Description
to firms if they possess certain characteristics
that cast doubt on auditor independence or
the reliability of accounting disclosures. This
paper investigates whether such mandatory
assignment of auditors improves investors’
perceptions of the quality of accounting
information.
Accounting Research Journal
Assigned Auditors and Market Valuation: Korean Evidence
Seok Woo J eong J inbae Kim Sungsoo Yoon
Article information:
To cite this document:
Seok Woo J eong J inbae Kim Sungsoo Yoon, (2007),"Assigned Auditors and Market Valuation: Korean Evidence",
Accounting Research J ournal, Vol. 20 Iss 1 pp. 37 - 46
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Assigned Auditors and Market Valuation: Korean Evidence
37
Assigned Auditors and Market Valuation:
Korean Evidence
Seok Woo Jeong, Jinbae Kim and Sungsoo Yoon
Korea University Business School
Abstract
In Korea, a regulatory body can assign auditors
to firms if they possess certain characteristics
that cast doubt on auditor independence or
the reliability of accounting disclosures. This
paper investigates whether such mandatory
assignment of auditors improves investors’
perceptions of the quality of accounting
information. Using over 4,000 firm-year
observations from 1994 to 2002, we find that
investors respond more favorably to positive
earnings audited by assigned auditors than
to those audited by non-assigned auditors.
Negative earnings, however, do not lead to
significantly different reactions. Capital market
participants respond more favorably to the book
value of equity audited by assigned auditors
than to that audited by non-assigned auditors.
1. Introduction
Recent audit failures have triggered a
worldwide controversy over how auditors
should be engaged. To protect investors and
improve the reliability and accuracy of financial
disclosures, the US Congress enacted the
Sarbanes-Oxley Act of 2002. This Act contains
several provisions intended to assure auditor
independence; for example, it mandates the
rotation of lead or coordinating audit partners
every five years and prohibits auditors from
providing certain non-audit services. The
Sarbanes-Oxley Act prompted similar changes
to the financial reporting framework in many
other countries, including Australia and Korea.
In Australia, for example, CLERP 9 requires
Acknowledgments: We thank Hun-Tong Tan, 2005 Korea
University Accounting Symposium participants, and an
anonymous referee for their helpful comments and
suggestions on the paper. All remaining errors are our own.
Please forward all correspondence to Sungsoo Yoon at
[email protected].
five-year audit and lead partner rotation and
places restrictions on audit partners’ becoming
directors and officers of a client company
(Brown and Tarca 2005).
Debates about how auditors should be
engaged, however, still abound. For example,
restrictions on the joint provision of consulting
and audit services may have little effect on the
reality or perception of auditor independence.
One response adopted by big accounting firms
has been to divide an accounting firm into two
independent entities: one providing only
auditing services, the other providing consulting
services (McClelland and Stanton 2004).
It remains to be seen whether mandatory
rotation of lead or coordinating auditors would
improve auditor independence. In fact, the
Sarbanes-Oxley Act required the US
Comptroller General to study the effect of the
mandatory rotation of auditing firms, not just of
audit partners within the same firm. We
believe that the Korean audit environment can
shed light on this issue. In Korea, the regulatory
authority, the Securities and Futures
Commission (SFC hereafter), can assign an
auditor to a firm if it believes the firm has high
incentives or great potential for earnings
management.
1
This paper investigates whether
mandatory assignment of auditors to these firms
improves investors’ perceptions of the quality
of accounting information and affects the
market valuation of firms.
Many studies have investigated the effects of
the joint provision of audit and non-audit
services on auditor independence. Frankel et al.
(2002), for example, find that non-audit fees are
positively associated with the magnitude of
discretionary accruals, which acts as a proxy for
earnings management. Ashbaugh et al. (2003)
1 See Section 2 for details of the auditor assignment rule in
Korea.
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
38
and Chung and Kallapur (2003), however,
provide evidence contradicting the significant
positive association between accrual measures
and measures of client importance such as the
non-audit fee ratio. The perceptions of auditor
independence found within the capital market
have also been examined. Ghosh et al. (2004)
examine investors’ perceptions of auditor
independence as a function of non-audit fees
and client importance. They find that earnings
response coefficients — a proxy for investor
perception of audit quality — are negatively
associated with client importance (the auditor’s
fee from a client divided by the auditor’s total
revenues) but not with the ratio of non-audit
fees to total fees.
While these studies provide evidence of the
effect of non-audit services on auditor
independence, there have been few studies on
auditor rotation, even though it may affect
auditor independence as much as non-audit
services. Auditor assignment may improve the
quality of accounting information if the
assigned auditor is more independent than those
freely selected by the company and/or if the
assigned auditor expects increased scrutiny by
the regulatory authority. Auditor assignment,
however, may not enhance the informativeness
of accounting numbers if the auditor fails to
conduct an effective audit due to a lack of
cooperation from the client who was forced to
hire him or her.
2
Previous research documents that auditor
assignment constrains earnings management.
Bae et al. (2004) examine the impact of auditor
assignment on discretionary accruals during the
period from 1991 to 2000. They report that
adjusted discretionary accruals for the firms
with assigned auditors are lower than those for
the firms with non-assigned auditors. In
addition, assigned auditors are found to increase
the level of conservatism for high-risk clients.
For the same period, Kim et al. (2004) find
similar results and conclude that the auditor
assignment rule enhances audit quality and the
credibility of financial reporting.
2 This negative impact works against rejecting the null
hypothesis that investors do not differentiate between
accounting information audited by an assigned auditor
and that audited by a non-assigned auditor.
While the effects of auditor assignment on
the magnitude of discretionary accruals have
been examined, it has not been investigated
whether investors respond differently to the
accounting information audited by these two
groups of auditors. The capital market may
believe that auditor assignment enhances
auditor independence and leads to higher
quality accounting information. Alternatively,
auditor assignment itself could be interpreted as
a warning sign that the firm may have a high
risk of accounting irregularity or that the firm’s
earnings may have lower persistence. While
it is an important and interesting finding that
firms with assigned auditors do not appear to
manage earnings as well as those without
assigned auditors, its policy implications
would be limited if the capital market does
not perceive such differences in auditor
independence and audit quality. We empirically
test whether capital market participants utilize
the accounting information audited by assigned
auditors differently from that audited by freely
selected auditors.
Using over 4,000 firm-year observations
from 1994 to 2002, we find that investors
respond more favorably to positive earnings
audited by assigned auditors than to those
audited by non-assigned auditors. Negative
earnings, however, do not lead to significantly
different reactions. Capital market participants
appear to respond more favorably to the book
value of equity audited by assigned auditors
than to that audited by non-assigned auditors.
Our study extends prior research on the
impact of the auditor selection process on
earnings quality by testing whether such an
impact, if any, is reflected in the market value.
The results suggest that investors perceive
assigned auditors as more independent than
those who are freely selected. This paper also
adds to the literature on auditor conservatism. If
the policy objective of assigning auditors is to
make reported earnings closer to unobservable
true earnings, and if such an objective is
accomplished, then investors will respond more
to reported earnings audited by assigned
auditors than to those audited by non-assigned
auditors regardless of their sign. However, we
observe asymmetric responses to profits and
losses: investors perceive assigned auditors as
being different (more conservative) from
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Assigned Auditors and Market Valuation: Korean Evidence
39
non-assigned auditors only when reported
earnings are positive.
Assigned auditors may be perceived as more
effective than non-assigned auditors because the
former are more independent than the latter or
because the former expect more scrutiny by
authorities. This study does not distinguish
between these two possibilities. If, however, the
policy goal is to constrain aggressive reporting
by firms, then investors appear to believe that
auditor assignment accomplishes such a goal.
The remainder of the paper is organized as
follows. Section 2 provides institutional details
of the auditor assignment system in Korea.
Section 3 discusses the research method used,
while Section 4 describes the data. The
empirical results are presented in Section 5.
Finally, Section 6 concludes the paper.
2. Institutional Background
Korean audit market is similar to that of the
United States in many respects. Korean
accounting and auditing standards are
comparable to the U.S. standards, and the Big
Six audit firms audit a majority of the listed
firms in Korea applying similar audit programs
(Bae et al. 2004). There are, however, a few
important differences between the two systems.
