kim et al - 2004 - selective auditor rotation and earnings management - evidence from korea

Selective Auditor Rotation and Earnings Management: Evidence from Korea Abstract In Korea, the regulatory authority designates external auditors for firms that are deemed to have high

Selective Auditor Rotation and Earnings Management:

Evidence from Korea

Jeong-Bon Kim,* Chung-Ki Min and Cheong H Yi

Current Draft June 2004

_

The first and third authors are at the School of Accounting and Finance, Faculty of Business, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong The second author is at the Department of Economics, The Hankuk University of Foreign Studies, Seoul, Korea The research is partially funded by the Hong Kong Polytechnic University We have received useful comments from Kwan Choi, Michael Firth, Dan Simunic, and workshop participants of The Hong Kong Polytechnic University, University of British Columbia, City University of Hong Kong, Korea University, the

2002 AAAA Annual Conference and the 2003 AAANZ Annual Conference The usual disclaimer applies

*Please forward all correspondence to Jeong-Bon Kim (Phone: 852-2766-7046; Fax: 852-2330-9845; E-mail: afjbkim@inet.polyu.edu.hk)

Selective Auditor Rotation and Earnings Management:

Evidence from Korea

Abstract

In Korea, the regulatory authority designates external auditors for firms that are deemed to have high incentives and/or great potential for opportunistic earnings management, and mandates these firms to replace their incumbent auditors by new designated auditors and requires them to keep the designated auditor for a period of typically one to three years We call this regulatory regime selective auditor rotation This paper investigates whether the selective auditor rotation rule in Korea is effective in deterring income-increasing earnings management Consistent with our hypothesis, we find that the level of discretionary accruals is significantly lower for firms with designated auditors than firms that freely select their auditors We also find that the level

of discretionary accruals is significantly lower during the designation period, compared to the level during a year prior to the imposed rotation The above findings are robust to a battery of robustness checks Overall, our results are consistent with the notion that the selective auditor rotation enhances audit quality and thus the credibility of financial reporting

JEL classification: G38; L15; L84

Keywords: Selective Auditor Rotation; Audit Quality; Earnings management

Selective Auditor Rotation and Earnings Management:

Evidence from Korea

Since 1991, the regulatory authority in Korea has designated external auditors for

a group of firms that are deemed to have high incentives or great potential for accounting manipulation (hereafter problematic firms) These problematic firms must replace their incumbent auditors with new auditors designated by the regulatory authority, and retain them for a specific period, typically one to three years During our sample period of 1991

to 2000, about 15 to 17 percent of all firms listed on the Korea Stock Exchange were required to replace their incumbent auditors with designated auditors We call this regulatory regime ‘selective auditor rotation’ in the sense that auditor changes are mandated only for select problematic firms and not for all firms.1

The selective auditor rotation (SAR) rule in Korea has several interesting features Firstly, the SAR rule mandates auditor changes only for problematic firms, thereby preserving a competitive, market-based audit engagement for firms that are not deemed problematic In this regard, the SAR contrasts with suggested or existing mandatory

rotation that typically requires auditor changes for all firms after a certain period of an initial engagement By mandating auditor for select problematic firms, the SAR rule intent is to alleviate alleged problems arising from long-term, auditor-client relationships

or repeat audit engagements Secondly, the SAR mandates retention of newly designated auditors for a certain period, thus protecting designated auditors from early dismissal, and

thereby mitigating a major threat to auditor independence Finally, by requiring that

1 Appendix explains detailed criteria used for selecting these problematic firms

incoming auditors be chosen by the regulatory authority rather than by audit clients, the SAR rule limits managerial influence over auditor selection and any potential for low-

balling, thereby enhancing auditor independence and audit quality

To our knowledge, no country other than Korea has ever introduced or considered

a selective auditor rotation policy This institutional feature unique to Korea provides us with an ideal laboratory setting in which one can compare differences in audit quality

between two distinct groups, namely firms with mandated auditor changes (treatment group) and those with a free selection of auditors (control group)

In this paper, we take advantage of this unique institutional feature to provide systematic evidence on the effect of selective auditor rotation on audit quality Audit quality is not directly observable, and thus it is difficult to measure empirically

