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.
an audit regime similar to mandatory auditor rotation, audit quality does appear to
improve when the duration of the auditor-client relationship is truncated. This suggests
that mandating auditor rotation could enhance auditor independence and provide auditors
greater incentives to resist management pressures.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
1
CHAPTER 1. INTRODUCTION
The recent business and audit failures of publicly held companies in the U.S. have
heightened the interest of many, regarding corporate earnings and thus audit quality. The
U.S. Congress, the Securities and Exchange Commission (SEC), the AICPA, and
academics all have become involved in various aspects of the consequences resulting
from these large scale financial debacles. Following scandalous events related to Enron,
WorldCom, and the collapse of Arthur Andersen, LLP, Congress enacted the Sarbanes-
Oxley Act (SOA) in July 2002. In addition to various other requirements to increase the
quality of statutory audits, the SOA required the U.S. Comptroller General to conduct a
study of the effectiveness and implications of mandatory audit firm rotation by July 30,
2003.u
In a recently released survey study of the mandatory rotation o f audit firms, the
General Accounting Office (GAO) concluded that “the most prudent course of action at
this time is for the SEC and Public Company Accounting Oversight Board (PCAOB) to
monitor and evaluate the effectiveness o f the Sarbanes-Oxley Act’s (SOA) requirements
for enhancing auditor independence and audit quality” mid delay any mandatory auditor
rotation reforms until the effects o f the SOA can be further evaluated (GAO 2003).
1 The Sarbanes-Oxley Act o f 2002 prohibits a firm’s auditor from providing a broad range of non-audit
services to the firm, in light o f the potential for conflicts of interest that can impair auditor independence.
2 According to Section 207 of the Sarbanes-Oxley Act, mandatory rotation refers to the “imposition of a

limit on the period of years in which a particular registered public accounting firm may be the auditor of
record for a particular issuer.”
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Although the mandatory rotation of audit firms is not currently recommended, GAO
(2003) suggests, however, that such rotations may be necessary if the SOA’s
requirements do not improve the quality of audits. Thus, the thorough investigation of
the potential effects of mandatory auditor rotation, before any regulatory measure is
undertaken, is imperative to the full assessment of its policy implications.
Mandatory audit firm rotation is a controversial topic with strong arguments on
both sides of the issue. The proponents of mandatory rotation argue that as the length of
auditor tenure increases, so does the tendency increase that auditors will gradually side
with management and thus compromise their independence. Also, auditors may develop
complacency when auditing long-term clients. More importantly, with no limit on the
length of the auditor-client relationship, the expected higher rents from the longer period
of incumbency can create auditor dependence on the client. By forcing mandatory
rotation of auditors, management’s ability to influence the auditor can be curtailed
(Brody 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 of 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 of mandatory rotation.3
While strong opinions exist on both sides of the mandatory auditor rotation
debate, little evidence exists on its impact on audit quality or costs. Since the U.S. audit
system with voluntary auditor change does not provide a setting to examine compulsory
3 The Cohen Commission (AICPA 1978) indicated that the duplication o f start-up costs would increase
auditor costs considerably. Also, lost audit efficiencies due to rotation may increase costs (Arrunada and
Paz-Ares 1997).
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
rotation issues, empirical research has instead focused on the relation between audit firm
tenure and audit quality, since tenure is precisely the variable that the mandatory rotation