In Korea, audit fees are much lower than in the
United States: the level of audit fees relative
to total assets of Korean firms is about 20-25%
of that of U.S. firms (Choi and Joo 1998).
Penalties for audit failures are also less severe in
Korea than in the United States. These factors
contribute to the notion that auditors in Korea
have fewer incentives to provide a high-quality
audit than do those in the United States.
In order to ensure audit quality, the SFC in
Korea introduced a system that authorizes it to
assign an auditor to a firm with certain
characteristics and to require the firm to retain
the auditor for up to three years. Specifically,
the SFC can assign an auditor if one of the
following occurs: a delay in auditor selection;
an improper change of auditor; violation of
GAAP; insufficient separation of ownership and
management; an excessive debt-to-equity ratio;
poor quality stock (traded on an “administrative
post”); excessive loans to management or
controlling stockholders; violation of the
Securities and Exchange Act; or a request by
the company or by the major creditor bank.
Assigned auditors are expected to be more
independent than non-assigned auditors for
several reasons. First, these auditors are not
chosen by their clients but are instead randomly
assigned to them. The SFC lists all the firms
subject to auditor assignment by their total
assets and lists auditors by their performance
measures, and then matches the first on the firm
list to the first on the auditor list, and so on.
Once an auditor is assigned to a firm, the firm
and the auditor are expected to complete an
audit engagement unless there are legitimate
reasons for not doing so. Second, once assigned
to a firm, an auditor is guaranteed to audit the
firm for up to three years unless the firm is not
subject to the auditor assignment requirement. If
the firm is still subject to the rule even after the
three-year period, then a new auditor is assigned
to replace the previous (assigned) auditor.
Bae et al. (2004) and Kim et al. (2004) find
evidence that firms with assigned auditors
report less discretionary accruals than do firms
with non-assigned auditors. This evidence
suggests that assigned auditors are more likely
to constrain aggressive reporting by firms than
are non-assigned auditors. It remains to be seen,
however, how the market perceives auditor
independence and the reliability of the financial
statements under the auditor assignment
system. In spite of the inconclusive evidence of
the effect of non-audit services on auditor
independence, the SEC changed its rule on
audits while emphasizing that investors’
perceptions of auditor independence are as
important as actual independence.
3. Research Design
To examine how the assignment of auditors is
perceived by investors and valued by the capital
market, we mainly follow the method used by
Core et al. (2003). Specifically, we regress the
market value of equity on the book value of
equity, the earnings level, and four proxies for
expected earnings growth. These growth
proxies are used to mitigate the loss in
explanatory power of the regression model
due to the lack of timeliness in accounting
information, as reported by Collins et al. (1997).
First, research and development expenditures
(RND) and advertising expenditures (ADVERT)
are included to capture expected growth in
earnings due to investments in intangible assets.
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
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Next, we include capital expenditures
(CAP_EX) to reflect expected growth in
earnings arising from new investments in
tangible assets. Finally, sales growth over the
previous year (SGROWTH) is included as an
additional proxy for expected earnings growth.
In addition to these independent variables,
we add two auditor assignment interaction
variables: one with the book value of equity
(ASGN*BVE) and the other with the earnings
level (ASGN*NI). These two interaction
variables are of major interest to us. If they are
significantly different from zero, it implies that
investors value the book value of equity or the
earnings audited by assigned auditors
differently from those audited by non-assigned
auditors.
The empirical model of interest is
MVE = ?
0
+ ?
1
(BVE) + ?
2
(NI) + ?
3
(NEG_NI)
+ ?
4
(RND) + ?
5
(ADVERT) + ?
6
(CAP_EX)
+ ?
7
(SGROWTH) +?
8
(ASGN*BVE)
+ ?
9
(ASGN*NI) + ?, (1)
where
MVE is the market value of equity measured at
the end of the fiscal year;
BVE is the book value of equity;
NI is the net income before extraordinary items;
NEG_NI is NI if NI is less than or equal to zero,
and 0 otherwise;
RND is research and development expenditures;
ADVERT is advertising expenditures;
CAP_EX is capital expenditures;
SGROWTH is the one-year change in sales; and
ASGN is 1 if a firm’s auditor is assigned, and 0
otherwise.
Following Core et al. (2003), we deflate
equation (1) by the book value of equity to
control for any differences that might be caused
by the different levels of book value of equity.
Therefore, the specification we use is
MVE/BVE = ?
0
(1/BVE) + ?
1
+ ?
2
(NI/BVE)
+ ?
3
(NEG_NI/BVE) + ?
4
(RND/BVE)
+ ?
5
(ADVERT/BVE)
+ ?
6
(CAP_EX/BVE)
+ ?
7
(SGROWTH/BVE) + ?
8
ASGN
+ ?
9
(ASGN*NI/BVE) + ?. (2)
The intercept in the unscaled model (1),
which explains economic variation in market
value not captured by other explanatory
variables, is transformed into the inverse of the
book value of equity in the scaled model (2), as
in Core et al. (2003).
4. Data
We obtain a sample of firms listed on the
Korean Stock Exchange over the period from
1994 to 2002 from publicly available sources.
The list of firms with assigned auditors is
announced by the SFC each year. We extract
financial statement items from the KIS-FAS
database, which contains financial statements of
Korean listed firms since 1980. We exclude
financial institutions from our sample because
these firms might have different price multiples
for book value and earnings from those of
manufacturing firms. Following Core et al.
(2003), we restrict our sample to firms with a
positive book value of equity. To mitigate the
effect of extreme values of the dependent
variable, we remove observations in the top and
bottom one-half percent of market to book
value of equity. Firms can voluntarily request
the SFC to assign auditors. Since voluntary
auditor assignment is not the focus of this paper,
such firms are excluded from our sample. Our
sample selection procedure results in a sample
size of 4,063 firm-year observations.
Table 1 lists the reasons for auditor
assignment and the number of observations for
each reason. Major reasons include insufficient
separation of ownership and management
(40%), excessive use of debts (28%), and
trading on an “administrative post” (18%).
Table 2 provides the sample distribution by
the type of auditor and by year. It also presents
the percentages of observations with negative
earnings. As expected, firms with assigned
auditors report negative earnings more
frequently than do firms with freely selected
auditors. Overall, 31.9% of firms with assigned
auditors report negative earnings while 20.2%
of firms with freely selected auditors report
negative earnings. This difference is statistically
significant at the 1% level with a t-value of
5.73. In each of the nine years in the sample
period, the percentage of firms reporting
negative earnings relative to total firms in the
group is higher for the group with assigned
auditors. The difference is statistically
significant at the 5% level in 1994, 2000, and
2002.
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Assigned Auditors and Market Valuation: Korean Evidence
41
Table 1
Number of Firms by Reason of Auditor Assignment
Reason of Auditor Assignment Number of Observations Percentage
Delay in auditor selection 5 1.1%
Improper change of auditor 5 1.1%
Violation of GAAP 19 4.3%
Insufficient separation of ownership and management 178 40.0%
Excessive loans to management 9 2.0%
Required by Industry Restructuring Act 17 3.8%
Excessive use of debts 124 27.9%
Trading on Administrative Post 80 18.0%
Required by Securities Exchange Act 2 0.5%
Required by Fair Trade Act 4 0.9%
Others 2 0.5%
Total 445 100.0%
Note: The sample includes firms whose auditors were assigned by the Securities and Futures Commission
(SFC) of Korea from 1994 to 2002. Firms can voluntarily request the SFC to assign auditors. There was
only one such case during the sample period. The observation was excluded from the final sample.
