재무기준 요건에 의한 외부감사인 지정제도 도입이 잠재적 지정대상회사의 이익조정 및 감사인의 감사시간에 미치는 영향

In order to improve accounting transparency in Korea, the Act on External Audit of Stock Companies was partially amended in the second half of 2014. The amendment involves adoption of a new mandatory external auditor designation system based on financial criteria(MADSFC) such as debt-to-equity ratio and interest coverage ratio, which is in effect from 2015 fiscal year. According to this amendment, any public company whose debt-to-equity ratio is more than 200%, more than 1.5 times of its respective industry average ratio, and whose interest coverage ratio is less than 1, is required to be audited by the external auditors designated by the Financial Supervisory Service(FSS) of Korea for the following fiscal year. This study empirically investigates the economic effects of the new MADSFC on managements’ financial reporting decision and external auditor’s decision in the year prior to its enforcement. Specifically, this study addresses two research questions. The first empirical question is to investigate whether the entities subject to potential external auditor designation() engage in earnings management in order to avoid the auditor designation by the new MADSFC. The second research question is to examine whether the external auditors of perform their audits on a stricter basis in order to reduce the higher audit risk due to higher likelihood of earnings management. This study includes 79 among the publicly traded companies in the Korean stock exchange and 79 control firms matched with by considering industries and asset sizes. To examine the first research question, this study uses two measures (: Discretionary accruals-based earnings management and : Real Activity–based earnings management) to proxy for earnings management. is measured by using two models: modified Jones model developed by Dechow et al.(1995) and modified Jones model suggested by Kothari et al.(2005) taking ROA into consideration. is measured by using the model used by Cohen and Zarowin(2010). Using both and , this study examines whether s are associated with higher (hypothesis 1-1) and (hypothesis 1-2). To address the second research question, this study uses audit hours stated in the annual reports disclosed by the publicly traded companies in Korea. Based on the regression model used by Lee et al.(2010), this study examines whether is associated with more external audit hours. The main findings of this paper are as follows: First, this paper finds that is not significantly associated with higher . In other words, does not manage earnings using more than control firms do. Second, this study finds that is significantly associated with higher . does manage earnings using real activities such as sales and operating expenses more than control firms do. This paper also finds that is significantly associated with more external audit hours. Earnings quality can be influenced by interaction among management, external auditors and regulatory bodies such as FSS of Korea. In 2014 when adoption of the MADSFC was disclosed, FSS announced that it would increse its monitoring activities on intentionally lowering the debt-to-equity ratio or increasing interest coverage ratio at 2014 fiscal year end and would examine external auditors more strictly and impose heavier penalties against audit failure. Considering FSS’s announcement, may prefer earnings management using real activities to earnings management using discretionary accruals, which is consistent with prior studies such as Graham et al.(2005) and Zang(2012). Earnings management using discretionary accruals can be detected and be asked to be adjusted by external auditors facing more severe (or heavier) penalties in the case of audit failure. From the perspective of external auditors of , they would input more audit hours in auditing which has incentives to manage earnings to avoid political costs due to external auditors designated in the next year. This study is the first attempt to empirically investigate the economic consequence of adoption of the MADSFC. While this study is in nature preliminary, it contributes to better understanding the economic influence on the interested parties’ decision such as managements and external auditors of the . This study also provides a basis for future research which will include test periods subsequent to the enforcement of the MADSFC and address its effectiveness. The main findings that managements of manage earnings based on rather than to avoid the external auditor designation and that external auditors of the input more audit hours may imply that supervisory authorities such as FSS of Korea would play a crucial role in settling down the MADSFC successfully and thus improving accounting transparency. This study also contributes to a series of research exploring managements’ motivation to manage earnings. This study documents that managements have motivation to manage earnings to avoid political costs. That is, in order to avoid designation of external auditor, which might cause political costs such as higher audit fees and higher costs of capital, managements of the have motivation to manage earnings. As an exploratory study, this study is subject to some limitations. First, this study focuses on only sample firms listed in Korean Securities Market, excluding firms listed in KOSDAQ. It will be interesting to see if a future study using the firms listed in KOSDAQ finds results consistent with this study. Second, since this paper investigates the economic effect of MADSFC in the year prior to its enforcement, this paper cannot investigate the actual effectiveness of the MADSFC in improving accounting transparency. Further research on the effectiveness of the newly adopted system which includes test periods subsequent to the enforcement of the MADSFC, will be necessary in the future.