is intended to affect (Casterella et al. 2002; Geiger and Raghunandan 2002; Johnson et al.
2002; Davis et al. 2003; Ghosh and Moon 2003; Myers et al. 2003; Carcello and Nagy
2004). Whether the results from these studies in U.S. can be extended to a regulatory
regime o f mandatory auditor rotation is, however, uncertain. For example, whether or
not a shorter-term tenure contributes to the finding that audit failures are more frequent
during the early years o f auditor-client relationship is not clear.4 That is, an alternative
explanation that companies prone to audit failures are more likely to change auditors
cannot be ruled out.5
In contrast to the above studies, this thesis empirically examines the auditor-client
relationship and its effect on audit quality in a setting similar to a mandatory auditor
rotation regime. Specifically, this study examines a hybrid government agency
regulation model adopted by the Korean government in 1989 that selectively mandates
auditor changes through auditor designation requirements. Although the auditor is
designated by a regulatory authority rather than freely selected by the client firm (as it
would be under the proposed mandatory rotation in the U.S.), the common feature is that
they both limit the length of the auditor-client relationship, which truncates the expected
rent from repeat engagements. By studying the unique auditing regulations governing
4 Geiger and Raghunandan (2002) define audit failure as issuing a clean audit report prior to a bankruptcy
filing. However, there are many possible definitions of audit failure, including restatements of financial
reports, not detecting material misstatements or fraud, intentionally allowing earnings manipulation, etc.
5 The increased failure rate in the early years of audit engagements may be the result of previous incumbent
auditors dropping their high risk clients, and not necessarily the result o f new auditor failures.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
4
Korean firms, this thesis examines whether limiting the length of the auditor-client
relationship through auditor designation requirements enhances auditor independence.
This study investigates the impact of mandated auditor changes on earnings, and
thus audit, quality by focusing on one element of earnings quality preceding and
following the Korean government’s adoption o f its auditor designation (AD) policy.
Specifically, I examine whether the earnings quality of Korean firms likely to be

designated an auditor increases after the passage of the Amendment to Act on External
Auditors (hereafter AAEA) in 1989, which includes a provision for the AD policy. Firms
likely to be designated an auditor are identified using the criteria for auditor designation
set by the Korean government. I compare pre- and post-AAEA measures o f earnings
quality using discretionary accruals as a proxy. By focusing on the pre- and post-AAEA
earnings quality, I examine the deterrent effects o f the policy, which are inherently more
interesting in terms of public policy perspective.
To identify the firms likely to be targets for government auditor designation, I use
debt-to-equity ratio, the most frequent reason for auditor designation during my sample
period. My findings show that the mean discretionary accruals of these firms
significantly decreased after the passage of the AAEA. Even after controlling for the
determinants o f accruals in a multivariate regression, I find that the discretionary accruals
of firms at high risk of auditor designation (proxied by high debt-to-equity ratio)
significantly decreased after the passage of the AAEA, suggesting that a limit on the
auditor tenure can improve earnings, and thus audit, quality.
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
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
improving auditor independence. I provide evidence on whether the expectation of future
quasi-rents impairs auditor independence. This is relevant to the mandatory rotation
debate, but there are other considerations (such as the time it takes a new auditor to
acquire expertise, cost of rotating auditors, and reduced incentives on the part of auditors
to make client-specific investments) for policy makers before they decide the issue.
In a broader context, this study adds to our current understanding of the impact on
auditor independence o f economic incentives. DeAngelo (1981b) argues that the auditor
has the incentive to yield to pressures from management and refrain from reporting the
breach in order to avoid losing the quasi-rents from the audit relationship. One
implication of DeAngelo’s theory, that larger audit firms provide higher-quality audits,
has been validated in a number of studies. However, prior empirical evidence on whether
auditors behave differently with different types of clients depending on economic

