUSIONS AND IMPLICATIONS 31

LIST OF REFERENCES 34

APPENDIX REGULATION ON EXTERNAL AUDIT OF CORPORATIONS 39

LIST OF TABLES

Table 4.1: Sample Selection Criteria 20

Table 4.2: AD Firms Sorted by Industry and Designation Reasons (1994 - 2002) 21

Table 4.3: Descriptive Statistics 23

Table 5.1: Mean Difference Test of Discretionary Accruals 26

Table 5.2: Parameter Estimates for Regressions of Discretionary Accruals on AAEA and Control Variables .29

Chung, Hyeesoo Hyun Ph.D., Purdue University, August 2004 Selective Mandatory Auditor Rotation and Audit Quality: An Empirical Investigation o f Auditor Designation Policy in Korea Major Professor: Sanjay Kallapur.

This study examines the impact of the limited auditor tenure on earnings, and thus audit, quality by taking advantage of the unique audit regulations that govern the listed firms in Korea I examine how discretionary accruals, a measure o f earnings quality drawn from prior literature, vary around an event that imposed a limit on the length of the auditor-client relationship via the auditor designation requirement for Korean firms likely

to manage earnings I find discretionary accruals of firms likely to be a target for mandatory auditor change decrease after the passage o f the AAEA, suggesting that a limit

on the length of the auditor-client relationship result in greater incentives for auditors to maintain independence, which effectively restrains firms’ opportunistic manipulation of earnings.

This study adds to our current understanding of the impact o f economic incentives

on auditor independence by providing additional evidence that opportunities for auditors

to earn client-specific economic rents from repeat engagements can be a potential threat

to auditor independence In addition, this study contributes to the current stream of research on the implications of mandatory audit firm rotation and informs policy makers

in the current debate on improving auditor independence I provide evidence that under

an audit regime similar to mandatory auditor rotation, audit quality does appear to improve when the duration o f the auditor-client relationship is truncated This suggests that mandating auditor rotation could enhance auditor independence and provide auditors greater incentives to resist management pressures.

CHAPTER 1 INTRODUCTION

The recent business and audit failures of publicly held companies in the U.S have heightened the interest o f many, regarding corporate earnings and thus audit quality The U.S Congress, the Securities and Exchange Commission (SEC), the AICPA, and

academics all have become involved in various aspects of the consequences resulting from these large scale financial debacles Following scandalous events related to Enron, WorldCom, and the collapse o f Arthur Andersen, LLP, Congress enacted the Sarbanes- Oxley Act (SOA) in July 2002 In addition to various other requirements to increase the quality o f statutory audits, the SOA required the U.S Comptroller General to conduct a study o f the effectiveness and implications of mandatory audit firm rotation by July 30, 2003.u

In a recently released survey study of the mandatory rotation o f audit firms, the General Accounting Office (GAO) concluded that “the most prudent course of action at this time is for the SEC and Public Company Accounting Oversight Board (PCAOB) to monitor and evaluate the effectiveness o f the Sarbanes-Oxley Act’s (SOA) requirements for enhancing auditor independence and audit quality” mid delay any mandatory auditor rotation reforms until the effects o f the SOA can be further evaluated (GAO 2003).

1 The Sarbanes-Oxley Act o f 2002 prohibits a firm’s auditor from providing a broad range of non-audit services to the firm, in light o f the potential for conflicts o f interest that can impair auditor independence.

2 According to Section 207 o f the Sarbanes-Oxley Act, mandatory rotation refers to the “imposition of a limit on the period o f years in which a particular registered public accounting firm may be the auditor of record for a particular issuer.”

Although the mandatory rotation o f audit firms is not currently recommended, GAO (2003) suggests, however, that such rotations may be necessary if the SOA’s

requirements do not improve the quality of audits Thus, the thorough investigation of the potential effects of mandatory auditor rotation, before any regulatory measure is undertaken, is imperative to the full assessment o f its policy implications.