Consistent with prior research (Becker et al 1998; DeFond and Subramanyam 1998; Myers et al 2003), we use accounting accruals measures to draw inferences about audit quality High quality auditors are more likely to detect accounting irregularities, object to the use of questionable accounting practices, and limit discretion over accrual choices for

client firms (Reynolds and Francis 2001; Frankel et al 2001) To the extent that the SAR

rule is effective in improving auditor independence and thus audit quality, designated auditors are likely to be less lenient towards managerial discretion over opportunistic accrual choices, and thus they are more effective in deterring aggressive earnings management by their clients, compared to non-designated auditors (auditors chosen by

clients) As a consequence, firms with designated auditors should report lower discretionary accruals than those with non-designated auditors, other things being equal

To test this proposition, we first compare the level of discretionary accruals between firms whose auditors are designated and firms whose auditors have never been

designated In addition, we also compare the level of discretionary accruals during the pre-designation period with the level during the designation period, using firm-year observations with designated auditors, to see if the level of discretionary accruals decreases after the imposition of mandated auditor changes We perform our analyses

using 752 firm-year observations with designated auditors and 2,784 firm-year observations with non-designated auditors during our sample period, 1991-2000 To address potential measurement error problems associated with the Jones model (Kothari

et al 2002), we include a control for firm performance in estimating discretionary accruals

Briefly, our analyses reveal that firms with mandated auditor changes report significantly lower discretionary accruals than firms with no mandated auditor changes, after controlling for other factors that have been shown to be associated with discretionary accruals We also find that for firms with mandated auditor changes, the

level of discretionary accruals becomes significantly lower (more negative) during the designation period, compared with the level during the last one year prior to auditor designation This evidence further corroborates our initial results Taken together, our results indicate that the selective auditor rotation rule enhances audit quality and is effective in deterring opportunistic earnings management Put differently, our results

suggest that the imposition of selective auditor rotation leads to the expected changes desired by the regulatory authority with respect to the problematic firms at which the SAR rule is targeted Finally, we conduct a battery of sensitivity analyses to check the

robustness of our findings Overall, the results of various sensitivity checks reveal that our findings are robust to alternative test designs and/or explanations

This paper adds to the existing literature on auditor independence and audit quality (e.g., Frankel et al 2002; Ashbaugh et al 2003; Myers et al 2003) in the following ways Recent incidents of audit failures in the US (e.g., Enron debacle) have triggered a world-wide regulatory debate over how to mitigate potential threats to auditor

independence ranging from managerial influence over auditor choice to auditors’ economic dependence on clients In response to the above concern, the US Congress enacted the Sarbanes-Oxley Act of 2002 in which the lead or the coordinating audit partner for a certain client must be rotated every five years In addition, the Act called for further research into the potential effects of requiring mandatory rotation of audit firms,

not just audit partners within the same firm.2 Proponents of mandatory auditor rotation argue that mandating auditor changes after some specified period would truncate potential economic gains to auditors arising from repeat audit engagements with the same client, and provide stronger incentives for auditors to act independently The selective

auditor rotation (SAR) is similar to the mandatory auditor rotation in the sense that both measures aim to enhance auditor independence by truncating the client-specific rents to auditors As mentioned earlier, however, the requirement for mandated auditor changes under the SAR rule applies only to problematic firms, while the mandatory rotation rule would apply to all firms The selective auditor rotation may be viewed as a regulatory

measure that lies between the mandatory rotation system and the voluntary rotation

2 Sec 207 of the Sarbanes-Oxley Act of 2002 states that the Comptroller General of the Unite States shall conduct a study and review of the potential effects of requiring the mandatory rotation of audit firms In fact, the imposition of mandatory rotation has been discussed at various times over the last three decades in

system Korean evidence reported in this paper suggests that a form of limited regulatory intervention on auditor changes targeted at potentially problematic firms could be

considered as a possible alternative to complete mandatory rotation

Several studies (e.g., Davies et al 2003; Geiger and Raghunandan 2002; Myers et

al 2003) have recently examined the effect of imposing limits on auditor tenure on financial reporting quality The evidence on whether extended auditor tenure improves or

deteriorates audit quality, however, is mixed For example, Myers et al (2003), using several accruals measures to proxy for earnings quality, find evidence suggesting that longer auditor tenure increases earnings quality In contrast, Davies et al (2003) find results suggesting that discretionary accruals increase with auditor tenure In addition, since the above evidence is obtained in a voluntary auditor rotation setting, it is difficult

to extrapolate the effects of mandated auditor changes from the evidence A notable exception is Dopuch et al (2001) who analyze the question in a laboratory setting, and provide experimental evidence in favor of mandatory auditor changes The results reported in this paper provide useful insights into the expected effect on audit quality, if

the mandatory auditor rotation policy is imposed in the US and other countries, in particular, for firms with high incentives for opportunistic earnings management

