The Effect of Agency Costs on Differentiated Audit Services: Evidence from Korean Audit Market

Using the Korean audit service market, we examine whether audit quality is systematically related to a broad spectrum of agency costs, including those originating from conflicts of interest between the controlling owner and minority shareholders. On the audit demand side, we find that firms with higher agency costs are more likely to demand higher quality audit. Specifically, as the discrepancy between the voting rights and cash flow rights of the controlling owner increases, the firm is more likely to hire a high-quality auditor. The equity ownership interest of foreign investors is related to audit quality after the 1997 Asian financial crisis. Additionally, as managerial ownership decreases and firms’ dependence on banks for financing increases, the firm tends to demand a high-quality auditor. On the supply side, audit fees were negatively related to agency problems between the controlling owners and minority shareholders prior to the crisis, thereby indicating that auditors were not compensated appropriately for the risk they assumed during this period. However, this negative association disappears after the crisis. In general, audit fees tend to reflect the agency costs during the post-crisis period.