Table 2
Sample Distribution by Year and Type of Auditor, and
Percentage of Observations with Negative Earnings
Firms with Non-Assigned Auditors Firms with Assigned Auditors
Year
Number of
observations
% of
observations with
negative earnings
Number of
observations
% of
observations with
negative earnings
t-statistics for
difference
1994 355 9.6% 45 31.1% 4.27
*
1995 383 11.0% 38 18.4% 1.37
1996 388 14.2% 52 23.1% 1.68
1997 383 28.5% 64 29.7% 0.20
1998 337 29.7% 105 30.5% 0.16
1999 404 17.6% 38 28.9% 1.73
2000 443 21.0% 18 50.0% 2.93
*
2001 459 27.9% 29 41.4% 1.56
2002 466 20.8% 56 46.4% 4.34
*
Total 3,618 20.2% 445 31.9% 5.73
*
Note: t-statistics show the difference in percentage of negative earnings between non-assigned auditor firms and
assigned auditor firms.
* denotes significance at the 5% level.
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
42
5. Empirical Results
To estimate the regression model, the
observations are pooled over the period from
1994 to 2002 and across firms. The main results
are reported in Table 3. In column (1) of
Table 3, which shows the results for the
regression model without assigned auditor
interaction terms, the signs of the estimated
coefficients are consistent with previous
research. All independent variables except sales
growth have statistically significant coefficients.
The adjusted R-squared is 34.3%. These results
and the magnitude of the coefficients are
comparable to those reported by Core et al.
(2003), even though they report a significant
coefficient for sales growth and an insignificant
coefficient for advertising expenditures.
The coefficient for negative earnings is
Table 3
Regression Results for Full Sample
MVE/BVE = ?0 (1/BVE) + ?1 + ?2(NI/BVE) + ?3(NEG_NI/BVE) + ?4(RND/BVE) + ?5(ADVERT/BVE)
+ ?6(CAP_EX/BVE) + ?7(SGROWTH /BVE) +?8(ASGN) + ?9(ASGN*NI/BVE)
+ Year Dummies + ?
Variables
(1)
Coefficients
(t-statistics)
(2)
Coefficients
(t-statistics)
Intercept 0.385
(13.30)
*
0.378
(13.01)
*
1/BVE 5.284
(22.09)
*
5.204
(21.5)
*
NI/BVE 0.348
(7.28)
*
0.346
(7.23)
*
NEG_NI/BVE -0.359
(-7.40)
*
-0.358
(-7.38)
*
RND/BVE 3.709
(8.02)
*
3.723
(8.00)
*
ADVERT/BVE 0.553
(6.52)
*
0.531
(6.24)
*
CAP_EX/BVE 0.079
(2.40)
*
0.073
(2.21)
*
SGROWTH/BVE 0.002
(0.81)
0.002
(0.80)
ASGN
0.105
(3.23)
*
ASGN*NI/BVE
0.024
(0.56)
Adj. R2 34.3% 34.5%
* denotes significance at the 5% level. Coefficients of year dummies are omitted.
Variable definitions are as follows:
MVE is the market value of equity.
BVE is the book value of equity.
NI is the net income before extraordinary items.
NEG_NI is NI if NI is less than or equal to zero, and 0 otherwise.
RND is research and development expenditures.
ADVERT is advertising expenditures.
CAP_EX is capital expenditures.
SGROWTH is the one-year change in sales.
ASGN is 1 if a firm’s auditor is assigned, and 0 otherwise.
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Assigned Auditors and Market Valuation: Korean Evidence
43
statistically significant and negative. Core et al.
(2003) interpret this result as suggesting that
“stock prices reflect expectations by investors
that large losses precede higher future cash
flows than small losses, possibly due to the
transitory nature of large losses.” The intercept,
which is the coefficient of the book value of
equity in the undeflated regression equation (1),
is highly significant with a t-value of 13.3.
This result, indicating a positive effect of the
book value of equity on the market value, is
consistent with expectations and with the results
of other studies such as Collins et al. (1999).
Overall, column (1) shows that the book value
of equity and earnings are positively related to
the market value of equity, as Ohlson (1995)
suggests.
In column (2), the coefficient of ASGN — an
auditor assignment interaction term with the
book value of equity in the undeflated model —
is positive and statistically significant. The
effect of the book value of equity on the market
value is greater for the firms with assigned
auditors than for the firms with non-assigned
auditors. This result implies that the capital
market perceives the book value of equity as
having a higher quality when verified by
an assigned auditor than when verified by a
non-assigned auditor.
Surprisingly, the coefficient of
ASGN*NI/BVE, the interaction term between
auditor assignment and earnings, is not
statistically significant. This seemingly
perplexing result may be due to the high
incidence of negative earnings for firms with
assigned auditors. As Table 2 shows, firms with
assigned auditors are more likely to report
negative earnings than are firms with non-
assigned auditors. Previous studies have
documented different valuations of positive and
negative earnings. For example, Ohlson (1995)
and Collins et al. (1999) show that the book
value of equity plays a more prominent role in
valuations of firms with negative earnings than
it does in valuations of firms with positive
earnings. Barth et al. (1998) report that investors
put more weight on the book value of equity in
valuations as the financial health of firms
deteriorates while they put less weight on
negative earnings under such conditions.
Therefore, to the extent that NEG_NI does not
fully control for the different relations between
the market value and negative earnings, the
results in Table 3 may not reveal the true
relation between the market value of firms and
accounting information. To further probe the
role of the sign of earnings in the market
perception of assigned auditors, we perform the
same analysis as in Table 3 separately for the
firms with positive earnings and again for the
firms with negative earnings.
Table 4 presents the results for our regression
model comparing the firm-years with positive
earnings (column 1) and those with negative
earnings (column 2). The signs, magnitudes,
and statistical significance of the coefficients of
the explanatory variables in column (1) of Table
4 are comparable to those in the full sample
case shown in Table 3. The remarkable
difference between the positive earnings case
and the full sample case is the interaction
term between auditor assignment and earnings,
ASGN*NI/BVE. The coefficient of the
interaction term is highly significant in the
positive earnings case shown in Table 4, which
is different from the non-significant result in the
full sample case shown in Table 3. This
suggests that, when a firm reports positive
earnings, the earnings are perceived by the
market as being more valuable if they are
audited by an assigned auditor than if they are
audited by a non-assigned auditor. The
coefficient of ASGN, representing an interaction
term between auditor assignment and the book
value of equity, however, is insignificant in
column (1). This suggests that investors in this
case put the same weight on the book value of
equity in valuations regardless of whether the
book value is audited by assigned auditors or by
non-assigned auditors.
Column (2) of Table 4 presents the results
for firms with negative earnings. The overall
significance of most variables drops. The
intercept (representing the book value of
equity), earnings, research and development
expenditures, and advertising expenditures lose
significance considerably. This confirms the
results of prior research that valuations of
positive earnings and negative earnings are
fundamentally different (e.g. Hayn 1995, Basu
1997, Collins et al. 1997).
Most notably, earnings lose significance; that
is, when earnings are negative, they have little
impact on market valuation. This result is
consistent with the view that negative earnings
are not a useful source of information about
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
44
Table 4
Regression Results for Positive Earnings Firms and
Negative Earnings Firms
MVE/BVE = ?0 (1/BVE) + ?1 + ?2(NI/BVE) + ?4(RND/BVE) + ?5(ADVERT/BVE) + ?6(CAP_EX/BVE)
+ ?7(SGROWTH /BVE) +?8(ASGN) + ?9(ASGN*NI/BVE) + Year Dummies + ?
Variables
(1)
Firms with
Positive Earnings
Coefficients
(t-statistics)
(2)
Firms with
Negative Earnings
Coefficients
(t-statistics)
Intercept 0.363
(11.72)
*
0.403
(5.55)
*
1/BVE 4.569
(13.37)
*
6.090
(14.8)
*
NI/BVE 0.310
(6.53)
*
-0.008
(-1.04)
RND/BVE 4.660
(7.98)
*
2.259
(2.68)
*
ADVERT/BVE 0.638
(6.43)
*
0.192
(1.11)
CAP_EX/BVE 0.049
(1.14)
0.166
(2.86)
*
SGROWTH/BVE 0.003
(0.43)
0.000
(0.02)
ASGN -0.000
(-0.00)
0.180
(2.30)
*
ASGN*NI/BVE 0.580
(2.26)
*
0.000
(0.01)
Adj. R2 34.8% 36.2%
Column (1) includes regression results for firms whose earnings are greater than or equal to 0.