incentives inherent in those audit-client relationships is limited and mixed.6 Using
revenues from clients as a proxy for economic incentives, Raghunathan et al. (1994)
examine problem audits and show that the possibility of being fired by a client could
affect an auditor’s willingness to report misrepresentations. Also, Lys and Watts (1994)
find a positive association between the proportion of audit revenues derived from the
client and the probability of a lawsuit and offer lack o f 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 dependency of the auditor-client relationship, viewing the auditor as an economic agent who
makes self-interested decisions and whose incentives to compromise independence depend on client
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
6
A related and more recent stream of research examines whether fees from non
audit services impair independence (among others, Defond et al. 2002, Frankel et al.
2002, Geiger and Raghunandan 2002, Ashbaugh et al. 2003, Chung and Kallapur 2003,
Francis and Ke 2003). In general, this stream o f research provides little evidence to
• a 7
suggest that economic incentives compromise auditor independence. The Korean
Auditor Designation Act is an exogenous event that reduces auditors’ quasi-rents from
specific groups o f clients. It therefore provides an opportunity to examine more directly
the effect on auditor independence of client-specific rents. An increase in earnings
quality of firms whose quasi-rents decrease provides evidence in support of DeAngelo’s
theory that quasi-rents create an economic incentive for auditors and affect auditors’
independent judgment.
I organize the rest of the thesis as follows. In Chapter 2 , 1 briefly discuss the
backgrounds 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) 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 Chapter 4 , 1 describe my data, and empirical results are presented in Chapter 5.
Chapter 6 summarizes the study and provides concluding comments and implications.
importance.
7 Frankel et al. (2002) show that non-audit service fees are positively related to the ability of firm to just
meet or beat earnings targets as well as the magnitude o f discretionary accruals. However, subsequent
studies fail to replicate their results (Ashbaugh et al. 2003, Chung and Kallapur 2003, Francis and Ke 2003,
Reynolds et al 2003). Moreover, studies using the propensity to issue modified audit opinions as a proxy
for auditor independence (Defond et al. 2002, Geiger and Raghunandan 2003) have failed to find evidence
that non-audit service fees impair auditor independence.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
7
CHAPTER 2. 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 by
client’s management, combined with managers’ strong motivation to attain or exceed
stated goals and objectives, imposes a heavy burden upon the auditor to stand firm.8
Managers may try to actively use auditor-switching to avoid qualified reports, and may
also use switch-threat to obtain a more favorable report from an incumbent auditor.9
Although there is little systematic evidence showing that long-term auditor-client
relationships reduce auditors’ incentives to maintain independence, mandatory auditor
rotation policy has been suggested in the past at various times as a solution to a recurring
problem of auditor independence. In the U.S., audit members of the SEC Practice
8 Despite the recent efforts o f the SEC to increase the role of the independent audit committee in the
selection and retention of auditors, the management o f audit clients continues to significantly influence
hiring and firing decisions o f auditors. Under the current US corporate governance system, investors are

allowed to ratify the manager’s selection of auditor through their proxy votes. However, the investors are
not given alternative auditor choices, nor are they allowed to make their own choice.
9 When the value o f incumbency exists, auditors may be willing to acquiesce to the wishes of management

when threatened by switch threat. Previous empirical studies show that auditors engage in “low-balling” by
offering an initial fee below cost in anticipation o f offsetting the initial loss by earning rents in subsequent
periods (e.g., Barber et al. 1987 and Simon and Francis 1988). Magee and Tseng (1990) analytically
examine the relationship between pricing o f audit engagements and auditor independence, and conclude
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Section are required to rotate partners every few years, but mandatory audit firm rotation
has never been adopted. The Metcalf report (1976) recommended mandatory rotation of
audit firms, but was later rejected by AICPA (1978) and the SEC Practice Section
(AICPA 1992). The widely held argument against mandatory auditor rotation is that it
increases the risk of audit failure as well as costs associated with frequent auditor
rotation. The Cohen Commission (AICPA 1978) and AICPA (1992) noted that audit
failures were more frequent in the early years of audit engagements.
Independent studies also suggest that mandatory auditor rotation does not
guarantee better audits since it takes time for 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 lower-
quality 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 early years of the auditor-client relationship. Johnson et al.
(2002) find that compared to “medium” auditor tenure, the absolute value o f unexpected
accruals is higher in the early years o f the auditor-client relationship. Using absolute
value o f abnormal accruals and current accruals, Myers et al. (2003) report that earnings
quality increases with auditor tenure. Ghosh and Moon (2003) show that absolute
discretionary accruals and the use of large special items decline with auditor tenure.
Finally, Carcello and Nagy (2004) examine the relation between auditor tenure and
fraudulent financial reporting and find that fraudulent reporting is more likely to occur in

