High investor sentiment and initial engagement discounts: evidence from Korea

ABSTRACT

This study examines whether high sentiment affects auditors’ risk assessment in a less litigious environment. Specifically, we use a Korean setting with relatively low litigation risks and investigate whether audit fees are lower when firms change auditors during high sentiment times. Lower audit fees responding to high sentiment in a weak legal environment may indicate that auditors perceive the overall audit risk including reputation risk and regulation risk as low within the given period, increasing the possibility of their failure to detect managerial opportunistic behaviour. Using 17,469 Korean public firm-year observations from 2003 to 2017, we find that initial audit fees are significantly lower when investor sentiment is high, while changing auditors has no influence on audit fees when investor sentiment is low. Furthermore, this result is maintained even when auditors are changed to Big4 or industry specialist auditors (SPEC), which are known to have high ability and risk sensitivity. We also find that Big4 and SPEC initial auditors input significantly less audit hours during high investor sentiment periods, suggesting that optimistic bias caused by high sentiment makes auditors expect that relaxed audits are tolerable regardless of the legal environment.

KEYWORDS:

• High investor sentiment
• initial engagement discounts
• audit fees
• audit hours
• auditor change type

JEL CLASSIFICATION:

• M42
• G14

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

¹ Investor sentiment is defined ‘as a belief about future cash flows and investment risks that is not justified by the facts at hand,’ and indicates investor optimism or pessimism (Baker and Wurgler 2007).

² ‘Litigation risk exposes auditors to financial penalties, while reputation risk impairs the ability to attract and retain clients. Regulation risk is the threat of regulatory intervention, which subjects auditors to sanctions that include fines and criminal penalties.’ (DeFond and Zhang 2014, 296).

³ Professional duty view argues that auditors spend more audit hours to reduce audit risks to an acceptable level in high sentiment periods, which leads to higher audit fees. In contrast, commercial incentives view suggests that auditors predict lower litigation risk due to investor inattention in high sentiment times, resulting in lower audit fees (Amin, Eshleman, and Guo 2021a).

⁴ Korean audit fees are about 90%, 70%, 40% lower than those of the US, Japan, and China, respectively (Kwon and Kim 2019). Korean government has made efforts such as establishing standard for appropriate audit hours to ensure auditors’ independence and to improve audit quality (Korea Herald 2018).

⁵ This study examines the effect of high sentiment on initial discounts by estimating Equation (7)(7) $\begin{array}{rl}& LNA{F}_{i,t}={\alpha }_1+{\beta }_{1}CHANG{E}_{i,t}+{\beta }_{2}SIZ{E}_{i,t}+{\beta }_{3}RO{A}_{i,t}\\ & +{\beta }_{4}LE{V}_{i,t}+{\beta }_{5}B{M}_{i,t}+{\beta }_{6}INVRE{C}_{i,t}+{\beta }_{7}QUIC{K}_{i,t}\\ & +{\beta }_{8}NEWFI{N}_{i,t}+{\beta }_{9}LOS{S}_{i,t}+{\beta }_{10}BIG{4}_{i,t}+{\beta }_{11}SPE{C}_{i,t}\\ & +{\beta }_{12}OPI{N}_{i,t}+{\beta }_{13}ACCLA{G}_{i,t}+{\beta }_{14}KOSDA{Q}_{i,t}\\ & +{\beta }_{15}DS{G}_{i,t}+YEAR+IND+{\epsilon }_{i,t}\end{array}$(7) for the high sentiment sub-sample. However, the empirical results of the full sample (high and low) and the low sentiment sub-sample are also presented in Table 3 for comparison.

⁶ The Korean public stock market is divided into two main categories: Korea Stock Price Index (KOSPI) and Korea Securities Dealers Automate Quotation (KOSDAQ). The KOSDAQ contains small- and mid-sized firms, and the KOSPI contains relatively larger-sized firms based on more complex listing requirements.