Column (2) includes regression results for firms whose earnings are less than 0.
* denotes significance at the 5% level. Coefficients of year dummies are omitted.
Variable definitions are as follows:
MVE is the market value of equity.
BVE is the book value of equity.
NI is the net income before extraordinary items.
RND is research and development expenditures.
ADVERT is advertising expenditures.
CAP_EX is capital expenditures.
SGROWTH is the one-year change in sales.
ASGN is 1 if a firm’s auditor is assigned, and 0 otherwise.
firms’ future earnings. Negative earnings cannot
persist in the future since shareholders have a
liquidation option. The significance of negative
earnings does not improve much even when the
earnings are audited by assigned auditors, which
is reflected in the insignificant coefficient of
ASGN*NI/BVE. Investors do not appear to take
into account negative earnings regardless of
whether the earnings numbers are audited by
assigned auditors or by client-selected auditors.
In contrast, the intercept in column (2) is
significant, as shown in Table 3, implying that
the book value of equity is still perceived by the
market as valuable even when earnings are
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Assigned Auditors and Market Valuation: Korean Evidence
45
negative. The coefficient of ASGN in column
(2) is also significant. These results suggest that
the perceived value of the book value of equity
increases when accounting numbers are audited
by assigned auditors. This is consistent with the
results of Barth et al. (1998) and Collins et al.
(1999).
When auditors are assigned by government
authorities, if these auditors are as competent as,
and have as much integrity as, other auditors,
we expect them to behave in two ways:
assigned auditors would be more independent
than non-assigned auditors, while assigned
auditors would be more conservative than non-
assigned auditors.
If assigned auditors are more independent
than non-assigned auditors, then one would
expect the accounting numbers, say earnings,
audited by the former to be closer to
(unobservable) the true numbers than those
audited by the latter, everything else being
equal. In other words, earnings audited by
assigned auditors would be more truthful
regardless of whether they were positive or
negative. The market reactions to earnings
audited by assigned auditors would then be
stronger than to those audited by non-assigned
auditors regardless of the sign of the earnings.
However, it is also possible that assigned
auditors are more conservative; that is, they
understate positive earnings and overstate
losses. Prior research documents that auditors
tend to be conservative, or income decreasing.
3
If the earnings audited by assigned auditors are
rather more conservative than truthful, the
3 Several studies document auditor conservatism. For
example, Francis and Krishnan (1999) observe that
auditors for high-accrual firms compensate for the
additional risk exposure by lowering thresholds for
issuing modified audit reports. Enforcement actions by
authorities such as the U.S. Securities and Exchange
Commission (SEC) may also lead to auditor
conservatism. Bannister and Wiest (2001) provide
evidence consistent with the notion that client firms have
more income-decreasing accruals during the period that
their auditor is subject to an investigation related to an
SEC enforcement action. Kim et al. (2003) suggest that
Big Six auditors are more (less) effective than non-Big
Six auditors in deterring income-increasing (income-
decreasing) accruals. Chung et al. (2003) find that Big
Six auditors appear to influence their clients to use more
conservative accounting than do non-Big Six auditors
when the clients’ financial performance is worse than
expected.
magnitude of market reactions to positive
(negative) earnings audited by assigned auditors
would be larger (smaller) than that to positive
(negative) earnings audited by non-assigned
auditors, and the magnitude of market reactions
to positive earnings would be different from that
to negative earnings.
The results of this paper — that there would
be a more favorable reaction to positive
earnings by assigned auditors than by non-
assigned auditors, and that there would be an
insignificant reaction to negative earnings
regardless of whether they are audited by
assigned auditors or non-assigned auditors —
are more consistent with the “conservatism”
view. The result that negative earnings do not
lead to significantly different reactions is also
consistent with the notion that capital market
participants perceive losses as temporary.
Auditors are assigned to firms for several
reasons, as Table 1 shows. It may be possible
that a group of firms whose auditors are
assigned for a specific reason drives the results
of this paper. To check the robustness of the
results, we repeat the same regression analysis
separately for the two major groups that account
for more than two-thirds of the firms with
assigned auditors. The regression results are
qualitatively similar to the results with the
whole sample. For example, when we run a
regression similar to that shown in Table 3 with
only the firms whose auditors are assigned due
to “insufficient separation of ownership and
management,” the coefficients of ASGN and
ASGN*NI/BVE are 0.217 with a t-value of 4.73
(significant at the 1% level) and -0.059 with a
t-value of -0.36, respectively. As for the firms
assigned auditors for “excessive use of debts,”
the coefficients of ASGN and ASGN*NI/BVE
are 0.126 with a t-value of 2.10 (significant at
the 5% level) and -0.038 with a t-value of -0.26,
respectively.
6. Conclusion
Recent accounting scandals in the United
States and other countries have made
investors seriously doubt the credibility of
accounting information. Impairment of auditor
independence is considered one of the most
important contributing factors. In response,
regulatory authorities have modified accounting
and auditing systems to secure auditor
independence and improve the quality of
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
46
financial reporting. This study empirically tests
how capital market participants “perceive” the
system that assigns auditors to firms when audit
independence is not assured.
We document that two factors affect
investors’ perceptions about the relation
between the market value of firms and the book
value of equity and earnings: whether the
auditor is assigned or not, and whether the
earnings are positive or negative. The results
suggest that capital market participants respond
more favorably to positive earnings audited by
assigned auditors than to those audited by non-
assigned auditors. Negative earnings, however,
fail to produce significantly different reactions.
For firms with negative earnings, investors
place more weight on the book value of equity
audited by assigned auditors than that audited
by non-assigned auditors. We interpret these
results as implying that auditor assignment may
enhance auditor independence in appearance,
and thereby increase the reliability of financial
statements as perceived by investors.
Our results may be useful for regulatory
bodies in other countries that are considering
a change in the auditor selection mechanism
to improve auditor independence. However,
one should be careful in generalizing the
implications of the results because the results of
this study may be caused by the uncontrolled
characteristics of firms with assigned auditors.
7. References
Ashbaugh, H., LaFond, R., and Mayhew, B. (2003), “Do
nonaudit services compromise auditor independence?
Further evidence”, The Accounting Review, vol.78 (3),
pp. 611–639.
Bae, G., Kwon, S., and Rho, J. (2004), “The effect of auditor
designation on discretionary accruals: Auditor rotation
and retention requirements in the Korean audit service
market”, Working paper, Korea University and
Chungnam National University.
Bannister, J. and Wiest, D. (2001), “Earnings management
and auditor conservatism: Effects of SEC enforcement
actions”, Managerial Finance, vol.7 (12), pp.57–71.
Barth, M., Beaver, W., and Landsman, W. (1998), “Relative
valuation roles of equity book value and net income as a
function of financial health”, Journal of Accounting and
Economics, vol.25, pp.1–34.
Basu, S. (1997), “The conservatism principle and the
asymmetric timeliness of earnings”, Journal of
Accounting and Economics, vol.24, pp.3–37.
Brown, P. and Tarca, A. (2005), “2005-It’s Here, Ready or
Not: A Review of the Australian Financial Reporting
Framework”, Australian Accounting Review, vol. 15(2),
pp.68–78.
Choi, K. and Joo, I. (1998), “A study on the appropriateness
of audit fees in Korea”, Korean Accounting Journal,
vol.7 (1), pp.61–86.
Chung, R., Firth, M., and Kim, J. (2003), “Auditor
conservatism and reported earnings”, Accounting and
Business Research, vol.33 (1), pp.19–32.
Chung, H. and Kallapur, S. (2003), “Client importance,
nonaudit services, and abnormal accruals”, The
Accounting Review, vol.78 (4), pp.931–955.
Collins, D., Maydew, E., and Weiss, I., (1997), “Changes in
the value-relevance of earnings and book values over
the past forty years”, Journal of Accounting and
Economics, vol.24, pp.39–67.
Collins, D., Pincus, M., and Xie, H. (1999), “Equity
valuation and negative earnings: The role of book value
and equity”, The Accounting Review, vol.74 (January),
pp.29–61.
