The Effect of Changes of Debt Size in the Fourth Quarter on Disagreement between Management and Auditors

This study aimes to understand the practice of reducing the scale of fourth-quarter debt by analyzing its impact on the disagreement between managers and auditors. In 2010, the U.S. Securities and Exchange Commission (SEC) required companies to disclose the reasons for significant differences between their average and maximum quarterly debt levels compared to their quarter end debt levels. However, in Korea, there are no regulations addressing the reduction of fourth-quarter debt, although many previous studies have identified this practice. Reducing debt at the end of the fourth quarter can lead to significant distortions in financial statements, potentially affecting auditors’ decisions regarding the fairness of these statements. This study utilizes a sample of 6,231 non-financial firms listed on the Korea Exchange from 2011 to 2022. The results from study are summarized as follows. First, firms with significant changes in debt levels at the end of the fourth quarter compared to the first three quarters exhibit increased disagreement between managers and auditors. This finding suggests that managers’ opportunistic behavior in reducing debt during the fourth quarter to conceal potential corporate risks delays consensus between managers and auditors. Furthermore, additional analyses reveal that this relationship is more pronounced in firms that have overstated their earnings. In other words, higher fluctuations in fourth-quarter debt levels are associated with a greater likelihood of financial statement distortions, leading auditors to make more adjustments and consequently increasing the disagreement between managers and auditors. This study contributes empirical evidence that fluctuations in fourth quarter debt levels can increase the disagreement between managers and auditors. The results of this study help information users efficiently understand the diverse information disclosed in audit firm reports and provide a benchmark for evaluating audit quality. Additionally, the study contributes to the current regulatory landscape by offering evidence that supports the need for policymakers to expand disclosure requirements in financial reports. Notably, in the absence of regulations regarding fourth quarter debt reductions in Korea, this study provides practical implications by reminding auditors of the need to recognize this issue.