The remainder of the paper is organized as follows The next section presents an overview of the Korean audit services market Section III develops our hypothesis Section VI discusses research design, including sample selection and empirical model

specification Section V presents empirical results Section VI reports the results of

additional analyses The final section concludes the paper

the U.S (e.g., the U.S Senate’s Metcalf Subcommittee Report 1977; the AICPA’s Cohen Commission Report 1978; SEC 2000), although it has never been adopted

II INSTITUTIONAL BACKGROUND Overview of the Korean Audit Services Market

During late 1970s and early 1980s, the Korean economy experienced phenomenal growth, along with a rapid development in capital markets, which in turn increased the demand for credible financial reporting and external auditing This change in the economic environment prompted the regulatory authority in Korea to introduce the Act

on External Audit (AEA) that was enacted in 1980 The AEA fermented many changes in the accounting and auditing professions in Korea On the demand side, the AEA increased significantly the number of firms that are subject to external audits by requiring the financial statements of a firm with more than 6 billion Korean Won in total assets to

be audited by an independent auditor About 7,000 firms, including unlisted firms, were subject to external audits in 2000 On the supply side, the AEA loosened restrictive licensing procedure for certified public accountants (CPAs), resulting in an increase in the number of CPA The Korean Institute of Certified Public Accountants (KICPA), established in 1954 to improve CPA skills and monitor professional conducts of its

members, had 5,309 CPAs registered in 2000 32 local audit firms were practicing as of

2000 and many of them have a member firm relationship with international accounting firms such as Big Five audit firms

While the introduction of the AEA led to the growth of the auditing profession,

there are several aspects of institutional and socio-economic environments that pose a threat to auditor independence and audit quality in Korea First, founding families of Korean firms typically exercise significant control over operations and other aspects of a

firm’s activities (Joh 2003) Members of founding families can effectively maintain control over firms through pyramidal ownership and cross shareholdings, even though

they have relatively low cash flow rights This separation of ownership and control creates agency conflicts between controlling shareholders and minority shareholders

(Johnson et al 2000a; Claessens et al 2002) Controlling shareholders also exert

significant influence over firms’ financial reporting and auditor selection (Fan and Wong

2002) The conflict of interest between controlling shareholders and minority shareholders motivates controlling shareholders to engage in opportunistic earnings management and hire auditors more acquiescent to their demands regarding accounting choices Controlling shareholders’ influence over auditors becomes even greater when auditors earn client-specific rents in the form of the provision of non-audit services

Second, the Korean society and economy have traditionally been operated, in large part, on the basis of personal relationships These personal relationships typically

take the form of family ties (heol yeon), school ties (hak yeon), or regional ties (chi yeon)

These relationships are deeply rooted in long-held Confucian cultural traditions, and

loyalty to organizations and obedience to seniors within the tie-based networks have been considered as the most important factor leading to an individual success or successful operations of organizations in Korea In this relationship-based economy, managers are likely to select auditors based on personal ties, which may cause inherent limitations on auditors being independent of managers In a related vein, conflicts among interested

parties have typically been resolved in Korea through direct communications among them to preserve future business within the relationship-based network Not surprisingly, shareholder litigation against auditors has been less common in Korea, and the amount of

court-awarded damage has been relatively small.3 In this relationship-based economy with low litigation risk, it is a daunting task to maintain auditor independence