Mandatory audit firm rotation is a controversial topic with strong arguments on both sides o f the issue The proponents of mandatory rotation argue that as the length of auditor tenure increases, so does the tendency increase that auditors will gradually side with management and thus compromise their independence Also, auditors may develop complacency when auditing long-term clients More importantly, with no limit on the length of the auditor-client relationship, the expected higher rents from the longer period

o f incumbency can create auditor dependence on the client By forcing mandatory rotation o f auditors, management’s ability to influence the auditor can be curtailed (Brody and Moscove 1998) On the other hand, the opponents of rotation argue that while mandatory rotation reduces managerial influence, it can also increase audit failures due to the replacement o f well-informed incumbent auditors with new, less-informed auditors In addition, the costs associated with frequent rotation o f auditors could far outweigh the benefits o f mandatory rotation.3

While strong opinions exist on both sides of the mandatory auditor rotation debate, little evidence exists on its impact on audit quality or costs Since the U.S audit system with voluntary auditor change does not provide a setting to examine compulsory

3 The Cohen Commission (AICPA 1978) indicated that the duplication o f start-up costs would increase auditor costs considerably Also, lost audit efficiencies due to rotation may increase costs (Arrunada and Paz-Ares 1997).

rotation issues, empirical research has instead focused on the relation between audit firm tenure and audit quality, since tenure is precisely the variable that the mandatory rotation

is intended to affect (Casterella et al 2002; Geiger and Raghunandan 2002; Johnson et al 2002; Davis et al 2003; Ghosh and Moon 2003; Myers et al 2003; Carcello and Nagy 2004) Whether the results from these studies in U.S can be extended to a regulatory regime o f mandatory auditor rotation is, however, uncertain For example, whether or not a shorter-term tenure contributes to the finding that audit failures are more frequent during the early years o f auditor-client relationship is not clear.4 That is, an alternative explanation that companies prone to audit failures are more likely to change auditors cannot be ruled out.5

In contrast to the above studies, this thesis empirically examines the auditor-client relationship and its effect on audit quality in a setting similar to a mandatory auditor rotation regime Specifically, this study examines a hybrid government agency regulation model adopted by the Korean government in 1989 that selectively mandates auditor changes through auditor designation requirements Although the auditor is designated by a regulatory authority rather than freely selected by the client firm (as it would be under the proposed mandatory rotation in the U.S.), the common feature is that they both limit the length o f the auditor-client relationship, which truncates the expected rent from repeat engagements By studying the unique auditing regulations governing

4 Geiger and Raghunandan (2002) define audit failure as issuing a clean audit report prior to a bankruptcy filing However, there are many possible definitions o f audit failure, including restatements o f financial reports, not detecting material misstatements or fraud, intentionally allowing earnings manipulation, etc.

5 The increased failure rate in the early years o f audit engagements may be the result o f previous incumbent auditors dropping their high risk clients, and not necessarily the result o f new auditor failures.

To identify the firms likely to be targets for government auditor designation, I use debt-to-equity ratio, the most frequent reason for auditor designation during my sample period My findings show that the mean discretionary accruals of these firms

significantly decreased after the passage o f the AAEA Even after controlling for the determinants o f accruals in a multivariate regression, I find that the discretionary accruals

o f firms at high risk o f auditor designation (proxied by high debt-to-equity ratio) significantly decreased after the passage of the AAEA, suggesting that a limit on the auditor tenure can improve earnings, and thus audit, quality.

This study contributes to the current stream of research on the implications of mandatory audit firm rotation and informs policy makers in the current debate on

improving auditor independence I provide evidence on whether the expectation o f future quasi-rents impairs auditor independence This is relevant to the mandatory rotation debate, but there are other considerations (such as the time it takes a new auditor to acquire expertise, cost of rotating auditors, and reduced incentives on the part o f auditors

to make client-specific investments) for policy makers before they decide the issue.

In a broader context, this study adds to our current understanding of the impact on auditor independence o f economic incentives DeAngelo (1981b) argues that the auditor has the incentive to yield to pressures from management and refrain from reporting the breach in order to avoid losing the quasi-rents from the audit relationship One

implication o f DeAngelo’s theory, that larger audit firms provide higher-quality audits, has been validated in a number of studies However, prior empirical evidence on whether auditors behave differently with different types o f clients depending on economic

incentives inherent in those audit-client relationships is limited and mixed.6 Using revenues from clients as a proxy for economic incentives, Raghunathan et al (1994) examine problem audits and show that the possibility o f being fired by a client could affect an auditor’s willingness to report misrepresentations Also, Lys and Watts (1994) find a positive association between the proportion o f audit revenues derived from the client and the probability of a lawsuit and offer lack o f auditor independence as an explanation for their finding On the other hand, Reynolds and Francis (2001) test this prediction using client size as a proxy for client importance and find no evidence that economic incentives affect the audit outcome.

