A Study on the Effect of Related Party Transactions on Audit Fees and Audit Hours - Evidence from Korea

This study examines the cross-sectional association between related party transactions and audit fees and audit hours. Previous studies about related party transactions showed the empirical evidence of which related party transactions are used as a way of earnings management in Korea. Therefore, auditors are likely to regard audit risk to be high when they audit clients with an amount of related party transactions. Auditors are likely to demand higher audit fees to compensate higher audit risk and spend more time in audit procedure to avoid potential audit failure. Thus, related party transactions are expected to be positively associated with audit fees and audit hours. This study uses Korean data of non-financial companies which are listed at the Korea Stock Exchange for the period of 1999 through 2006 consisting of the final sample of 2,411 firm-years. Our empirical results show that related party transactions are positively associated with audit fees and audit hours. This finding suggests that auditors regard related party transactions as a means of earnings management and, therefore, they demand higher audit fees and audit hours than other clients to compensate for high audit risk. This finding suggests that auditors spend more time in audit procedures to avoid potential audit failures when the amount of related party transactions is large. This study adds to previous studies examining the association between related party transactions earnings management and tunneling behavior. By focusing on the relation between related party transactions and factors related to auditing, this study improves our understanding on the effect of the transactions on audit risk. Due to data constraints, this study, however, is not able to examine the effects of related party transactions on different levels of audit hour across ranks in an audit firm (e.g., partner, manager, or staff). Future study may investigate the relation between related party transactions and audit hours by different audit stages (e.g., audit planning, test of controls, substantive tests, communication with client) utilizing internal data from a public accounting firm. Future research may also investigate the differences in the effects of related party transactions on audit fees and audit hours across different legal environments (e.g. U.S., U.K., Hong Kong, etc.).