Introduction of Auditor Designation

In response to concerns over audit quality and the credibility of financial reporting voiced by financial statement users, the Financial Supervisory Commission (FSC), equivalent to the Securities and Exchange Commission (SEC) in the U.S., established the Committee for External Audit Improvement with a mandate to propose a remedial action plan for improving auditor independence in 1989 Following the Committee’s

recommendation, the Amendment of the AEA became effective in December 1989 Under the Amendment, the FSC is empowered to impose mandated auditor changes for a group of problematic firms As described in Appendix in details, Article 10 of the FSC Regulation associated with the AEA stipulates the type of firms that could be subject to

mandated auditor changes A close examination of Article 10 reveals that these problematic firms may have poor corporate governance or high agency problems (e.g., insufficient separation of ownership and management, and excess loans to related parties), may face financial troubles (e.g., excessive reliance on debts, industry restructuring, and trading on administrative post), and may make questionable auditor

changes, or violate GAAP in preparing annual reports These firms are believed to have high incentives or great potential for accounting manipulation or opinion shopping To increase audit quality, the FSC is empowered to mandate firms falling under the categories described in the Appendix (what we call problematic firms earlier) to replace

their incumbent auditors with auditors designated by the FSC, and to retain designated

3 Since the first case of auditor litigation happened in 1991, there have been a total of 22 litigations against auditors during the period 1991-1999 The largest amount of court-awarded damage was far less than

auditors over a certain period, typically one to three years Since the selective auditor rotation rule was first introduced in 1991, the FSC has imposed mandated auditor

changes for about 15 to 17 percent of all firms listed on the KSE every year

III HYPOTHESIS DEVELOPMENT

Audit quality is often defined as the probability of both detecting and reporting a breach in the financial statements (DeAngelo 1981; Watts and Zimmerman 1986) The

reporting of a detected breach partially requires auditor independence In the based economy with relatively low litigation risk where external auditors tend to be chosen on the basis of their personal relations with incumbent managers or corporate insiders, the selective auditor rotation (SAR) rule could be an effective regulatory

relationship-measure for enhancing auditor independence and audit quality Under the SAR rule, control over the hiring and firing of external auditors is taken away from management, and designated auditors must be retained for the designation period The selective auditor rotation could minimize managerial influence over the firing and hiring of external auditors, in particular, for firms with high incentives for opportunistic earnings

management As a result, designated auditors would be in a stronger position to resist clients’ pressure to bias financial reporting, and they are more likely to make objective professional judgments

On the other hand, the selective auditor rotation could decrease audit quality

Incoming auditors designated by the regulatory authority may be less competent because they are not industry experts or they lack knowledge of a client’s business and operations Since auditors’ understanding of their clients increases with auditor tenure, imposing

US$1.0 million

limits on auditor tenure may increase the number of audit failures Consistent with this argument, the AICPA’s Quality Control Inquiry Committee of the SEC Practice Section

reported that allegations of audit failure occur much more frequently when auditors are in their first or second year of a new audit engagement (AICPA 1992) Similarly, Geiger and Raghunandan (2002) found that more audit reporting failures occur in the earlier years of the auditor-client relationship It should be noted, however, that the above US

evidence on the earlier-year audit failures has been obtained in an environment of no mandatory auditor rotation and thus be interpreted cautiously (Imhoff 2003)

In this study, we empirically investigate whether the selective auditor rotation for problematic firms improves audit quality, which, in turn, enhances the ability of an auditor to detect and report accounting manipulation or substandard reporting Higher

quality auditors are better able to withstand clients’ pressure to allow substandard reporting and they are more likely to object to questionable accounting practices, and constrain management’s ability to distort the true financial performance of the firm (Levitt 1998; Public Oversight Board 2000) To the extent that the selective auditor

rotation for problematic firms is effective in constraining opportunistic earnings management by such firms, the level of discretionary accruals should be lower for firms with designated auditors than for firm with non-designated auditors Hence, we test the following hypothesis in an alternative form:

H A : Firms with designated auditors report lower discretionary accruals than firms with non-designated auditors, other things being equal

Our analysis focuses on the level of discretionary accruals or income-increasing earnings management for several reasons: First, evidence shows that managers are more likely to be involved in income overstatement than income understatement (DeFond and