6 Since quasi-rents and auditor independence are both unobservable, empirical research examines the financial dependency of the auditor-client relationship, viewing the auditor as an economic agent who makes self-interested decisions and whose incentives to compromise independence depend on client

I organize the rest o f the thesis as follows In Chapter 2 , 1 briefly discuss the backgrounds o f the mandatory auditor rotation debate, including evidence supporting and opposing this policy measure I also describe the auditor designation policy (selective mandatory auditor rotation) adopted by the Korean government to improve auditor independence, followed by development o f my main hypothesis A discussion o f my choice of sample partitioning variables and proxy for audit quality is provided in Chapter

3 In Chapter 4 , 1 describe my data, and empirical results are presented in Chapter 5 Chapter 6 summarizes the study and provides concluding comments and implications.

importance.

7 Frankel et al (2002) show that non-audit service fees are positively related to the ability o f firm to just meet or beat earnings targets as well as the magnitude o f discretionary accruals However, subsequent studies fail to replicate their results (Ashbaugh et al 2003, Chung and Kallapur 2003, Francis and Ke 2003, Reynolds et al 2003) Moreover, studies using the propensity to issue modified audit opinions as a proxy for auditor independence (Defond et al 2002, Geiger and Raghunandan 2003) have failed to find evidence that non-audit service fees impair auditor independence.

CHAPTER 2 BACKGROUND AND HYPOTHESIS DEVELOPMENT

Mandatory Auditor Rotation

External auditors play an important role in the capital markets by providing a service to protect the interests of the investing public This “public watchdog” function requires that accounting firms remain “independent” of the audit client and act on behalf

of the public, not the audit client However, the control over hiring and firing auditors by client’s management, combined with managers’ strong motivation to attain or exceed stated goals and objectives, imposes a heavy burden upon the auditor to stand firm.8 Managers may try to actively use auditor-switching to avoid qualified reports, and may also use switch-threat to obtain a more favorable report from an incumbent auditor.9

Although there is little systematic evidence showing that long-term auditor-client relationships reduce auditors’ incentives to maintain independence, mandatory auditor rotation policy has been suggested in the past at various times as a solution to a recurring problem of auditor independence In the U.S., audit members o f the SEC Practice

8 Despite the recent efforts o f the SEC to increase the role o f the independent audit committee in the selection and retention o f auditors, the management o f audit clients continues to significantly influence hiring and firing decisions o f auditors Under the current US corporate governance system, investors are allowed to ratify the manager’s selection of auditor through their proxy votes However, the investors are not given alternative auditor choices, nor are they allowed to make their own choice.

9 When the value of incumbency exists, auditors may be willing to acquiesce to the wishes of management when threatened by switch threat Previous empirical studies show that auditors engage in “low-balling” by offering an initial fee below cost in anticipation o f offsetting the initial loss by earning rents in subsequent periods (e.g., Barber et al 1987 and Simon and Francis 1988) Magee and Tseng (1990) analytically examine the relationship between pricing o f audit engagements and auditor independence, and conclude

Section are required to rotate partners every few years, but mandatory audit firm rotation has never been adopted The Metcalf report (1976) recommended mandatory rotation of audit firms, but was later rejected by AICPA (1978) and the SEC Practice Section (AICPA 1992) The widely held argument against mandatory auditor rotation is that it increases the risk of audit failure as well as costs associated with frequent auditor rotation The Cohen Commission (AICPA 1978) and AICPA (1992) noted that audit failures were more frequent in the early years o f audit engagements.

