kim et al - 2004 - selective auditor rotation and earnings management - evidence from korea

Selective Auditor Rotation and Earnings Management: Evidence from Korea Jeong-Bon Kim,* Chung-Ki Min and Cheong H Yi Current Draft June 2004 _ The first and third authors are at the School of Accounting and Finance, Faculty of Business, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong The second author is at the Department of Economics, The Hankuk University of Foreign Studies, Seoul, Korea The research is partially funded by the Hong Kong Polytechnic University We have received useful comments from Kwan Choi, Michael Firth, Dan Simunic, and workshop participants of The Hong Kong Polytechnic University, University of British Columbia, City University of Hong Kong, Korea University, the 2002 AAAA Annual Conference and the 2003 AAANZ Annual Conference The usual disclaimer applies *Please forward all correspondence to Jeong-Bon Kim (Phone: 852-2766-7046; Fax: 852-2330-9845; E-mail: afjbkim@inet.polyu.edu.hk) Selective Auditor Rotation and Earnings Management: Evidence from Korea Abstract In Korea, the regulatory authority designates external auditors for firms that are deemed to have high incentives and/or great potential for opportunistic earnings management, and mandates these firms to replace their incumbent auditors by new designated auditors and requires them to keep the designated auditor for a period of typically one to three years We call this regulatory regime selective auditor rotation This paper investigates whether the selective auditor rotation rule in Korea is effective in deterring income-increasing earnings management Consistent with our hypothesis, we find that the level of discretionary accruals is significantly lower for firms with designated auditors than firms that freely select their auditors We also find that the level of discretionary accruals is significantly lower during the designation period, compared to the level during a year prior to the imposed rotation The above findings are robust to a battery of robustness checks Overall, our results are consistent with the notion that the selective auditor rotation enhances audit quality and thus the credibility of financial reporting JEL classification: G38; L15; L84 Keywords: Selective Auditor Rotation; Audit Quality; Earnings management Selective Auditor Rotation and Earnings Management: Evidence from Korea I INTRODUCTION Since 1991, the regulatory authority in Korea has designated external auditors for a group of firms that are deemed to have high incentives or great potential for accounting manipulation (hereafter problematic firms) These problematic firms must replace their incumbent auditors with new auditors designated by the regulatory authority, and retain them for a specific period, typically one to three years During our sample period of 1991 to 2000, about 15 to 17 percent of all firms listed on the Korea Stock Exchange were required to replace their incumbent auditors with designated auditors We call this regulatory regime ‘selective auditor rotation’ in the sense that auditor changes are mandated only for select problematic firms and not for all firms.1 The selective auditor rotation (SAR) rule in Korea has several interesting features Firstly, the SAR rule mandates auditor changes only for problematic firms, thereby preserving a competitive, market-based audit engagement for firms that are not deemed problematic In this regard, the SAR contrasts with suggested or existing mandatory rotation that typically requires auditor changes for all firms after a certain period of an initial engagement By mandating auditor for select problematic firms, the SAR rule intent is to alleviate alleged problems arising from long-term, auditor-client relationships or repeat audit engagements Secondly, the SAR mandates retention of newly designated auditors for a certain period, thus protecting designated auditors from early dismissal, and thereby mitigating a major threat to auditor independence Finally, by requiring that Appendix explains detailed criteria used for selecting these problematic firms incoming auditors be chosen by the regulatory authority rather than by audit clients, the SAR rule limits managerial influence over auditor selection and any potential for lowballing, thereby enhancing auditor independence and audit quality To our knowledge, no country other than Korea has