Core, J., Guay, W., and Buskirk, A. (2003), “Market
valuations in the new economy: An investigation of
what has changed”, Journal of Accounting and
Economics, vol.34, pp.43–67.
Francis, J. and Krishnan, J. (1999), “Accounting accruals
and auditor reporting conservatism”, Contemporary
Accounting Research, vol.16 (1), pp.135–165.
Frankel, R., Johnson, M., and Nelson, K. (2002), “The
relation between auditors’ fees for nonaudit services and
earnings management”, The Accounting Review, vol. 77
(Supplement), pp.71–105.
Ghosh, A., Kallapur, S., and Moon. D. (2004), “Audit and
non-audit fees and capital market perceptions of auditor
independence”, Working paper, US Securities and
Exchange Commission, Purdue University, and SUNY-
Oldwestbury.
Hayn, C. (1995), “The information content of losses”,
Journal of Accounting and Economics, vol.20 (2),
pp.125–153.
Kim, J., Chung, R., and Firth, M. (2003), “Auditor
conservatism, asymmetric monitoring, and earnings
management”, Contemporary Accounting Research,
vol.20 (2), pp.323–359.
Kim, J., Min, C., and Yi, C. (2004), “Selective auditor
rotation and earnings management: Evidence from
Korea”, Working paper, Hong Kong Polytechnic
University and Hankuk University of Foreign Studies.
McClelland, P., and Stanton, P. (2004), “Sarbanes-Oxley
and the Future of Accounting”, Australian Accounting
Review, vol.14 (2), pp.91–96.
Ohlson, J. (1995), “Earnings, book values, and dividends in
equity valuation”, Contemporary Accounting Research,
vol.11, pp.661–687.
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This article has been cited by:
1. Dong Heun Lee, Seon Mi Kim, Kwang Wuk Oh, Seung Weon Yoo. 2013. New Auditors’ Decisions for Released Firms
from the Mandatory Auditor Designation Rule: Evidence From South Korea. Australian Accounting Review 23:10.1111/
auar.2013.23.issue-4, 341-356. [CrossRef]
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doc_543490090.pdf
to firms if they possess certain characteristics
that cast doubt on auditor independence or
the reliability of accounting disclosures. This
paper investigates whether such mandatory
assignment of auditors improves investors’
perceptions of the quality of accounting
information.
Accounting Research Journal
Assigned Auditors and Market Valuation: Korean Evidence
Seok Woo J eong J inbae Kim Sungsoo Yoon
Article information:
To cite this document:
Seok Woo J eong J inbae Kim Sungsoo Yoon, (2007),"Assigned Auditors and Market Valuation: Korean Evidence",
Accounting Research J ournal, Vol. 20 Iss 1 pp. 37 - 46
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Assigned Auditors and Market Valuation: Korean Evidence
37
Assigned Auditors and Market Valuation:
Korean Evidence
Seok Woo Jeong, Jinbae Kim and Sungsoo Yoon
Korea University Business School
Abstract
In Korea, a regulatory body can assign auditors
to firms if they possess certain characteristics
that cast doubt on auditor independence or
the reliability of accounting disclosures. This
paper investigates whether such mandatory
assignment of auditors improves investors’
perceptions of the quality of accounting
information. Using over 4,000 firm-year
observations from 1994 to 2002, we find that
investors respond more favorably to positive
earnings audited by assigned auditors than
to those audited by non-assigned auditors.
Negative earnings, however, do not lead to
significantly different reactions. Capital market
participants respond more favorably to the book
value of equity audited by assigned auditors
than to that audited by non-assigned auditors.
1. Introduction
Recent audit failures have triggered a
worldwide controversy over how auditors
should be engaged. To protect investors and
improve the reliability and accuracy of financial
disclosures, the US Congress enacted the
Sarbanes-Oxley Act of 2002. This Act contains
several provisions intended to assure auditor
independence; for example, it mandates the
rotation of lead or coordinating audit partners
every five years and prohibits auditors from
providing certain non-audit services. The
Sarbanes-Oxley Act prompted similar changes
to the financial reporting framework in many
other countries, including Australia and Korea.
In Australia, for example, CLERP 9 requires
Acknowledgments: We thank Hun-Tong Tan, 2005 Korea
University Accounting Symposium participants, and an
anonymous referee for their helpful comments and
suggestions on the paper. All remaining errors are our own.
Please forward all correspondence to Sungsoo Yoon at
[email protected].
five-year audit and lead partner rotation and
places restrictions on audit partners’ becoming
directors and officers of a client company
(Brown and Tarca 2005).
Debates about how auditors should be
engaged, however, still abound. For example,
restrictions on the joint provision of consulting
and audit services may have little effect on the
reality or perception of auditor independence.
One response adopted by big accounting firms
has been to divide an accounting firm into two
independent entities: one providing only
auditing services, the other providing consulting
services (McClelland and Stanton 2004).
It remains to be seen whether mandatory
rotation of lead or coordinating auditors would
improve auditor independence. In fact, the
Sarbanes-Oxley Act required the US
Comptroller General to study the effect of the
mandatory rotation of auditing firms, not just of
audit partners within the same firm. We
believe that the Korean audit environment can
shed light on this issue. In Korea, the regulatory
authority, the Securities and Futures
Commission (SFC hereafter), can assign an
auditor to a firm if it believes the firm has high
incentives or great potential for earnings
management.
1
This paper investigates whether
mandatory assignment of auditors to these firms
improves investors’ perceptions of the quality
of accounting information and affects the
market valuation of firms.
Many studies have investigated the effects of
the joint provision of audit and non-audit
services on auditor independence. Frankel et al.
(2002), for example, find that non-audit fees are
positively associated with the magnitude of
discretionary accruals, which acts as a proxy for
earnings management. Ashbaugh et al. (2003)
1 See Section 2 for details of the auditor assignment rule in
Korea.
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
38
and Chung and Kallapur (2003), however,
provide evidence contradicting the significant
positive association between accrual measures
and measures of client importance such as the
non-audit fee ratio. The perceptions of auditor
independence found within the capital market
have also been examined. Ghosh et al. (2004)
examine investors’ perceptions of auditor
independence as a function of non-audit fees
and client importance. They find that earnings
response coefficients — a proxy for investor
perception of audit quality — are negatively
associated with client importance (the auditor’s
fee from a client divided by the auditor’s total
revenues) but not with the ratio of non-audit
fees to total fees.
While these studies provide evidence of the
effect of non-audit services on auditor
independence, there have been few studies on
auditor rotation, even though it may affect
auditor independence as much as non-audit
services. Auditor assignment may improve the
quality of accounting information if the
assigned auditor is more independent than those
freely selected by the company and/or if the
assigned auditor expects increased scrutiny by
the regulatory authority. Auditor assignment,
however, may not enhance the informativeness
of accounting numbers if the auditor fails to
conduct an effective audit due to a lack of
cooperation from the client who was forced to
hire him or her.
2
Previous research documents that auditor
assignment constrains earnings management.
Bae et al. (2004) examine the impact of auditor
assignment on discretionary accruals during the
period from 1991 to 2000. They report that
adjusted discretionary accruals for the firms
with assigned auditors are lower than those for
the firms with non-assigned auditors. In
addition, assigned auditors are found to increase
the level of conservatism for high-risk clients.
For the same period, Kim et al. (2004) find
similar results and conclude that the auditor
assignment rule enhances audit quality and the
credibility of financial reporting.
2 This negative impact works against rejecting the null
hypothesis that investors do not differentiate between
accounting information audited by an assigned auditor
and that audited by a non-assigned auditor.
While the effects of auditor assignment on
the magnitude of discretionary accruals have
been examined, it has not been investigated
whether investors respond differently to the
accounting information audited by these two
groups of auditors. The capital market may
believe that auditor assignment enhances
auditor independence and leads to higher
quality accounting information. Alternatively,
auditor assignment itself could be interpreted as
a warning sign that the firm may have a high
risk of accounting irregularity or that the firm’s
earnings may have lower persistence. While
it is an important and interesting finding that
firms with assigned auditors do not appear to
manage earnings as well as those without
assigned auditors, its policy implications
would be limited if the capital market does
not perceive such differences in auditor
independence and audit quality. We empirically
test whether capital market participants utilize
the accounting information audited by assigned
auditors differently from that audited by freely
selected auditors.