Independent studies also suggest that mandatory auditor rotation does not guarantee better audits since it takes time for newly appointed auditors to become familiar with their clients Truncating the length of auditor-client relationships can reduce auditors’ incentives to invest in learning about their clients, resulting in lower- quality audits (St Pierre and Andersen 1984; Arrunada and Paz-Ares 1997) Geiger and Raghunandan (2002) show that auditors are more likely to issue a clean report prior to a bankruptcy filing in the early years o f the auditor-client relationship Johnson et al (2002) find that compared to “medium” auditor tenure, the absolute value o f unexpected accruals is higher in the early years o f the auditor-client relationship Using absolute value o f abnormal accruals and current accruals, Myers et al (2003) report that earnings quality increases with auditor tenure Ghosh and Moon (2003) show that absolute discretionary accruals and the use o f large special items decline with auditor tenure Finally, Carcello and Nagy (2004) examine the relation between auditor tenure and fraudulent financial reporting and find that fraudulent reporting is more likely to occur in the first three years o f the auditor-client relationship These studies suggest that

that the auditor’s value o f incumbency can pose a threat to independence.

mandatory rotation can actually work to the detriment of audit quality, strengthening the argument that mandatory rotation is not a desirable policy.10

Evidence in support of mandatory auditor rotation, on the other hand, is sparse.

In an experimental setting, Dopuch et al (2001) find that mandatory rotation reduces the auditor’s willingness to issue biased reports Dopuch et al conclude that mandatory rotation, with or without mandatory retention requirement, can increase auditor independence Also, using a model to analyze the cost and benefit o f mandating the rotation o f auditors, Gietzmann and Sen (2002) conclude that in certain well-defined circumstances, mandatory rotation o f auditors is a desirable policy In audit markets with relatively few new client opportunities, removing the ability o f management to influence the auditor reappointment decision can improve the incentives for auditors to maintain independence Empirically, Davis et al (2003) show a positive relation between discretionary accruals and auditor tenure and conclude that audit quality decreases with longer auditor tenure Similarly, Casterella et al (2002) find that audit failures are more likely when auditor tenure is long, supporting the view that longer the tenure, the lower the audit quality.

10 Aminada and Paz-Ares (1997) argue that, in addition to hampering the auditor’s technical competence due to a greater number o f initial audits, mandatory rotation can also harm auditor independence This argument is based on the reasoning that mandatory rotation probably reduces the expected cost o f not reporting and becoming dependent However, direct empirical evidence for such a claim is lacking.

Auditor Designation Policy in Korea

In all markets, the established practice of fairness and transparency is an essential element in the issuing and trading o f securities The securities market in Korea is no exception Many securities-related laws and regulations exist to provide this basic foundation to investor protection Prior to 1981, firms requiring external audits were assigned auditors by the government In an effort to improve the quality o f audits and to foster the growth o f the auditing profession in Korea, in December 1980, the government introduced competition into the audit market by increasing the demand for independent audits as well as increasing the supply of auditors However, with the introduction of competition, management realized a newly-gained power over the auditors Park (1990) provides evidence that companies that received qualified opinions tended to change auditors more frequently than those with clean opinions Moreover, companies received qualified reports less frequently after switching, suggesting that managements engage in successful opinion-shopping.11 Therefore, the threat o f switching can weaken the ability

o f auditors to withstand pressure from client management to bias the reports in the client’s favor.

Among many reforms to the Korean audit system undertaken by the government,

an auditor designation (AD) policy was adopted through the AAEA in December 1989 The objective o f the new AD policy was to promote independent and quality audits by

11 Opinion-shopping was defined by the SEC, in FRR 31, as the practice o f seeking an auditor willing to support a proposed accounting treatment designed to help a company achieve its reporting objectives even though doing so might frustrate reliable reporting The reporting objectives envisioned in opinion shopping would be to improve reported operating results or the financial condition by obtaining an interpretation o f GAAP that is not consistent with those of the past or with the economic substance o f a transaction, or by obtaining support for a change to a less-preferred or marginally acceptable accounting treatment.

limiting managerial influence over auditor switching According to the regulation on external audit o f listed corporations under the Securities Exchange Act in Korea, firms meeting certain criteria (see Appendix A) are subject to auditor designation by the Financial Supervisory Commission (FSC) Typically, these firms have been assessed with a high potential to manipulate accounting numbers and are deemed in need of a reliable audit as a result o f the FSC audit review All other firms not subject to auditor designation can freely select an auditor o f their choice.

