Audit review, Window dressing settlement and conditional accounting conservatism:An empirical investigation of South Korea

We examine evidence on the relationship between firms that engaged in window dressing and accounting conservatism, an issue with important public policy implications. The main purpose of this paper is to empirically investigate the extent to which Korean WDS(Window Dressing Settlement) firms identified by the financial supervisory service in their audit review exhibit higher level of conservatism in order to avoid any potential negative effects and to regain public confidence. Additionally, we also examine whether the two conditional conservatism measures; Ball and Shivakumar(2006) and Basu(1997) models, provide valuable information in terms of detecting window dressing activities. We find some evidence that both models identify WDS firms as anti-conservatism, evidenced by lack of conditional conservatism from financial statements of WDS firms compared to that of Non-WDS firms. However, the results from Ball and Shivakumar(2006) measure are slightly stronger. More specifically, we find some evidence from ball and shivkumar measure that WDS firms exhibit lower level of conservatism compared to Non-WDS firms. Furthermore, WDS firms show highest level of conservatism during post-WDS periods when comparing WDS firms among different periods, suggesting changes in their accounting conservatism tendency. The results are overall consistent with Basu(1997) measure. Thus, we provide overall evidence that political pressure affects firms' conservatism policy. Our findings have important implications for accounting regulators and policy makers. First, we explicitly establish that two conditional conservatism measures provide useful information to detect window dressing activities since they capture lack of conservatism level from the manipulated financial statements. This suggests that conditional conservatism may help standard setters or other regulators to have an idea to capture possible financial shenanigans. Second, the FSS audit review creates the environment where firms turn to be conservative, providing useful information to external users. Thus, it may be suggested that the FSS finds more efficient ways to lead listed firms to provide transparent financial statements. More ideally, the FSS should directly monitor audit firms to increase responsibilities and to relieve adhesions relationship between auditors and audited firms. Likewise, establishment of korean version of PCAOB may be another alternative to create political pressure, which in turn may prevent firms to engage in window dressing.