chung - 2004 - selective mandatory auditor rotation and audit quality - an empirical investigation of auditor designation policy in korea [mar]

Graduate School Form 9 (Revised 6/03) PURDUE UNIVERSITY GRADUATE SCHOOL Thesis Acceptance This is to certify that the thesis prepared By HYEESOO HYUN CHUNG Entitled SELECTIVE MANDATORY AUDITOR ROTATION AND AUDIT QUALITY: AN EMPIRICAL INVESTIGATION OF AUDITOR DESIGNATION POLICY IN KOREA Complies w ith University regulations and m eets the standards o f the Graduate School for originality and quality For the degree o f DOCTOR OF PHILOSOPHY Signed by the final examining committee: Chair Sanjay Kallapur . WiMiamJJK.mss Byung-Tak Ro Susan G. Watts Approved by: Head o f the Gctfaual im Q is This thesis is not to be regarded as confidential. J Major Professl Format Approved by: or Chair, Final Examining Committee lartment T hesifyorm at Advisor Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. SELECTIVE MANDATORY AUDITOR ROTATION AND AUDIT QUALITY: AN EMPIRICAL INVESTIGATION OF AUDITOR DESIGNATION POLICY IN KOREA A Thesis Submitted to the Faculty of Purdue University by Hyeesoo Hyun Chung In Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy August 2004 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. UMI Num ber: 3 1 5 4 6 0 6 INFORMATION TO USERS The quality of this reproduction is dependent upon the quality of the copy submitted. Broken or indistinct print, colored or poor quality illustrations and photographs, print bleed-through, substandard margins, and improper alignment can adversely affect reproduction. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if unauthorized copyright material had to be removed, a note will indicate the deletion. ® UMI UMI M icroform 3154606 Copyright 2005 by ProQuest Information and Learning Company. All rights reserved. This microform edition is protected against unauthorized copying under Title 17, United States Code. ProQuest Information and Learning Company 300 North Zeeb Road P.O. Box 1346 Ann Arbor, Ml 48106-1346 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. To Chaebung, Soyoung, and Shinyoung. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ACKNOWLEDGEMENTS I am deeply grateful for the opportunity to study at the graduate level at Purdue University with a research assistantship. My five years here have been among the most rewarding periods of my life, thanks both to the faculty at the Krannert School of Management, and to my fellow graduate students, many of whom will be deeply missed when we part after graduation. A special acknowledgement goes to my major professor and committee chair, Dr. Sanjay Kallapur, for his ability to put me back on track whenever I got lost in my research, and for his patience and time spent training me and reviewing early drafts of this thesis. I also want to express my gratitude to my committee members, Drs. William Kross, Byung Ro, and Susan Watts, for their contribution to my scholastic progress and my thesis research. Finally, my husband deserves a special gratitude for encouraging me to take on the challenge o f a graduate study and looking after my daughter and son while pursuing his own doctoral degree. Without his love and support, I would not be what I am today. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. TABLE OF CONTENTS Page LIST OF TABLES vi ABSTRACT vii CHAPTER 1. INTRODUCTION 1 CHAPTER 2. BACKGROUND AND HYPOTHESIS DEVELOPMENT Mandatory Auditor Rotation 7 Auditor Designation Policy in Korea 10 Hypothesis Development 13 CHAPTER 3. RESEARCH DESIGN Identifying Treatment and Control Samples 15 Discretionary Accruals as Proxy for Audit Quality 16 CHAPTER 4. DATA AND DESCRIPTIVE STATISTICS Sample Description 19 Descriptive Statistics 22 CHAPTER 5. EMPIRICAL TESTS AND RESULTS Mean Difference Test of Discretionary Accruals. 24 Multivariate Results 27 Sensitivity Analysis 30 CHAPTER 6. CONCLUSIONS AND IMPLICATIONS 31 LIST OF REFERENCES 34 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. V Page APPENDIX. REGULATION ON EXTERNAL AUDIT OF CORPORATIONS 39 VITA. 41 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. vi LIST OF TABLES Table Page Table 4.1: Sample Selection Criteria 20 Table 4.2: AD Firms Sorted by Industry and Designation Reasons (1994 - 2002) 21 Table 4.3: Descriptive Statistics 23 Table 5.1: Mean Difference Test of Discretionary Accruals 26 Table 5.2: Parameter Estimates for Regressions of Discretionary Accruals on AAEA and Control Variables 29 Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. ABSTRACT Chung, Hyeesoo Hyun. Ph.D., Purdue University, August 2004. Selective Mandatory Auditor Rotation and Audit Quality: An Empirical Investigation of Auditor Designation Policy in Korea. Major Professor: Sanjay Kallapur. This study examines the impact of the limited auditor tenure on earnings, and thus audit, quality by taking advantage of the unique audit regulations that govern the listed firms in Korea. I examine how discretionary accruals, a measure o f earnings quality drawn from prior literature, vary around an event that imposed a limit on the length of the auditor-client relationship via the auditor designation requirement for Korean firms likely to manage earnings. I find discretionary accruals of firms likely to be a target for mandatory auditor change decrease after the passage o f the AAEA, suggesting that a limit on the length of the auditor-client relationship result in greater incentives for auditors to maintain independence, which effectively restrains firms’ opportunistic manipulation of earnings. This study adds to our current understanding of the impact of economic incentives on auditor independence by providing additional evidence that opportunities for auditors to earn client-specific economic rents from repeat engagements can be a potential threat to auditor independence. In addition, this study contributes to the current stream of research on the implications of mandatory audit firm rotation and informs policy makers in the current debate on improving auditor independence. I provide evidence that under Reproduced with permission of the copyright owner. Further reproduction prohibited without permission. [...]