Jiambalvo 1991, 1993; Kinney and Martin 1994; Becker et al 1998) Second, when examining the issue of earnings management in a general context, income-decreasing

earnings management is inherently less interesting than income-increasing earnings management Third, previous research (e.g., Dechow et al 1996) suggests that poor corporate governance facilitates earnings manipulation During the 1990s (which includes our sample period), the Korean corporate sector had experienced low profitability due

primarily to poor corporate governance For example, Joh (2003) shows that low profitability is associated with poor corporate governance in Korea, which allows controlling shareholders to divert assets and profits from the firm for their private gains at the expense of minority shareholders Low profitability, along with poor corporate governance, is likely to create incentives for controlling shareholders and incumbent

managers to boost reported earnings via income-increasing accruals to camouflage poor earnings performance Consistent with this conjecture, more than 80 % of firms receiving qualified audit opinions for departures from GAAP allegedly overstated reported earnings during our sample period (Financial Supervisory Commission 1999) Finally, unlike

accounting standards in Japan and Germany, Korea’s accounting standards are not closely tied to tax accounting rules, thus lowering potential opportunity costs associated with income-increasing earnings management For the above reasons, we are primarily interested in examining the effect of selective auditor rotation on the level of

discretionary accruals

IV RESEARCH DESIGN Sample Description

The initial sample for this study consists of all firms listed on the Korea Stock Exchange (KSE) that are included in the 2001 KIS-DATA files developed by the Korea Information Service (KIS) The KIS is a credit rating agency in Korea and provides corporate financial and ownership information of all listed firms on the KSE For our

auditor-designated sample, we obtained a list of 362 firms (948 firm-year observations) whose auditors are designated during 1991-2000 from the Accounting System and Audit Review Department of the Korea Financial Supervisory Service, the operating arm of the FSC.4 We delete 6 firms (12 firm-years) in the financial services industry (commercial banking, investment brokerage, insurance, etc) from the sample because the nature of accruals for firms in this industry differs from that in other industries 52 firms (184 firm-years) are also excluded from the sample due to missing data for measuring research variables in this study

Table 1 summarizes our sample selection procedure As outlined in Panel A of

Table 1, we identify a total of 304 firms (752 firm-year observations) with designated auditors over the period 1991-2000 after applying the above selection criteria Panel B of Table 1 reports the distribution of firms with designated auditors (our treatment sample), along with firms with non-designated auditors (our control sample) by year of auditor

designation Our control sample consists of 2,784 firm-year observations (between 250 and 293 firms each year) with sufficient data that never have their auditors designated by

4 We thank Professor Choi Kwan of SungKyunKwan University in Seoul, Korea for providing the list of firms subject to auditor designation during the period 1991-1993

the FSC during the sample period Panel C classifies our designated sample according to the designated period.5 Over 62% of the firm-years are designated for three years or less

[INSERT TABLE 1 ABOUT HERE]

Table 2 displays our treatment sample by reason for auditor designation The table indicates that two major reasons for auditor designation are excess reliance on external debts (51%) and insufficient separation of ownership and management (28%) Before the Korean financial crisis erupted in December 1997, 71% of our firm-year observations have their auditors designated because of high leverage, while concentrated ownership

structure is the major reason for auditor designation after the crisis

[INSERT TABLE 2 ABOUT HERE]

Measuring Discretionary Accruals

Like many other studies, this study uses the level of discretionary accruals to proxy for the extent of opportunistic earnings management Previous research indicates that it is important to control for the effect of firm performance on accruals when

measuring discretionary accruals using the Jones (1991) model or its variants Dechow et

al (1995) and Kasznik (1999) show that estimated discretionary accruals are correlated with earnings performance Firms with low (high) earnings tend to have negative (positive) discretionary accruals Further, testing for earnings management could yield

biased results if measurement error in the estimated discretionary accruals is correlated with the partitioning variable of interest (e.g., whether a firm is auditor-designated or not

in our study) To the extent that firms with poor earnings performance are more likely to

5 In Panel C of Table 1, the total number of frequency (345) is different from the total number of firms subject to auditor designation (304) because several firms are auditor designated more than once at different points in the sample period

be auditor-designated, failure to control for this correlated omitted variable would induce

a bias in our study, which may lead to erroneous inferences

Kasznik (1999) and Kothari et al (2002) suggest two approaches to control for

correlated omitted variables: (1) to use a matched firm (or portfolio) technique; or (2) to

include a control for firm performance in the regression model used to estimate

nondiscretionary accruals We take the latter approach in this study since there is a risk of

mismatching on the conditioning variables (firm performance and industry membership)

given the relatively small number of listed firms (704 firms as of year 2000) on the KSE.6