ever introduced or considered a selective auditor rotation policy This institutional feature unique to Korea provides us with an ideal laboratory setting in which one can compare differences in audit quality between two distinct groups, namely firms with mandated auditor changes (treatment group) and those with a free selection of auditors (control group) In this paper, we take advantage of this unique institutional feature to provide systematic evidence on the effect of selective auditor rotation on audit quality Audit quality is not directly observable, and thus it is difficult to measure empirically Consistent with prior research (Becker et al 1998; DeFond and Subramanyam 1998; Myers et al 2003), we use accounting accruals measures to draw inferences about audit quality High quality auditors are more likely to detect accounting irregularities, object to the use of questionable accounting practices, and limit discretion over accrual choices for client firms (Reynolds and Francis 2001; Frankel et al 2001) To the extent that the SAR rule is effective in improving auditor independence and thus audit quality, designated auditors are likely to be less lenient towards managerial discretion over opportunistic accrual choices, and thus they are more effective in deterring aggressive earnings management by their clients, compared to non-designated auditors (auditors chosen by clients) As a consequence, firms with designated auditors should report lower discretionary accruals than those with non-designated auditors, other things being equal To test this proposition, we first compare the level of discretionary accruals between firms whose auditors are designated and firms whose auditors have never been designated In addition, we also compare the level of discretionary accruals during the pre-designation period with the level during the designation period, using firm-year observations with designated auditors, to see if the level of discretionary accruals decreases after the imposition of mandated auditor changes We perform our analyses using 752 firm-year observations with designated auditors and 2,784 firm-year observations with non-designated auditors during our sample period, 1991-2000 To address potential measurement error problems associated with the Jones model (Kothari et al 2002), we include a control for firm performance in estimating discretionary accruals Briefly, our analyses reveal that firms with mandated auditor changes report significantly lower discretionary accruals than firms with no mandated auditor changes, after controlling for other factors that have been shown to be associated with discretionary accruals We also find that for firms with mandated auditor changes, the level of discretionary accruals becomes significantly lower (more negative) during the designation period, compared with the level during the last one year prior to auditor designation This evidence further corroborates our initial results Taken together, our results indicate that the selective auditor rotation rule enhances audit quality and is effective in deterring opportunistic earnings management Put differently, our results suggest that the imposition of selective auditor rotation leads to the expected changes desired by the regulatory authority with respect to the problematic firms at which the SAR rule is targeted Finally, we conduct a battery of sensitivity analyses to check the robustness of our findings Overall, the results of various sensitivity checks reveal that our findings are robust to alternative test designs and/or explanations This paper adds to the existing literature on auditor independence and audit quality (e.g., Frankel et al 2002; Ashbaugh et al 2003; Myers et al 2003) in the following ways Recent incidents of audit failures in the US (e.g., Enron debacle) have triggered a world-wide regulatory debate over how to mitigate potential threats to auditor independence ranging from managerial influence over auditor choice to auditors’ economic dependence on clients In response to the above concern, the US Congress enacted the Sarbanes-Oxley Act of 2002 in which the lead or the coordinating audit partner for a certain client must be rotated every five years In addition, the Act called for further research into the potential effects of requiring mandatory rotation of audit firms, not just audit partners within the same firm.2 Proponents of mandatory