Using over 4,000 firm-year observations
from 1994 to 2002, we find that investors
respond more favorably to positive earnings
audited by assigned auditors than to those
audited by non-assigned auditors. Negative
earnings, however, do not lead to significantly
different reactions. Capital market participants
appear to respond more favorably to the book
value of equity audited by assigned auditors
than to that audited by non-assigned auditors.
Our study extends prior research on the
impact of the auditor selection process on
earnings quality by testing whether such an
impact, if any, is reflected in the market value.
The results suggest that investors perceive
assigned auditors as more independent than
those who are freely selected. This paper also
adds to the literature on auditor conservatism. If
the policy objective of assigning auditors is to
make reported earnings closer to unobservable
true earnings, and if such an objective is
accomplished, then investors will respond more
to reported earnings audited by assigned
auditors than to those audited by non-assigned
auditors regardless of their sign. However, we
observe asymmetric responses to profits and
losses: investors perceive assigned auditors as
being different (more conservative) from
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non-assigned auditors only when reported
earnings are positive.
Assigned auditors may be perceived as more
effective than non-assigned auditors because the
former are more independent than the latter or
because the former expect more scrutiny by
authorities. This study does not distinguish
between these two possibilities. If, however, the
policy goal is to constrain aggressive reporting
by firms, then investors appear to believe that
auditor assignment accomplishes such a goal.
The remainder of the paper is organized as
follows. Section 2 provides institutional details
of the auditor assignment system in Korea.
Section 3 discusses the research method used,
while Section 4 describes the data. The
empirical results are presented in Section 5.
Finally, Section 6 concludes the paper.
2. Institutional Background
Korean audit market is similar to that of the
United States in many respects. Korean
accounting and auditing standards are
comparable to the U.S. standards, and the Big
Six audit firms audit a majority of the listed
firms in Korea applying similar audit programs
(Bae et al. 2004). There are, however, a few
important differences between the two systems.
In Korea, audit fees are much lower than in the
United States: the level of audit fees relative
to total assets of Korean firms is about 20-25%
of that of U.S. firms (Choi and Joo 1998).
Penalties for audit failures are also less severe in
Korea than in the United States. These factors
contribute to the notion that auditors in Korea
have fewer incentives to provide a high-quality
audit than do those in the United States.
In order to ensure audit quality, the SFC in
Korea introduced a system that authorizes it to
assign an auditor to a firm with certain
characteristics and to require the firm to retain
the auditor for up to three years. Specifically,
the SFC can assign an auditor if one of the
following occurs: a delay in auditor selection;
an improper change of auditor; violation of
GAAP; insufficient separation of ownership and
management; an excessive debt-to-equity ratio;
poor quality stock (traded on an “administrative
post”); excessive loans to management or
controlling stockholders; violation of the
Securities and Exchange Act; or a request by
the company or by the major creditor bank.
Assigned auditors are expected to be more
independent than non-assigned auditors for
several reasons. First, these auditors are not
chosen by their clients but are instead randomly
assigned to them. The SFC lists all the firms
subject to auditor assignment by their total
assets and lists auditors by their performance
measures, and then matches the first on the firm
list to the first on the auditor list, and so on.
Once an auditor is assigned to a firm, the firm
and the auditor are expected to complete an
audit engagement unless there are legitimate
reasons for not doing so. Second, once assigned
to a firm, an auditor is guaranteed to audit the
firm for up to three years unless the firm is not
subject to the auditor assignment requirement. If
the firm is still subject to the rule even after the
three-year period, then a new auditor is assigned
to replace the previous (assigned) auditor.
Bae et al. (2004) and Kim et al. (2004) find
evidence that firms with assigned auditors
report less discretionary accruals than do firms
with non-assigned auditors. This evidence
suggests that assigned auditors are more likely
to constrain aggressive reporting by firms than
are non-assigned auditors. It remains to be seen,
however, how the market perceives auditor
independence and the reliability of the financial
statements under the auditor assignment
system. In spite of the inconclusive evidence of
the effect of non-audit services on auditor
independence, the SEC changed its rule on
audits while emphasizing that investors’
perceptions of auditor independence are as
important as actual independence.
3. Research Design
To examine how the assignment of auditors is
perceived by investors and valued by the capital
market, we mainly follow the method used by
Core et al. (2003). Specifically, we regress the
market value of equity on the book value of
equity, the earnings level, and four proxies for
expected earnings growth. These growth
proxies are used to mitigate the loss in
explanatory power of the regression model
due to the lack of timeliness in accounting
information, as reported by Collins et al. (1997).
First, research and development expenditures
(RND) and advertising expenditures (ADVERT)
are included to capture expected growth in
earnings due to investments in intangible assets.
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Next, we include capital expenditures
(CAP_EX) to reflect expected growth in
earnings arising from new investments in
tangible assets. Finally, sales growth over the
previous year (SGROWTH) is included as an
additional proxy for expected earnings growth.
In addition to these independent variables,
we add two auditor assignment interaction
variables: one with the book value of equity
(ASGN*BVE) and the other with the earnings
level (ASGN*NI). These two interaction
variables are of major interest to us. If they are
significantly different from zero, it implies that
investors value the book value of equity or the
earnings audited by assigned auditors
differently from those audited by non-assigned
auditors.
The empirical model of interest is
MVE = ?
0
+ ?
1
(BVE) + ?
2
(NI) + ?
3
(NEG_NI)
+ ?
4
(RND) + ?
5
(ADVERT) + ?
6
(CAP_EX)
+ ?
7
(SGROWTH) +?
8
(ASGN*BVE)
+ ?
9
(ASGN*NI) + ?, (1)
where
MVE is the market value of equity measured at
the end of the fiscal year;
BVE is the book value of equity;
NI is the net income before extraordinary items;
NEG_NI is NI if NI is less than or equal to zero,
and 0 otherwise;
RND is research and development expenditures;
ADVERT is advertising expenditures;
CAP_EX is capital expenditures;
SGROWTH is the one-year change in sales; and
ASGN is 1 if a firm’s auditor is assigned, and 0
otherwise.
Following Core et al. (2003), we deflate
equation (1) by the book value of equity to
control for any differences that might be caused
by the different levels of book value of equity.
Therefore, the specification we use is
MVE/BVE = ?
0
(1/BVE) + ?
1
+ ?
2
(NI/BVE)
+ ?
3
(NEG_NI/BVE) + ?
4
(RND/BVE)
+ ?
5
(ADVERT/BVE)
+ ?
6
(CAP_EX/BVE)
+ ?
7
(SGROWTH/BVE) + ?
8
ASGN
+ ?
9
(ASGN*NI/BVE) + ?. (2)
The intercept in the unscaled model (1),
which explains economic variation in market
value not captured by other explanatory
variables, is transformed into the inverse of the
book value of equity in the scaled model (2), as
in Core et al. (2003).
4. Data
We obtain a sample of firms listed on the
Korean Stock Exchange over the period from
1994 to 2002 from publicly available sources.
The list of firms with assigned auditors is
announced by the SFC each year. We extract
financial statement items from the KIS-FAS
database, which contains financial statements of
Korean listed firms since 1980. We exclude
financial institutions from our sample because
these firms might have different price multiples
for book value and earnings from those of
manufacturing firms. Following Core et al.
(2003), we restrict our sample to firms with a
positive book value of equity. To mitigate the
effect of extreme values of the dependent
variable, we remove observations in the top and
bottom one-half percent of market to book
value of equity. Firms can voluntarily request
the SFC to assign auditors. Since voluntary
auditor assignment is not the focus of this paper,
such firms are excluded from our sample. Our
sample selection procedure results in a sample
size of 4,063 firm-year observations.
Table 1 lists the reasons for auditor
assignment and the number of observations for
each reason. Major reasons include insufficient
separation of ownership and management
(40%), excessive use of debts (28%), and
trading on an “administrative post” (18%).
