The Effect of the Extension of Auditor Designation Range on Audit Hour
Asian Tax Journal Vol. 17 No. 6 (2016), pp. 39-77
Abstract
This study investigates the effect of the extension external auditor designation range based on financial criteria, such as debt ratio (＝debt/equity) is ① more than 200%, ② more than 1.5 times of its industry average ratio, and ③ interest coverage ratio (＝operating income/cost of interest) is less than 1 is the Act on External Audit of Stock Companies and its enforcement ordinance was amended in 2014 on audit effort (e.g. audit hour and abnormal audit hour). Thus, this paper empirically investigates the effects of new system for the extension external auditor designation range on external auditor’s audit hour in the year prior to its enforcement. To do this, we use the audit hour determinants and abnormal audit hours models. Measurement of the variable of interest represented by the indicator variable is an ex ante benchmark use, such as (1) the cumulative three－quarter or the end of third quarter for 2014 year, and the annual financial criteria for 2013 year is 1 if firms’s debt ratio is ① more than 200%, ② more than 1.5 times of its industry average ratio, and ③ interest coverage ratio is less than 1, otherwise 0, (2) if ① and ② meet the requirement, and ③ interest coverage ratio is less than 1.3 (1.5 or 2), (3) financial criteria through first three quarters or at the end of the third quarter for 2014 year, annual financial criteria for 2013 year. Firms’ managers have an incentive to manage financial criteria (e.g, ①～③) to avoid auditor external auditor designation. Therefore, the purpose of this paper examines whether the effect of firm’s financial criteria to meet or avoid certain benchmark on audit hours of the external auditor. For empirical analyses, we collected data on the listed companies in Korea for the year of 2014 and our final sample consists of 1,612 firm－year observations. Findings of this paper are following. First, we find that auditor’s audit hours significantly increase for if firm’s financial criteria ①～③ is all meet, which the case such as the cumulative three－quarter or the end of third quarter for 2014 year. Second, we do find the positive association between if firm’s financial criteria ① and ② is all meet, and in such a case if ③ interest coverage ratio is at slightly in excess of 1 and audit hours. Third, we find that auditor’s audit hours significantly increase for if firm’s financial criteria ①～③ is all meet, which firms manage to avoid designation of external auditor by the annual financial criteria for 2014 year prior to its enforcement. Overall, our results suggest that the extension external auditor designation range based on financial criteria by the Act on External Audit of Stock Companies and its enforcement ordinance was announced publicly in 2014 influences the level of audit efforts exerted by auditors measured as both actual and abnormal audit hours. Our study makes several contributions. First, this study is an initial document that the effect adoption of new system for the external auditor designation mandatorily based on financial criteria on additional audit effort of auditor, it shows very timely and appropriate results. Second, the preliminary test result of this study contributes to better understanding the association between the extension external auditor designation range based on financial criteria and the auditor’s reaction and address its effectiveness. This study also fills a void in the audit quality literature. Finally, our results are very useful and provide a lot of important implications to regulators, investors, and practitioners that are interested in audit quality. Moreover, our finding is in line with the direction of the revised policy plan for the Act on External Audit of Stock Companies and its enforcement ordinance with the external auditor designation mandatorily based on financial criteria. Academics can also apply the discussion in this paper to related future researches.
Keywords
- External auditor designation system
- Financial criteria
- Audit effort
- Audit Hour
- Abnormal audit hour
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