auditor rotation argue that mandating auditor changes after some specified period would truncate potential economic gains to auditors arising from repeat audit engagements with the same client, and provide stronger incentives for auditors to act independently The selective auditor rotation (SAR) is similar to the mandatory auditor rotation in the sense that both measures aim to enhance auditor independence by truncating the client-specific rents to auditors As mentioned earlier, however, the requirement for mandated auditor changes under the SAR rule applies only to problematic firms, while the mandatory rotation rule would apply to all firms The selective auditor rotation may be viewed as a regulatory measure that lies between the mandatory rotation system and the voluntary rotation Sec 207 of the Sarbanes-Oxley Act of 2002 states that the Comptroller General of the Unite States shall conduct a study and review of the potential effects of requiring the mandatory rotation of audit firms In fact, the imposition of mandatory rotation has been discussed at various times over the last three decades in system Korean evidence reported in this paper suggests that a form of limited regulatory intervention on auditor changes targeted at potentially problematic firms could be considered as a possible alternative to complete mandatory rotation Several studies (e.g., Davies et al 2003; Geiger and Raghunandan 2002; Myers et al 2003) have recently examined the effect of imposing limits on auditor tenure on financial reporting quality The evidence on whether extended auditor tenure improves or deteriorates audit quality, however, is mixed For example, Myers et al (2003), using several accruals measures to proxy for earnings quality, find evidence suggesting that longer auditor tenure increases earnings quality In contrast, Davies et al (2003) find results suggesting that discretionary accruals increase with auditor tenure In addition, since the above evidence is obtained in a voluntary auditor rotation setting, it is difficult to extrapolate the effects of mandated auditor changes from the evidence A notable exception is Dopuch et al (2001) who analyze the question in a laboratory setting, and provide experimental evidence in favor of mandatory auditor changes The results reported in this paper provide useful insights into the expected effect on audit quality, if the mandatory auditor rotation policy is imposed in the US and other countries, in particular, for firms with high incentives for opportunistic earnings management The remainder of the paper is organized as follows The next section presents an overview of the Korean audit services market Section III develops our hypothesis Section VI discusses research design, including sample selection and empirical model specification Section V presents empirical results Section VI reports the results of additional analyses The final section concludes the paper the U.S (e.g., the U.S Senate’s Metcalf Subcommittee Report 1977; the AICPA’s Cohen Commission Report 1978; SEC 2000), although it has never been adopted II INSTITUTIONAL BACKGROUND Overview of the Korean Audit Services Market During late 1970s and early 1980s, the Korean economy experienced phenomenal growth, along with a rapid development in capital markets, which in turn increased the demand for credible financial reporting and external auditing This change in the economic environment prompted the regulatory authority in Korea to introduce the Act on External Audit (AEA) that was enacted in 1980 The AEA fermented many changes in the accounting and auditing professions in Korea On the demand side, the AEA increased significantly the number of firms that are subject to external audits by requiring the financial statements of a firm with more than billion Korean Won in total assets to be audited by an independent auditor About 7,000 firms, including unlisted firms, were subject to external audits in 2000 On the supply side, the AEA loosened restrictive licensing procedure for certified public accountants (CPAs), resulting in an increase in the number of CPA The Korean Institute of Certified Public Accountants (KICPA), established in 1954 to improve CPA skills and monitor professional conducts of its members, had 5,309 CPAs registered in 2000 32 local audit firms were practicing as of 2000 and many of them have a member firm relationship with international