the first three years o f the auditor-client relationship. These studies suggest that
that the auditor’s value of incumbency can pose a threat to independence.
Reproduced with 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.10
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 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 of auditors, Gietzmann and Sen (2002) conclude that in certain well-defined
circumstances, mandatory rotation of auditors is a desirable policy. In audit markets with
relatively few new client opportunities, removing the ability of management to influence
the auditor reappointment decision can improve the incentives for auditors to maintain
independence. Empirically, Davis et al. (2003) show a positive relation between
discretionary accruals and auditor tenure and conclude that audit quality decreases with
longer auditor tenure. Similarly, Casterella et al. (2002) find that audit failures are more
likely when auditor tenure is long, supporting the view that longer the tenure, the lower
the audit quality.
10 Aminada and Paz-Ares (1997) argue that, in addition to hampering the auditor’s technical competence
due to a greater number of initial audits, mandatory rotation can also harm auditor independence. This
argument is based on the reasoning that mandatory rotation probably reduces the expected cost of not
reporting and becoming dependent. However, direct empirical evidence for such a claim is lacking.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
10
Auditor Designation Policy in Korea
In all markets, the established practice of fairness and transparency is an essential
element in the issuing and trading of securities. The securities market in Korea is no
exception. Many securities-related laws and regulations exist to provide this basic
foundation to investor protection. Prior to 1981, firms requiring external audits were

assigned auditors by the government. In an effort to improve the quality of audits and to
foster the growth o f the auditing profession in Korea, in December 1980, the government
introduced competition into the audit market by increasing the demand for independent
audits as well as increasing the supply of auditors. However, with the introduction of
competition, management realized a newly-gained power over the auditors. Park (1990)
provides evidence that companies that received qualified opinions tended to change
auditors more frequently than those with clean opinions. Moreover, companies received
qualified reports less frequently after switching, suggesting that managements engage in
successful opinion-shopping.11 Therefore, the threat of switching can weaken the ability
of auditors to withstand pressure from client management to bias the reports in the
client’s favor.
Among many reforms to the Korean audit system undertaken by the government,
an auditor designation (AD) policy was adopted through the AAEA in December 1989.
The objective o f the new AD policy was to promote independent and quality audits by
11 Opinion-shopping was defined by the SEC, in FRR 31, as the practice o f seeking an auditor willing to
support a proposed accounting treatment designed to help a company achieve its reporting objectives even
though doing so might frustrate reliable reporting. The reporting objectives envisioned in opinion shopping
would be to improve reported operating results or the financial condition by obtaining an interpretation of
GAAP that is not consistent with those of the past or with the economic substance o f a transaction, or by
obtaining support for a change to a less-preferred or marginally acceptable accounting treatment.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
11
limiting managerial influence over auditor switching. According to the regulation on
external audit of listed corporations under the Securities Exchange Act in Korea, firms
meeting certain criteria (see Appendix A) are subject to auditor designation by the
Financial Supervisory Commission (FSC). Typically, these firms have been assessed
with a high potential to manipulate accounting numbers and are deemed in need of a
reliable audit as a result o f the FSC audit review. All other firms not subject to auditor
designation can freely select an auditor o f their choice.
Under AD policy, the FSC designates auditors for firms based on the size of

