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. (The rest omitted)
The first and third authors are at the School of Accounting and Finance, Faculty of Business, The Hong Kong Polytechnic University, Hung Hom, Kowloon, Hong Kong. The second author is at the Department of Economics, The Hankuk University of Foreign Studies, Seoul, Korea. The research is partially funded by the Hong Kong Polytechnic University. We have received useful comments from Kwan Choi, Michael Firth, Dan Simunic, and workshop participants of The Hong Kong Polytechnic University, University of British Columbia, City University of Hong Kong, Korea University, the 2002 AAAA Annual Conference and the 2003 AAANZ Annual Conference. The usual disclaimer applies.