accounting firms such as Big Five audit firms While the introduction of the AEA led to the growth of the auditing profession, there are several aspects of institutional and socio-economic environments that pose a threat to auditor independence and audit quality in Korea First, founding families of Korean firms typically exercise significant control over operations and other aspects of a firm’s activities (Joh 2003) Members of founding families can effectively maintain control over firms through pyramidal ownership and cross shareholdings, even though they have relatively low cash flow rights This separation of ownership and control creates agency conflicts between controlling shareholders and minority shareholders (Johnson et al 2000a; Claessens et al 2002) Controlling shareholders also exert significant influence over firms’ financial reporting and auditor selection (Fan and Wong 2002) The conflict of interest between controlling shareholders and minority shareholders motivates controlling shareholders to engage in opportunistic earnings management and hire auditors more acquiescent to their demands regarding accounting choices Controlling shareholders’ influence over auditors becomes even greater when auditors earn client-specific rents in the form of the provision of non-audit services Second, the Korean society and economy have traditionally been operated, in large part, on the basis of personal relationships These personal relationships typically take the form of family ties (heol yeon), school ties (hak yeon), or regional ties (chi yeon) These relationships are deeply rooted in long-held Confucian cultural traditions, and loyalty to organizations and obedience to seniors within the tie-based networks have been considered as the most important factor leading to an individual success or successful operations of organizations in Korea In this relationship-based economy, managers are likely to select auditors based on personal ties, which may cause inherent limitations on auditors being independent of managers In a related vein, conflicts among interested parties have typically been resolved in Korea through direct communications among them to preserve future business within the relationship-based network Not surprisingly, shareholder litigation against auditors has been less common in Korea, and the amount of court-awarded damage has been relatively small In this relationship-based economy with low litigation risk, it is a daunting task to maintain auditor independence Introduction of Auditor Designation In response to concerns over audit quality and the credibility of financial reporting voiced by financial statement users, the Financial Supervisory Commission (FSC), equivalent to the Securities and Exchange Commission (SEC) in the U.S., established the Committee for External Audit Improvement with a mandate to propose a remedial action plan for improving auditor independence in 1989 Following the Committee’s recommendation, the Amendment of the AEA became effective in December 1989 Under the Amendment, the FSC is empowered to impose mandated auditor changes for a group of problematic firms As described in Appendix in details, Article 10 of the FSC Regulation associated with the AEA stipulates the type of firms that could be subject to mandated auditor changes A close examination of Article 10 reveals that these problematic firms may have poor corporate governance or high agency problems (e.g., insufficient separation of ownership and management, and excess loans to related parties), may face financial troubles (e.g., excessive reliance on debts, industry restructuring, and trading on administrative post), and may make questionable auditor changes, or violate GAAP in preparing annual reports These firms are believed to have high incentives or great potential for accounting manipulation or opinion shopping To increase audit quality, the FSC is empowered to mandate firms falling under the categories described in the Appendix (what we call problematic firms earlier) to replace their incumbent auditors with auditors designated by the FSC, and to retain designated Since the first case of auditor litigation happened in 1991, there have been a total of 22 litigations against auditors during the period 1991-1999 The largest amount of court-awarded damage was far less than 10 References American Institute of Certified Public Accountants 1978 The commission on auditors’ responsibilities: Report, conclusion, and recommendations (also called the Cohen Commission Report) (New York: AICPA) American Institute of Certified Public Accountants 1992 Statement of position regarding mandatory rotation of audit firms of publicly held companies (New York: AICPA) Ashbaugh, H., R LaFond, and B W Maydew 2003 Do nonaudit services compromise auditor independence? 