client-firm assets at the close of the prior accounting period, and the points accumulated
10
by the auditors (AD scores). The auditor with the highest points will be allotted the
auditor-designated firms that have the largest assets. The designation period is usually
three years, but this can be adjusted based on the yearly review of designated firms. If a
firm is not released from the auditor designation requirement after the period of three
years, then the FSC designates an auditor other than the incumbent auditor to ensure the
independence o f the auditors. Once the firm is released from the auditor designation
requirement, it can choose to remain with the incumbent auditor or switch to a different
auditor.
12 The AD score o f an auditor is calculated as follows: AD Score = Auditor Score / (1+ Number of
Designated Client Firms). The FSC maintains an auditor score system based on factors such as experience,
performance, and number of years with no allotment of FSC designated firms. The experience of an
auditor is determined by multiplying the number of auditors in the audit firm by the points based on the
number of years o f experience (the more experienced, the higher the points). If the audit reviewed by the
FSC is substandard, then the score is reduced for the auditor who performed the audit. Auditors who have
not been designated a firm for some periods get additional points added to their auditor score. The AD
scoring system provides auditors with an incentive to attain high auditor scores for a larger allotment of AD
firms. However, gaining more designated clients reduces future designations since the denominator of AD
score increases.
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
Two recent studies (Kim et al. 2002; Bae et al. 2003) have examined the effect on
audit quality of the Korean government auditor designation policy. Using discretionary
accruals as a proxy for audit quality, Kim et al. (2002) find that (1) discretionary accruals
for the firms with designated auditors are significantly lower than those for the firms with
non-designated auditors, and (2) for auditor designated firms, discretionary accruals
during the designation period are significantly lower than those during the non
designation period. Based on their findings, Kim et al. conclude that auditor designation
improves auditor independence. Bae et al. (2003), on the other hand, find that although
no difference in discretionary accruals between firms with designated auditors versus

non-designated auditors manifests, discretionary accruals for auditor-designated firms are
more income decreasing (1) the higher the audit risk, and (2) the longer the period of
auditor designation (in which case, the designated auditor will be mandatorily replaced
by another designated auditor). Bae et al.’s findings suggest that auditor designation
increases auditor conservatism, thus implying improvement in auditor independence.
The evidence provided by Kim et al. (2002) and Bae et al. (2003), however,
cannot be unambiguously attributed to improved independence due to mandatory auditor
changes. Under an audit regime with an auditor designation (AD) policy in effect (post-
1989), it is a common knowledge to all auditors that they could be mandatorily replaced
if their audit clients meet any one o f the designation criteria set forth by the government.
Under these conditions, the incumbent auditors have no economic incentives to give
lenient treatment to clients in hope o f repeat business. Also, under the AD regime, the
designated auditors are under regulatory scrutiny and are likely to prevent earnings
management for that reason, and not because o f increased independence. Likewise, the
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
13
companies themselves could have voluntarily reduced earnings management in response
to the public scrutiny, rather than, the auditors prevented manipulative earnings
management due to increased independence. In such cases, the same effect can be
obtained through heightened regulatory 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) improves audit quality. DeAngelo (1981a) and Watts and
Zimmerman (1981, 1986) define audit quality as the probability that an auditor will both
discover and truthfully report a discovered breach, and suggest that the probability of
reporting is a function of independence. Since high-quality, independent auditors are
more likely to detect and object to the client firms’ use of aggressive and questionable

accounting practices, earnings management is expected to decrease as audit quality
improves.
DeAngelo (1981b) suggests that an existing audit client provides the auditor with
client-specific rents that the auditor expects to receive over the life o f the auditor-client
relationship. This source of perpetual rents may create an economic dependency of the
auditor on the client. When the value o f incumbency exists, auditors may be willing to
acquiesce to the wishes of management, thus compromising their independence (Magee
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.
14
and Tseng 1990). The possibility ofbeing terminated by a client could affect an auditor’s
reporting decision (Raghunathan et al. 1994). If the length of the auditor-client
relationship were limited, lowering the expected period of incumbency and reducing
expected rents, then the auditors would have greater incentive to resist management
pressures (AICPA 1992; Dopuch et al. 2001; Gietzmann and Sen 2002).
Under the audit regime with the AD policy, the auditors o f Korean firms likely to
be targeted for auditor designation can no longer expect unlimited tenure. Therefore,
those auditors have no economic incentive to give lenient treatment in hope of repeat
business since FSC-designated auditors could mandatorily replace them. Hence, I
hypothesize the AAEA to have the desired effect of causing auditors o f firms at risk of
designation to be more independent, and thus effectively restrain firms’ opportunistic
manipulation of earnings. Stated in an alternative form:
Ha: Opportunistic earnings management of firms at risk of auditor designation
by the FSC decreases after the passage o f the AAEA (post-AAEA).
Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.