Under AD policy, the FSC designates auditors for firms based on the size of client-firm assets at the close of the prior accounting period, and the points accumulated

10

by the auditors (AD scores) The auditor with the highest points will be allotted the auditor-designated firms that have the largest assets The designation period is usually three years, but this can be adjusted based on the yearly review of designated firms If a firm is not released from the auditor designation requirement after the period of three years, then the FSC designates an auditor other than the incumbent auditor to ensure the independence o f the auditors Once the firm is released from the auditor designation requirement, it can choose to remain with the incumbent auditor or switch to a different auditor.

12 The AD score o f an auditor is calculated as follows: AD Score = Auditor Score / (1+ Number of Designated Client Firms) The FSC maintains an auditor score system based on factors such as experience, performance, and number o f years with no allotment o f FSC designated firms The experience o f an auditor is determined by multiplying the number o f auditors in the audit firm by the points based on the number o f years o f experience (the more experienced, the higher the points) If the audit reviewed by the FSC is substandard, then the score is reduced for the auditor who performed the audit Auditors who have not been designated a firm for some periods get additional points added to their auditor score The AD scoring system provides auditors with an incentive to attain high auditor scores for a larger allotment o f AD firms However, gaining more designated clients reduces future designations since the denominator o f AD score increases.

Two recent studies (Kim et al 2002; Bae et al 2003) have examined the effect on audit quality o f the Korean government auditor designation policy Using discretionary accruals as a proxy for audit quality, Kim et al (2002) find that (1) discretionary accruals for the firms with designated auditors are significantly lower than those for the firms with non-designated auditors, and (2) for auditor designated firms, discretionary accruals during the designation period are significantly lower than those during the non­

designation period Based on their findings, Kim et al conclude that auditor designation improves auditor independence Bae et al (2003), on the other hand, find that although

no difference in discretionary accruals between firms with designated auditors versus non-designated auditors manifests, discretionary accruals for auditor-designated firms are more income decreasing (1) the higher the audit risk, and (2) the longer the period of auditor designation (in which case, the designated auditor will be mandatorily replaced

by another designated auditor) Bae et al.’s findings suggest that auditor designation increases auditor conservatism, thus implying improvement in auditor independence.

The evidence provided by Kim et al (2002) and Bae et al (2003), however, cannot be unambiguously attributed to improved independence due to mandatory auditor changes Under an audit regime with an auditor designation (AD) policy in effect (post- 1989), it is a common knowledge to all auditors that they could be mandatorily replaced

if their audit clients meet any one o f the designation criteria set forth by the government Under these conditions, the incumbent auditors have no economic incentives to give lenient treatment to clients in hope o f repeat business Also, under the AD regime, the designated auditors are under regulatory scrutiny and are likely to prevent earnings management for that reason, and not because o f increased independence Likewise, the

companies themselves could have voluntarily reduced earnings management in response

to the public scrutiny, rather than, the auditors prevented manipulative earnings management due to increased independence In such cases, the same effect can be obtained through heightened regulatory scrutiny without mandating auditor changes Thus, it is difficult to draw an unambiguous conclusion from a research design that examines firms with designated auditors That is, one cannot decipher whether an increase in audit quality is due to auditor changes or some other reason.

Hypothesis Development

In this study, I examine empirically whether auditor designation (selective mandatory auditor rotation) improves audit quality DeAngelo (1981a) and Watts and Zimmerman (1981, 1986) define audit quality as the probability that an auditor will both discover and truthfully report a discovered breach, and suggest that the probability of reporting is a function o f independence Since high-quality, independent auditors are more likely to detect and object to the client firms’ use o f aggressive and questionable accounting practices, earnings management is expected to decrease as audit quality improves.

DeAngelo (1981b) suggests that an existing audit client provides the auditor with client-specific rents that the auditor expects to receive over the life o f the auditor-client relationship This source of perpetual rents may create an economic dependency of the auditor on the client When the value o f incumbency exists, auditors may be willing to acquiesce to the wishes o f management, thus compromising their independence (Magee

Under the audit regime with the AD policy, the auditors o f Korean firms likely to

be targeted for auditor designation can no longer expect unlimited tenure Therefore, those auditors have no economic incentive to give lenient treatment in hope of repeat business since FSC-designated auditors could mandatorily replace them Hence, I hypothesize the AAEA to have the desired effect o f causing auditors o f firms at risk of designation to be more independent, and thus effectively restrain firms’ opportunistic manipulation of earnings Stated in an alternative form:

H a : Opportunistic earnings management o f firms at risk o f auditor designation

by the FSC decreases after the passage o f the AAEA (post-AAEA).