... auditor s willingness to issue biased reports Dopuch et al conclude that mandatory rotation, with or without mandatory retention requirement, can increase auditor independence Also, using a model to analyze the cost and benefit of mandating the rotation o f auditors, Gietzmann and Sen (2002) conclude that in certain well-defined circumstances, mandatory rotation of auditors is a desirable policy In audit markets... requirements enhances auditor independence This study investigates the impact of mandated auditor changes on earnings, and thus audit, quality by focusing on one element o f earnings quality preceding and following the Korean government’s adoption of its auditor designation (AD) policy Specifically, I examine whether the earnings quality of Korean firms likely to be designated an auditor increases after... newly appointed auditors to become familiar with their clients Truncating the length of auditor- client relationships can reduce auditors’ incentives to invest in learning about their clients, resulting in lowerquality audits (St Pierre and Andersen 1984; Arrunada and Paz-Ares 1997) Geiger and Raghunandan (2002) show that auditors are more likely to issue a clean report prior to a bankruptcy filing in the... client and the probability of a lawsuit and offer lack of auditor independence as an explanation for their finding On the other hand, Reynolds and Francis (2001) test this prediction using client size as a proxy for client importance and find no evidence that economic incentives affect the audit outcome 6 Since quasi-rents and auditor independence are both unobservable, empirical research examines the financial... mandatory auditor rotation debate, including evidence supporting and opposing this policy measure I also describe the auditor designation policy (selective mandatory auditor rotation) adopted by the Korean government to improve auditor independence, followed by development of my main hypothesis A discussion o f my choice of sample partitioning variables and proxy for audit quality is provided in Chapter 3 In. .. permission of the copyright owner Further reproduction prohibited without permission mandatory rotation can actually work to the detriment of audit quality, strengthening the argument that mandatory rotation is not a desirable policy. 1 0 Evidence in support of mandatory auditor rotation, on the other hand, is sparse In an experimental setting, Dopuch et al (2001) find that mandatory rotation reduces the auditor s... BACKGROUND AND HYPOTHESIS DEVELOPMENT Mandatory Auditor Rotation External auditors play an important role in the capital markets by providing a service to protect the interests of the investing public This “public watchdog” function requires that accounting firms remain “independent” of the audit client and act on behalf of the public, not the audit client However, the control over hiring and firing auditors... and Moscove 1998) On the other hand, the opponents of rotation argue that while mandatory rotation reduces managerial influence, it can also increase audit failures due to the replacement o f well-informed incumbent auditors with new, less-informed auditors In addition, the costs associated with frequent rotation o f auditors could far outweigh the benefits o f mandatory rotation. 3 While strong opinions... scrutiny without mandating auditor changes Thus, it is difficult to draw an unambiguous conclusion from a research design that examines firms with designated auditors That is, one cannot decipher whether an increase in audit quality is due to auditor changes or some other reason Hypothesis Development In this study, I examine empirically whether auditor designation (selective mandatory auditor rotation) ... auditor designation policy increases auditor independence by examining auditors’ ability to constrain the aggressive and questionable accounting accruals before and after the passage o f the AAEA The financial reports are assumed to be a joint outcome of both the client management’s and the auditor s preferences, and accounting accruals are important accounting attribute that the auditor is expected to influence . permission. ABSTRACT Chung, Hyeesoo Hyun. Ph.D., Purdue University, August 2004. Selective Mandatory Auditor Rotation and Audit Quality: An Empirical Investigation of Auditor Designation Policy in Korea. . o f the mandatory auditor rotation debate, including evidence supporting and opposing this policy measure. I also describe the auditor designation policy (selective mandatory auditor rotation) . requirement, can increase auditor independence. Also, using a model to analyze the cost and benefit of mandating the rotation of auditors, Gietzmann and Sen (2002) conclude that in certain well-defined