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.

Keywords: Selective Auditor Rotation, Audit Quality, Earnings management

JEL Classification: G38, L15, L84, G34, M41, M43, M49