Imperfect matching will introduce noise into discretionary accruals, which weakens the

power of our test for earnings management However, the weakness of the latter approach

is that it imposes a linear relation linking accruals to earnings performance in the

cross-section

To estimate discretionary accruals (DAC), we first compute total accruals as the

change in non-cash current assets minus the change in current liabilities excluding the

current portion of long-term debt minus depreciation and amortization expenses

Formally,

jt jt

jt jt

jt

TAC =(∆ −∆ )−(∆ −∆ )− (1) where, for firm j and in year t:

TAC jt = total accruals;

6 We tried to control for the impact of performance on estimated discretionary accruals using a

performance-matched firm’s discretionary accruals We attempted to match performance (lagged ROA)

within the 80%-120% filter in the same industry and year However, given the small number of firms listed

on the stock exchange, we were unable to identify a matched firm for more than 60% of our treatment

sample

∆CL jt = change in current liabilities;

∆STD jt = change in long-term debt included in current liabilities; and

Dep jt = depreciation and amortization expenses

As discussed above, we employ an augmented version of the cross-sectional

modified Jones (1991) model to decompose total accruals (TAC) into discretionary and

nondiscretionary accruals Specifically, we include last year’s return on assets (ROA) as a

control for firm performance in the model:

jt jt

jt jt jt

jt jt

jt jt

e ROA

A PPE A

REV A

A

TAC

+ +

+

∆ +

=

−

−

−

−

−

] [

] / [ ] / [ ] / 1 [ /

1 4 1 3 1 2 1 1 1 α α α α (2)

where: TAC jt = total accruals for firm j in year t; A jt-1 = total assets for firm j in year t-1; ∆REV jt = change in net revenues for firm j in year t; PPE jt = gross property, plant, and equipment for firm j in year t; ROA jt-1 = return on assets (earnings before extraordinary items divided by lagged total assets) for firm j in year t-1; and e jt = error term For each year and industry, we estimate regression parameters in Eq (2) using cross-sectional observations Following the industry classification of the KSE, we classify firms into 18 industries.7 To obtain meaningful cross-sectional estimates of

7 The distribution of auditor-designated firms (304 firms) across 18 industries is as follows: Fishing (0); Mining (0); Food & Beverage (26); Textile & Apparel (31); Paper & Wood (21); Chemicals (38); Medical Supplies (14); Non-metallic Minerals (10); Iron-Metals (32); Machinery (15); Electrical & Electronic Equipment (44); Medical & Precision Machines (0); Transport Equipment (25); Distribution (0); Electricity

& Gas (19); Construction (2); Transport & Storage (20); and Services (7)

regression parameters in Eq (2), we require that at least 10 firms exist for each industry

in each sample year The parameters from Eq (2) are used to calculate nondiscretionary

accruals with a performance control (NDAC):

][

]/[

]//

[]/1[

1 4

1 3

1 1

2 1 1

∆

−

∆+

=

jt jt

jt

jt jt jt

jt jt

jt

ROA A

PPE

A REC A

REV A

NDAC

αα

αα

(3)

where ∆REC jt is the change in net receivables DAC is equal to TAC minus NDAC As in

other studies, DAC is considered to be the outcome of managers’ opportunistic accrual choices

Model Specification

We test our hypotheses by estimating the following OLS regression model linking

DAC with auditor designation and other control variables:

it it

it it

it it

it it

Industry BIG

TAC L LEV SIZE

OCF DESIG

DAC

εβ

ββ

ββ

ββ

++

+

++

++

+

=

) Dummies(

5

1

6

5 4

3 2

1

where, for firm i and year t:

DAC it = the level of discretionary accruals computed using Eq (2);

DESIG it = a dummy variable that takes the value of 1 if a firm’s auditor

is designated and zero otherwise;

OCF it = operating cash flows (earnings before extraordinary items

less total accruals) scaled by total assets;

SIZE it = the natural logarithm of the book value of total assets;

LEV it = the ratio of total debts to total assets;

L1TAC it = last year’s total accruals scaled by total assets;

BIG5 it = a dummy variable that takes the value of 1 if the auditor is a

Big Five and 0 otherwise;

Industry dummies = dummy variables controlling for industry differences; and

εit = error term

Our variable of interest, DESIG, is an indicator variable that takes the value of 1

when a firm’s auditor is designated Its coefficient, β1, captures the difference in the level

of discretionary accruals between the designated and non-designated samples after controlling for all other variables included in Eq (4) To the extent that auditor designation is effective in constraining the ability of managers to boost reported earnings through income-increasing accrual choices, one would observe a negative coefficient for