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The influence of large clients 36 on office-level auditor reporting decisions Journal of Accounting and Economics 30: 375-400 Securities & Exchange Commission 2000 Revision of the commission’s auditor independence requirements Available at http://www.sec.gov/rules/proposed/3342994.htm United States Senate 1977 Improving the accountability of publicly owned corporations and their auditors: Report of the subcommittee on reports, accounting, and management of the committee on government operations (also called the Metcalf Subcommittee Report) (Washington D.C.: US Government Printing Office) Watts, R and J Zimmerman 1986 Positive Accounting Theory (Prentice-Hall: Englewood Cliffs, N J.) 37 Table 1: Sample Selection Panel A: Experimental samples with designated auditors No of firms No of firm-years 362 (6) 948 (12) (52) (184) 304 Selection criteria 752 Auditor Designated Firms during 1991-2000 Firms in the financial service industry Firms with insufficient data for discretionaryaccruals calculation and missing control variable data Firms in the final sample with designated auditors Panel B: Distribution of firms with designated auditors and with non-designated auditors by year of designation Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 Firms with designated auditors 58 65 88 87 104 97 136 65 45 752 Firms with non-designated auditors 266 278 287 284 284 293 288 285 269 250 2,784 Frequency (b) 160 81 50 20 15 11 345 Firm years [=(a)*(b)] 160 162 150 80 75 66 35 24 752 Panel C: Designation period Designation Period (a) year years years years years years years years 38 Table 2: Reason for Designation Reason for auditor designation Full sample Delay in auditor selection Pre-crisis period (1991-1997) Questionable change of auditor 7 Auditing enforcement action 22 15 Insufficient separation of ownership and management 210 73 137 Excess loans to related parties 36 14 22 Industry restructuring 28 23 Excess reliance on external debts 384 361 23 Trading on ‘Administrative Post’ 43 38 Violation of the Securities Trading Act 12 11 Voluntary designation (requested by firms) 3 Other 4 Total 752 506 246 39 Post-crisis period (1998-2000) Table Descriptive Statistics for Sample Firms and Univariate Tests ROA Panel A: Firm-years of designated auditors (N=752) Mean Median -0.019 0.009 Panel B: Firm-years of nondesignated auditors (N=2,784) Mean Median 0.033 0.030 Panel C: Differences in Mean Median t-statistic Z-statistic -10.69*** -15.37*** OCF 0.033 0.045 0.066 0.067 -5.39*** -6.01*** SIZE 18.94 18.73 19.08 18.88 -2.53** -1.33 LEV 0.90 0.88 0.75 0.72 9.51*** 13.47*** BIG5 0.52 0.57 -2.55** -2.55** L1TAC -0.05 -0.05 -0.03 -0.03 -4.38*** -4.98*** DAC -0.011 -0.002 0.001 0.000 -2.33*** -1.59* * ** , , and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, based on one-tailed tests for DAC, two-tailed tests otherwise Variables are defined as follows: ROA = Earnings before extraordinary items/lagged total assets; OCF = Operating cash flows/lagged total assets; SIZE = Natural log of total assets; LEV = Total debts/lagged total assets; BIG5 = Big Five auditor dummy; L1TAC = Lagged total accruals/lagged total assets; DAC = Discretionary accruals /lagged total assets 40 Table Results of Regressions of DAC on Auditor Designation and Control Variables Panel A: Level of discretionary accruals Variable DAC Intercept 0.051 (2.30) ** -0.026 (-6.51)*** -0.528 (-49.70)*** 0.001 (1.65) -0.037 (-7.24)*** -0.026 (-2.18)** -0.003 (-1.06) Included DESIG OCF SIZE LEV L1TAC BIG5 Industry dummies Adjusted R2 0.42 N 3,536 Panel B: Signed discretionary accruals Variable Intercept DESIG OCF SIZE LEV L1TAC BIG5 Industry dummies Adjusted R2 N Positive discretionary accruals 0.122 (5.53) -0.010 (-2.57)*** -0.417 (-36.91)*** -0.002 (-1.43) -0.012 (-1.97) ** -0.034 (-2.60)*** 0.005 (1.55) Included Negative discretionary accruals -0.041 (-1.48) -0.025 (-4.97)*** -0.225 (-13.85)*** 0.003 (2.23)** -0.047 (-8.12)*** -0.011 (-0.79) -0.009 (-2.31)** Included 