CHAPTERS RESEARCH DESIGN

Identifying Treatment and Control Samples

In order to study the impact o f limiting the length o f the auditor-client relationship

on auditor independence, I examine pre- and post-AAEA earnings quality measures of firms listed on the Korea Stock Exchange (KSE) in 1989 over the sample period 1985-

1995, excluding 1990 Although the AAEA was passed in December 1989, the actual designation o f auditors did not take place until 1991 Year 1990 is thus the transition year, and therefore excluded from the sample Hence, I set 1989 as the base year and use the FSC’s criteria for auditor designation to identify treatment firms (firms at high risk o f auditor designation) and control firms (firms at low risk o f auditor designation).

Debt-to-equity ratio and ownership percentage (the percentage o f shares held by major shareholder and related parties) are chosen as the sample partitioning variables since they are related to the firm-specific factors in the FSC auditor designation criteria and also the two most frequent reasons for auditor designation during my sample period

These two variables are used to partition KSE-listed firms in 1989 into High and Low AD

risk firms Since other accounting reforms were initiated in response to the increasing liberalization and internationalization o f Korea’s capital market in the late 1980s and

early 1990s, I include Low AD risk firms in my tests to control for the effects of

potentially confounding events For example, in 1990, the use of lower-of-cost-or-market

method was introduced as a required valuation method for marketable securities and long-term investments Pension accounting also experienced significant changes along with more disclosures required on financial statements In 1994, the Statement o f Cash Flows became an integral part o f corporate financial reports Transparent and

comparable accountings with more disclosures on corporate activities were the focus of these reforms.

Discretionary Accruals as Proxy for Audit Quality

I use discretionary accruals, a commonly used proxy o f earnings management in extant literature (e.g., Becker et al 1998; DeFond and Subramanyam 1998; Francis et al.

1 T

1999), to measure earnings, and therefore audit, quality I test whether auditor designation policy increases auditor independence by examining auditors’ ability to constrain the aggressive and questionable accounting accruals before and after the passage o f the AAEA The financial reports are assumed to be a joint outcome o f both the client management’s and the auditor’s preferences, and accounting accruals are important accounting attribute that the auditor is expected to influence Prior research also shows that discretionary accruals are good proxies for audit quality Nelson et al (2002) find that the most frequently attempted method of earnings management by managers in their sample involves reserves, and these are reflected in accruals Henninger (2001) finds the Jones-model abnormal accruals to be associated with eventual litigation against auditors.

13 The less-stringent financial reporting and litigation environment, combined with a lack of general oversight functions, made it easy for Korean firms to engage in earnings management practices before the

1997 financial crisis Yoon and Miller (2002) document Korean firms managing earnings using

Bartov et al (2001) show that the cross-sectional Jones model abnormal accruals are associated with audit qualifications Geiger and Raghunandan (2002) find that higher accrual levels are positively associated with audit failures.

Discretionary accruals are estimated using the cross-sectional modified Jones model (Jones 1991; DeFond and Jiambalvo 1994; Dechow et al 1995) as follows:14

TACC = a0 1 / TA-! + aj (ASALES - AAR)/ TA.} + a2 PPE/ TA.} + e,

where;

TACC = total accruals deflated by TA_i, where total accruals are computed using the

balance sheet approach:

TACC = (ACA- ACASH - ACL + ACurrentLTDebt - Dep)/ TA.u TA_i = total assets at the beginning o f the year;

as well as upwards (Healy 1985; DeFond and Park 1997; Degeorge et al 1999) Becker

et al (1998), however, argue that audit firms are never sued for permitting accruals that decrease earnings Evidence also shows that managers are more likely to be involved in income overstatement than income understatement (DeFond and Jiambalvo 1991, 1993;

discretionary accruals proxies calculated from Jones (1991) and Kang and Sivaramakrishnan (1995) models.

14 Although the Korean corporate accounting standards have faced some major reforms (12/1981, 9/1984, 12/1985, and 3/1990), fundamental accounting principles have not changed The accounting rules in Korea are roughly similar to those in the U.S., providing mangers similar latitude in terms o f the timing and magnitude of revenues and expenses This, in addition to the wide usage o f the Jones model in earnings