Table 2 provides the sample distribution by
the type of auditor and by year. It also presents
the percentages of observations with negative
earnings. As expected, firms with assigned
auditors report negative earnings more
frequently than do firms with freely selected
auditors. Overall, 31.9% of firms with assigned
auditors report negative earnings while 20.2%
of firms with freely selected auditors report
negative earnings. This difference is statistically
significant at the 1% level with a t-value of
5.73. In each of the nine years in the sample
period, the percentage of firms reporting
negative earnings relative to total firms in the
group is higher for the group with assigned
auditors. The difference is statistically
significant at the 5% level in 1994, 2000, and
2002.
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Table 1
Number of Firms by Reason of Auditor Assignment
Reason of Auditor Assignment Number of Observations Percentage
Delay in auditor selection 5 1.1%
Improper change of auditor 5 1.1%
Violation of GAAP 19 4.3%
Insufficient separation of ownership and management 178 40.0%
Excessive loans to management 9 2.0%
Required by Industry Restructuring Act 17 3.8%
Excessive use of debts 124 27.9%
Trading on Administrative Post 80 18.0%
Required by Securities Exchange Act 2 0.5%
Required by Fair Trade Act 4 0.9%
Others 2 0.5%
Total 445 100.0%
Note: The sample includes firms whose auditors were assigned by the Securities and Futures Commission
(SFC) of Korea from 1994 to 2002. Firms can voluntarily request the SFC to assign auditors. There was
only one such case during the sample period. The observation was excluded from the final sample.
Table 2
Sample Distribution by Year and Type of Auditor, and
Percentage of Observations with Negative Earnings
Firms with Non-Assigned Auditors Firms with Assigned Auditors
Year
Number of
observations
% of
observations with
negative earnings
Number of
observations
% of
observations with
negative earnings
t-statistics for
difference
1994 355 9.6% 45 31.1% 4.27
*
1995 383 11.0% 38 18.4% 1.37
1996 388 14.2% 52 23.1% 1.68
1997 383 28.5% 64 29.7% 0.20
1998 337 29.7% 105 30.5% 0.16
1999 404 17.6% 38 28.9% 1.73
2000 443 21.0% 18 50.0% 2.93
*
2001 459 27.9% 29 41.4% 1.56
2002 466 20.8% 56 46.4% 4.34
*
Total 3,618 20.2% 445 31.9% 5.73
*
Note: t-statistics show the difference in percentage of negative earnings between non-assigned auditor firms and
assigned auditor firms.
* denotes significance at the 5% level.
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5. Empirical Results
To estimate the regression model, the
observations are pooled over the period from
1994 to 2002 and across firms. The main results
are reported in Table 3. In column (1) of
Table 3, which shows the results for the
regression model without assigned auditor
interaction terms, the signs of the estimated
coefficients are consistent with previous
research. All independent variables except sales
growth have statistically significant coefficients.
The adjusted R-squared is 34.3%. These results
and the magnitude of the coefficients are
comparable to those reported by Core et al.
(2003), even though they report a significant
coefficient for sales growth and an insignificant
coefficient for advertising expenditures.
The coefficient for negative earnings is
Table 3
Regression Results for Full Sample
MVE/BVE = ?0 (1/BVE) + ?1 + ?2(NI/BVE) + ?3(NEG_NI/BVE) + ?4(RND/BVE) + ?5(ADVERT/BVE)
+ ?6(CAP_EX/BVE) + ?7(SGROWTH /BVE) +?8(ASGN) + ?9(ASGN*NI/BVE)
+ Year Dummies + ?
Variables
(1)
Coefficients
(t-statistics)
(2)
Coefficients
(t-statistics)
Intercept 0.385
(13.30)
*
0.378
(13.01)
*
1/BVE 5.284
(22.09)
*
5.204
(21.5)
*
NI/BVE 0.348
(7.28)
*
0.346
(7.23)
*
NEG_NI/BVE -0.359
(-7.40)
*
-0.358
(-7.38)
*
RND/BVE 3.709
(8.02)
*
3.723
(8.00)
*
ADVERT/BVE 0.553
(6.52)
*
0.531
(6.24)
*
CAP_EX/BVE 0.079
(2.40)
*
0.073
(2.21)
*
SGROWTH/BVE 0.002
(0.81)
0.002
(0.80)
ASGN
0.105
(3.23)
*
ASGN*NI/BVE
0.024
(0.56)
Adj. R2 34.3% 34.5%
* denotes significance at the 5% level. Coefficients of year dummies are omitted.
Variable definitions are as follows:
MVE is the market value of equity.
BVE is the book value of equity.
NI is the net income before extraordinary items.
NEG_NI is NI if NI is less than or equal to zero, and 0 otherwise.
RND is research and development expenditures.
ADVERT is advertising expenditures.
CAP_EX is capital expenditures.
SGROWTH is the one-year change in sales.
ASGN is 1 if a firm’s auditor is assigned, and 0 otherwise.
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statistically significant and negative. Core et al.
(2003) interpret this result as suggesting that
“stock prices reflect expectations by investors
that large losses precede higher future cash
flows than small losses, possibly due to the
transitory nature of large losses.” The intercept,
which is the coefficient of the book value of
equity in the undeflated regression equation (1),
is highly significant with a t-value of 13.3.
This result, indicating a positive effect of the
book value of equity on the market value, is
consistent with expectations and with the results
of other studies such as Collins et al. (1999).
Overall, column (1) shows that the book value
of equity and earnings are positively related to
the market value of equity, as Ohlson (1995)
suggests.
In column (2), the coefficient of ASGN — an
auditor assignment interaction term with the
book value of equity in the undeflated model —
is positive and statistically significant. The
effect of the book value of equity on the market
value is greater for the firms with assigned
auditors than for the firms with non-assigned
auditors. This result implies that the capital
market perceives the book value of equity as
having a higher quality when verified by
an assigned auditor than when verified by a
non-assigned auditor.
Surprisingly, the coefficient of
ASGN*NI/BVE, the interaction term between
auditor assignment and earnings, is not
statistically significant. This seemingly
perplexing result may be due to the high
incidence of negative earnings for firms with
assigned auditors. As Table 2 shows, firms with
assigned auditors are more likely to report
negative earnings than are firms with non-
assigned auditors. Previous studies have
documented different valuations of positive and
negative earnings. For example, Ohlson (1995)
and Collins et al. (1999) show that the book
value of equity plays a more prominent role in
valuations of firms with negative earnings than
it does in valuations of firms with positive
earnings. Barth et al. (1998) report that investors
put more weight on the book value of equity in
valuations as the financial health of firms
deteriorates while they put less weight on
negative earnings under such conditions.
Therefore, to the extent that NEG_NI does not
fully control for the different relations between
the market value and negative earnings, the
results in Table 3 may not reveal the true
relation between the market value of firms and
accounting information. To further probe the
role of the sign of earnings in the market
perception of assigned auditors, we perform the
same analysis as in Table 3 separately for the
firms with positive earnings and again for the
firms with negative earnings.
Table 4 presents the results for our regression
model comparing the firm-years with positive
earnings (column 1) and those with negative
earnings (column 2). The signs, magnitudes,
and statistical significance of the coefficients of
the explanatory variables in column (1) of Table
4 are comparable to those in the full sample
case shown in Table 3. The remarkable
difference between the positive earnings case
and the full sample case is the interaction
term between auditor assignment and earnings,
ASGN*NI/BVE. The coefficient of the
interaction term is highly significant in the
positive earnings case shown in Table 4, which
is different from the non-significant result in the
full sample case shown in Table 3. This
suggests that, when a firm reports positive
earnings, the earnings are perceived by the
market as being more valuable if they are
audited by an assigned auditor than if they are
audited by a non-assigned auditor. The
coefficient of ASGN, representing an interaction
term between auditor assignment and the book
value of equity, however, is insignificant in
column (1). This suggests that investors in this
case put the same weight on the book value of
equity in valuations regardless of whether the
book value is audited by assigned auditors or by
non-assigned auditors.