0.46 1,770 0.17 1,766 41 * ** , , and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, based on one-tailed tests for DESIG, two-tailed tests otherwise Variables are defined as follows: DACit = the level of discretionary accruals computed using Eq (2) for firm i and year t; DESIGit = a dummy variable that takes the value of if a firm’s auditor is designated and zero otherwise for firm i and year t; OCFit = operating cash flows (earnings before extraordinary items less total accruals) scaled by total assets for firm i and year t; SIZEit = the natural logarithm of the book value of total assets for firm i and year t; LEVit = the ratio of total debts to total assets for firm i and year t; L1TACit = last year’s total accruals for firm i and year t; BIG5it = a dummy variable that takes the value of if the auditor is a Big Five and otherwise for firm i and year t 42 Table Results of Regressions of DAC on Auditor Designation and Control Variables After Deleting Observations with Extreme ROA Variable DAC Intercept 0.058 (3.13) *** -0.013 (-3.85)*** -0.664 (-66.02)*** 0.000 (0.53) -0.001 (-0.22) -0.017 (-1.54) 0.000 (0.09) Included DESIG OCF SIZE LEV L1TAC BIG5 Industry dummies Adjusted R2 0.60 N 2,940 * ** , , and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, based on one-tailed tests for DESIG, two-tailed tests otherwise Variables are defined as follows: = the level of discretionary accruals computed using Eq (2) for firm i and year t; DACit = a dummy variable that takes the value of if a firm’s auditor is designated and zero DESIGit otherwise for firm i and year t; = operating cash flows (earnings before extraordinary items less total accruals) scaled by OCFit total assets for firm i and year t; = the natural logarithm of the book value of total assets for firm i and year t; SIZEit LEVit = the ratio of total debts to total assets for firm i and year t; = last year’s total accruals for firm i and year t; L1TACit = a dummy variable that takes the value of if the auditor is a Big Five and otherwise for BIG5it firm i and year t 43 Table Results of Regressions of Discretionary Accruals on Auditor Designation and Control Variables Using Auditor Designated Firm Years only Panel A: Differences in DACs before and after the imposition of auditor designation Variable DAC Intercept -0.038 (-0.75) -0.017 (-2.48)*** -0.503 (-24.27)*** 0.005 (1.92) * -0.018 (-2.08) ** -0.034 (-1.75) * -0.008 (-1.22) Included DESIG OCF SIZE LEV L1TAC BIG5 Industry dummies Adjusted R2 0.36 N 1,072 Panel B: Differences in DACs before and after the imposition of auditor designation considering the effect of the designation period Variable DAC Intercept -0.036 (-0.70) -0.019 (-2.29)** -0.021 (-2.13) ** -0.012 (-1.28) -0.504 (-24.26)*** 0.005 (1.86) * -0.018 (-2.11) ** -0.034 (-1.75) * -0.008 (-1.16) Included DESIG1 DESIG2 DESIG3-8 OCF SIZE LEV L1TAC BIG5 Industry dummies Adjusted R2 0.36 N 1,072 * ** , , and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, based on one-tailed tests for DESIG, two-tailed tests otherwise 44 Variables are defined as follows: DACit = the level of discretionary accruals computed using Eq (2) for firm i and year t; DESIG1 = a dummy variable that takes the value of if the observation is from the first year of the designation and zero otherwise; DESIG2 = a dummy variable that takes the value of if the observation is from the second year of the designation and zero otherwise; DESIG3-8 = a dummy variable that takes the value of if the observation is from the third, fourth, fifth, sixth, seventh, or eighth year of the designation and zero otherwise; OCFit = operating cash flows (earnings before extraordinary items less total accruals) scaled by total assets for firm i and year t; SIZEit = the natural logarithm of the book value of total assets for firm i and year t; LEVit = the ratio of total debts to total assets for firm i and year t; L1TACit = last year’s total accruals for firm i and year t; BIG5it = a dummy variable that takes the value of if the auditor is a Big Five and otherwise for firm i and year t; 45 Table Results of Regressions of Discretionary Accruals on Auditor Designation and Control Variables Before and After the Crisis Period Variable Before the crisis (1991-1997) 0.062 (3.11) *** -0.023 (-6.15) *** -0.604 (-50.54) *** 0.001 (0.92) -0.012 (-2.25) ** -0.019 (-1.40) 0.000 (0.09) Included After the crisis (1998-2000) -0.040 (-0.72) -0.029 (-3.05) *** -0.533 (-26.32) *** 0.008 (2.91) *** -0.103 (-9.33) *** -0.016 (-0.73) -0.011 (-1.47) Included Adjusted R2 0.52 0.42 N 2,486 1,050 Intercept DESIG OCF SIZE LEV L1TAC BIG5 Industry dummies * ** , , and *** denote significance at the 0.10, 0.05, and 0.01 levels, respectively, based on one-tailed tests for DESIG, two-tailed tests otherwise Variables are defined as follows: DACit = the level of discretionary accruals computed using Eq (2) for firm i and year t; DESIGit = a dummy variable that takes the value of if a firm’s auditor is designated and zero otherwise for firm i and year t; OCFit = operating cash flows (earnings before extraordinary items less total accruals) scaled by total assets for firm i and year t; SIZEit = the natural logarithm of the book value of total assets for firm i and year t; LEVi t = the ratio of total debts to total assets for firm i and year t; L1TACit = last year’s total accruals for firm i and year t; BIG5it = a dummy variable that takes the value of if the auditor is a Big Five and otherwise for firm i and year t 46 Table Results of a Two-stage Treatment Effects Model to Control for Self-selection Bias Panel A: Results of Probit Estimation DESIGit = β + β ROAit −1 + β LEVit −1 + β LEVit −1 + β OWN it −1 + β 5WEDGEit −1 + β GROUPit −1 + IndustryDummies + ε it Variable Expected sign Intercept ? ROA - LEV + LOAN + OWN + WEDGE + GROUP + Industry Dummies ? Coefficient (z-statistic) -1.687 (-13.92)*** -2.840 (-8.93)*** 1.009 (10.56)*** -0.310 (-0.35) 0.016 (8.97) *** -0.001 (-0.67) 0.078 (1.22) Included LR statistic 340.68 Probability 0.000 Classification rate Number of observations 77.10% 2,843 *** denotes significance at the 0.01 level based on two-tailed tests otherwise Variables are defined as follows: DESIG = a dummy variable that takes the value of if a firm’s auditor is designated and zero otherwise; ROA = return on assets for firm i and year t-1; LEV = the ratio of total debts to total assets for firm i and year t-1; LOAN = the sum of short-term and long-term loans to directors, large shareholders, affiliated companies, and other related parties/lagged total assets for firm i and year t-1; OWN = the largest shareholder’s and his/her family member’s ownership for firm i and year t-1; WEDGE = the difference between control rights and cash flow rights held by the largest shareholder; GROUP = a dummy variable that takes the value of if a firm belongs to a business group (chaebol) 47 Panel B: Results of OLS Regression of DAC on DESIG and Other Control Variables with the Inverse Mills Ratio Variable DAC Intercept Industry Dummies 0.006 (0.270) -0.086 (-6.32)*** -0.531 (-44.76)*** 0.004 (3.41)*** -0.034 (-5.40)*** -0.055 (-4.27)*** -0.003 (-0.95) 0.044 (5.40)*** Included Adjusted R2 0.42 Number of observations 2,843 DESIG OCF SIZE LEV L1TAC BIG5 Mills ** , and *** denote significance at the 0.05, and 0.01 levels, respectively, based on one-tailed tests for DESIG, two-tailed tests otherwise Variables are defined as follows: DACit = the level of discretionary accruals computed using Eq (2) for firm i and year t; DESIGit = a dummy variable that takes the value of if a firm’s auditor is designated and zero otherwise for firm i and year t; OCFit = operating cash flows (earnings before extraordinary items less total accruals) scaled by total assets for firm i and year t; SIZEit = the natural logarithm of the book value of total assets for firm i and year t; LEVit = the ratio of total debts to total assets for firm i and year t; L1TACit = last year’s total accruals for firm i and year t; BIG5it = a dummy variable that takes the value of if the auditor is a Big Five and otherwise for firm i and year t; Mills it = the inverse Mills ratio obtained from Eq (4) for firm i and year t 48 ... -0 .012 (-1 .97) ** -0 .034 (-2 .60)*** 0.005 (1.55) Included Negative discretionary accruals -0 .041 (-1 .48) -0 .025 (-4 .97)*** -0 .225 (-1 3.85)*** 0.003 (2.23)** -0 .047 (-8 .12)*** -0 .011 (-0 .79) -0 .009... Selective Auditor Rotation; Audit Quality; Earnings management Selective Auditor Rotation and Earnings Management: Evidence from Korea I INTRODUCTION Since 1991, the regulatory authority in Korea. .. 18.88 -2 .53** -1 .33 LEV 0.90 0.88 0.75 0.72 9.51*** 13.47*** BIG5 0.52 0.57 -2 .55** -2 .55** L1TAC -0 .05 -0 .05 -0 .03 -0 .03 -4 .38*** -4 .98*** DAC -0 .011 -0 .002 0.001 0.000 -2 .33*** -1 .59* * ** , , and