DESIG in Eq (4)

We include several control variables in Eq (4) that may affect the level of

discretionary accruals Previous research documents a negative correlation between DAC

and cash flow performance (Dechow et al 1995; Becker et al 1998; Kim et al 2003)

We thus include operating cash flows scaled by lagged total assets (OCF) in Eq (4) to

control for the potential confounding effects of OCF on our results We also include the natural logarithm of the book value of total assets (SIZE) and the ratio of total debts to total assets (LEV) as control variables because previous research suggests that they may

affect discretionary accrual choices in the current period (DeFond and Jiambalvo 1993;

Becker et al 1998; DeFond and Park 1997; Kim et al 2003)

As in Ashbaugh et al (2003), we include the prior year’s total accruals (L1TAC)

to capture the reversal of accruals over time Previous research provides evidence that Big Five auditors are effective in constraining managers’ abilities to boost reported earnings through income-increasing accrual choices (Becker et al 1998; Francis et al

1999; and Kim et al 2003) Fan and Wong (2002) also document that in East Asian

economies, Big Five auditors are more effective in mitigating agency problems To control for the effect of audit quality differentiation on our results, we include a dummy

variable (BIG5) indicating auditor type in Eq (4).8 Finally, we include industry dummies

to control for potential confounding effects of industry differences on DAC

V EMPIRICAL RESULTS Descriptive Statistics and Univariate Tests

Table 3 presents descriptive statistics for major financial variables, along with univariate tests for differences between the two samples, namely one with designated auditors and the other without designated auditors Panels A and B of the table present the mean and median for the sample of firm-years with designated auditor and the sample

of firm-years with non-designated auditors, respectively Panel C presents the results of parametric and non-parametric tests for differences in each variable between the two samples Overall, Table 3 reveals that the designated sample tends to be less profitable, smaller, and more leveraged than the non-designated sample The designated sample also generates less cash flows than the non-designated sample Compared with the designated

sample, a larger portion of the non-designated sample is audited by Big Five auditors

The level of lagged total accruals (L1TAC) is negative for both the designated and designated samples, although L1TAC is more negative for the designated sample

non-Finally, the firm-years with designated auditors have a lower level of

discretionary accruals (DAC) than the firm-years with non-designated auditors The mean (median) DAC is -1.1% (-0.2%) of lagged total assets for the designated sample,

8 Big Five auditors have a member firm relationship with large local audit firms since Big Five auditors are not allowed to run their own operations in Korea without partnering with local firms The local firms are provided services of technical expertise and quality control from Big Five firms

compared to 0.1 % (0.0%) for the non-designated sample As indicated in Panel C, the difference is statistically significant with p < 0.01 (p < 0.10) for parametric test (non-

parametric test) The significant difference in DAC between the two samples is

consistent with our hypothesis (HA) that firms with designated auditors report relatively lower discretionary accruals than firms with non-designated auditors However, significant differences in other firm characteristics observed between the two samples are

likely to confound the univariate comparison In what follows, our analysis thus focuses

on various multivariate tests

[INSERT TABLE 3 ABOUT HERE]

Multivariate Analysis

Panel A of Table 4 reports the regression results for Eq (4),9 using the full sample (with both positive and negative DAC) The regressions in Table 4 include industry dummies to control for potential confounding effects of industry-level variations in

accounting standards and regulations on our results, though their coefficients are not reported for brevity As shown in the Panel A of Table 4, the coefficient of the auditor

designation dummy (DESIG), namely β1, is highly significant with an expected negative sign The β1-coefficient of -0.026 is significant (p < 0.01) enough to support our hypothesis (HA) that, ceteris paribus, firms with designated auditors report lower DAC than those with non-designated auditors Given that mean return on assets (ROA),

measured by earnings before extraordinary items divided by lagged total assets, is -1.9% and 3.3% for firms with designated auditors and those of non-designated auditors,

9 To avoid cross-correlation of residuals in our analysis, we estimate the model in Eq (4) separately for each of the ten years in our sample Our results (untabulated) show that the average coefficient of DESIG is –0.024 with t=-2.11, confirming the result of the pooled regression That is, firms with designated auditors report lower DAC than firms with non-designated auditors

respectively, as shown in Table 3, this incremental DAC difference (2.6% of lagged total

assets) is economically significant as well The above results suggest that auditor

designation for Korean firms is effective in limiting management’s ability to boost reported earnings through income-increasing accrual choices