Column (2) of Table 4 presents the results
for firms with negative earnings. The overall
significance of most variables drops. The
intercept (representing the book value of
equity), earnings, research and development
expenditures, and advertising expenditures lose
significance considerably. This confirms the
results of prior research that valuations of
positive earnings and negative earnings are
fundamentally different (e.g. Hayn 1995, Basu
1997, Collins et al. 1997).
Most notably, earnings lose significance; that
is, when earnings are negative, they have little
impact on market valuation. This result is
consistent with the view that negative earnings
are not a useful source of information about
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Table 4
Regression Results for Positive Earnings Firms and
Negative Earnings Firms
MVE/BVE = ?0 (1/BVE) + ?1 + ?2(NI/BVE) + ?4(RND/BVE) + ?5(ADVERT/BVE) + ?6(CAP_EX/BVE)
+ ?7(SGROWTH /BVE) +?8(ASGN) + ?9(ASGN*NI/BVE) + Year Dummies + ?
Variables
(1)
Firms with
Positive Earnings
Coefficients
(t-statistics)
(2)
Firms with
Negative Earnings
Coefficients
(t-statistics)
Intercept 0.363
(11.72)
*
0.403
(5.55)
*
1/BVE 4.569
(13.37)
*
6.090
(14.8)
*
NI/BVE 0.310
(6.53)
*
-0.008
(-1.04)
RND/BVE 4.660
(7.98)
*
2.259
(2.68)
*
ADVERT/BVE 0.638
(6.43)
*
0.192
(1.11)
CAP_EX/BVE 0.049
(1.14)
0.166
(2.86)
*
SGROWTH/BVE 0.003
(0.43)
0.000
(0.02)
ASGN -0.000
(-0.00)
0.180
(2.30)
*
ASGN*NI/BVE 0.580
(2.26)
*
0.000
(0.01)
Adj. R2 34.8% 36.2%
Column (1) includes regression results for firms whose earnings are greater than or equal to 0.
Column (2) includes regression results for firms whose earnings are less than 0.
* denotes significance at the 5% level. Coefficients of year dummies are omitted.
Variable definitions are as follows:
MVE is the market value of equity.
BVE is the book value of equity.
NI is the net income before extraordinary items.
RND is research and development expenditures.
ADVERT is advertising expenditures.
CAP_EX is capital expenditures.
SGROWTH is the one-year change in sales.
ASGN is 1 if a firm’s auditor is assigned, and 0 otherwise.
firms’ future earnings. Negative earnings cannot
persist in the future since shareholders have a
liquidation option. The significance of negative
earnings does not improve much even when the
earnings are audited by assigned auditors, which
is reflected in the insignificant coefficient of
ASGN*NI/BVE. Investors do not appear to take
into account negative earnings regardless of
whether the earnings numbers are audited by
assigned auditors or by client-selected auditors.
In contrast, the intercept in column (2) is
significant, as shown in Table 3, implying that
the book value of equity is still perceived by the
market as valuable even when earnings are
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negative. The coefficient of ASGN in column
(2) is also significant. These results suggest that
the perceived value of the book value of equity
increases when accounting numbers are audited
by assigned auditors. This is consistent with the
results of Barth et al. (1998) and Collins et al.
(1999).
When auditors are assigned by government
authorities, if these auditors are as competent as,
and have as much integrity as, other auditors,
we expect them to behave in two ways:
assigned auditors would be more independent
than non-assigned auditors, while assigned
auditors would be more conservative than non-
assigned auditors.
If assigned auditors are more independent
than non-assigned auditors, then one would
expect the accounting numbers, say earnings,
audited by the former to be closer to
(unobservable) the true numbers than those
audited by the latter, everything else being
equal. In other words, earnings audited by
assigned auditors would be more truthful
regardless of whether they were positive or
negative. The market reactions to earnings
audited by assigned auditors would then be
stronger than to those audited by non-assigned
auditors regardless of the sign of the earnings.
However, it is also possible that assigned
auditors are more conservative; that is, they
understate positive earnings and overstate
losses. Prior research documents that auditors
tend to be conservative, or income decreasing.
3
If the earnings audited by assigned auditors are
rather more conservative than truthful, the
3 Several studies document auditor conservatism. For
example, Francis and Krishnan (1999) observe that
auditors for high-accrual firms compensate for the
additional risk exposure by lowering thresholds for
issuing modified audit reports. Enforcement actions by
authorities such as the U.S. Securities and Exchange
Commission (SEC) may also lead to auditor
conservatism. Bannister and Wiest (2001) provide
evidence consistent with the notion that client firms have
more income-decreasing accruals during the period that
their auditor is subject to an investigation related to an
SEC enforcement action. Kim et al. (2003) suggest that
Big Six auditors are more (less) effective than non-Big
Six auditors in deterring income-increasing (income-
decreasing) accruals. Chung et al. (2003) find that Big
Six auditors appear to influence their clients to use more
conservative accounting than do non-Big Six auditors
when the clients’ financial performance is worse than
expected.
magnitude of market reactions to positive
(negative) earnings audited by assigned auditors
would be larger (smaller) than that to positive
(negative) earnings audited by non-assigned
auditors, and the magnitude of market reactions
to positive earnings would be different from that
to negative earnings.
The results of this paper — that there would
be a more favorable reaction to positive
earnings by assigned auditors than by non-
assigned auditors, and that there would be an
insignificant reaction to negative earnings
regardless of whether they are audited by
assigned auditors or non-assigned auditors —
are more consistent with the “conservatism”
view. The result that negative earnings do not
lead to significantly different reactions is also
consistent with the notion that capital market
participants perceive losses as temporary.
Auditors are assigned to firms for several
reasons, as Table 1 shows. It may be possible
that a group of firms whose auditors are
assigned for a specific reason drives the results
of this paper. To check the robustness of the
results, we repeat the same regression analysis
separately for the two major groups that account
for more than two-thirds of the firms with
assigned auditors. The regression results are
qualitatively similar to the results with the
whole sample. For example, when we run a
regression similar to that shown in Table 3 with
only the firms whose auditors are assigned due
to “insufficient separation of ownership and
management,” the coefficients of ASGN and
ASGN*NI/BVE are 0.217 with a t-value of 4.73
(significant at the 1% level) and -0.059 with a
t-value of -0.36, respectively. As for the firms
assigned auditors for “excessive use of debts,”
the coefficients of ASGN and ASGN*NI/BVE
are 0.126 with a t-value of 2.10 (significant at
the 5% level) and -0.038 with a t-value of -0.26,
respectively.
6. Conclusion
Recent accounting scandals in the United
States and other countries have made
investors seriously doubt the credibility of
accounting information. Impairment of auditor
independence is considered one of the most
important contributing factors. In response,
regulatory authorities have modified accounting
and auditing systems to secure auditor
independence and improve the quality of
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ACCOUNTING RESEARCH JOURNAL VOLUME 20 NO 1 (2007)
46
financial reporting. This study empirically tests
how capital market participants “perceive” the
system that assigns auditors to firms when audit
independence is not assured.
We document that two factors affect
investors’ perceptions about the relation
between the market value of firms and the book
value of equity and earnings: whether the
auditor is assigned or not, and whether the
earnings are positive or negative. The results
suggest that capital market participants respond
more favorably to positive earnings audited by
assigned auditors than to those audited by non-
assigned auditors. Negative earnings, however,
fail to produce significantly different reactions.
For firms with negative earnings, investors
place more weight on the book value of equity
audited by assigned auditors than that audited
by non-assigned auditors. We interpret these
results as implying that auditor assignment may
enhance auditor independence in appearance,
and thereby increase the reliability of financial
statements as perceived by investors.
Our results may be useful for regulatory
bodies in other countries that are considering
a change in the auditor selection mechanism
to improve auditor independence. However,
one should be careful in generalizing the
implications of the results because the results of
this study may be caused by the uncontrolled
characteristics of firms with assigned auditors.
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This article has been cited by:
1. Dong Heun Lee, Seon Mi Kim, Kwang Wuk Oh, Seung Weon Yoo. 2013. New Auditors’ Decisions for Released Firms
from the Mandatory Auditor Designation Rule: Evidence From South Korea. Australian Accounting Review 23:10.1111/
auar.2013.23.issue-4, 341-356. [CrossRef]
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