The coefficient on OCF is highly significant with a negative sign This is

consistent with the findings of Dechow et al (1995), Becker et al (1998) and Kim et al

(2003) DAC is positively associated with firm size, but not significant The relation between DAC and LEV is significantly negative This negative relation is consistent with

the debt-monitoring hypothesis that outside debt suppliers, primarily commercial banks, monitor managerial opportunism such as opportunistic earnings management (Jensen

1986, 1989) The association between DAC and L1TAC is highly significant with a

negative sign, consistent with the findings of Ashbaugh et al (2003) The coefficient for

the Big Five auditor dummy (BIG5) is negative but not significant

Next, we partition our sample into two groups based on the sign of firms’ discretionary accruals to examine whether there is any differential relation between the

auditor designation and our measures of discretionary accruals conditional upon the sign

of discretionary accruals (DAC) Panel B of Table 4 reports the results separately for firms with positive DAC and for firms with negative DAC10 We find the association

between DAC and DESIG is significantly negative for firms with positive DAC This

finding lends further support to our hypothesis that mandated auditor changes effectively

limit managers’ ability to boost reported earnings through income-increasing accrual

10 Previous studies (Myers et al 2003; Ashbaugh et al 2003) note that the OLS estimates are, in general, biased toward zero when a sample is truncated To address this problem, we also use a maximum likelihood

choices We also find a negative association between DAC and DESIG for firms with

negative DAC On the one hand, this is consistent with the notion that auditor designation

leads to lower DAC regardless of whether firms have positive or negative DAC On the other hand, designated auditors may be more likely to exercise a heightened degree of professional skepticism on managers’ income-increasing accrual choices and their impact

on current earnings, compared to non-designated auditors, because firms subject to

auditor designation (i.e., problematic firms) presumably have high incentives to overstate current earnings and the period of designation is rather short Thus, to the extent that

firms with negative DAC are more likely to have engaged in income-decreasing earnings

management, the above finding may be interpreted in such a way that designated auditors

are less effective in constraining income-decreasing accrual choices than non-designated

auditors

[INSERT TABLE 4 ABOUT HERE]

The Effect of Extreme Performances on Regression Results

Table 3 suggests that our designated sample is in a relatively poor financial health

measured by ROA and OCF Although we controlled for individual firm performance

when estimating discretionary accruals, a concern still remains that the results we present

in Table 4 may be attributable to differences in firm performance between the designated and non-designated samples To mitigate this concern, we re-estimate Eq (4) after

deleting observations in the extreme (top and bottom) deciles of ROA (measured by year and industry) Deleting firms that fall into the extreme deciles of ROA reduces the sample

size to 2,940 observations: 568 firm years of designated firms and 2,372 firm years of

truncated regression approach The results are similar to those reported in the table and our inferences based on OLS estimations are unchanged

non-designated firms The regression results are presented in Table 5 Overall, the regression results reported in Table 5 are similar to those reported in Panel A of Table 4,

suggesting that the regression results reported in table 4 are not driven by extreme performance In particular, we find the coefficient on DESIG is significant with an expected negative sign (p < 0.01), which further supports our hypothesis, HA

[INSERT TABLE 5 ABOUT HERE]

Analyzing Auditor-designated Firms Only

In the above analyses, we have examined the difference in the levels of

discretionary accruals between the sample of firms with designated auditors (treatment sample) and that with non-designated auditors (control sample) to draw inference about the impact of selective auditor rotation In this subsection, we further investigate the behavior of discretionary accruals only for the sample of firms with designated auditors

before and after the imposition of mandated auditor changes For this test, we require that the sample of firms with auditor designation must have data required to compute discretionary accruals and control variables in the last one year prior to auditor designation and in each of the years during the designation period This requirement

yields 1,072 firm year observations The results are reported in Table 6 Panel A of Table

6 shows that the level of discretionary accruals is significantly lower during the auditor designation period compared to the level in the last one year prior to auditor designation, suggesting selective auditor rotation is effective in constraining managers’ income-increasing accounting choices

To further examine any differential effect of differences in the auditor designation period on our analysis, we include several dummy variables to capture potential