Effects of agency costs on the relationship of corporate governance with audit quality and accounting conservatism in the Korean audit market

Abstract

This study examines the effects of agency costs (AC) on the relationship of corporate governance with audit quality and accounting conservatism. We employ audit hours and audit fees as proxies for audit quality, and accounting conservatism as a proxy for financial reporting quality. We find that the positive relation between corporate governance and audit quality is attenuated in the presence of AC. We also document that AC tend to weaken the negative relation between corporate governance and accounting conservatism. These results demonstrate that the relationship of corporate governance with audit quality and accounting conservatism is conditional on AC.

Keywords:

• corporate governance
• audit hours
• audit fees
• accounting conservatism
• agency costs

JEL Codes:

• M41
• M42

Acknowledgments

The authors are grateful for valuable comments from participants at the Journal of Contemporary Accounting and Economics (JCAE) Symposium 2012 in Kuala Lumpur, at the 2012 AAA annual conference in Washington DC, Jung Hwa Lee at Australian National University, two anonymous reviewers, and Agnes Cheng (Editor) at the Hong Kong Polytechnic University.

Notes

1. Chen, Elder, and Hsieh (2011) found that firms with independent directors are associated with lower incidence of earnings restatements.

2. The KCGS is an independent nonprofit organization under the joint sponsorship of six securities-related organizations in Korea.

3. Abbott et al. (2003) and Goodwin-Stewart and Kent (2006) found that firms with independent audit committees and/ or strong accounting and finance expertise are likely to demand a high level of assurance and support the auditor’s demand for more testing, resulting in increased audit fees.

4. Hu et al. (2012) found that the severity of agency problem would increase with the increasing distance of the layer from the listed companies to the ultimate owners, and results in increased audit fees due to the audit risk.

5. Black, Jang, and Kim (2006), Park, Park, and Hwang (2005), Yoon and Oh (2005), and Choi and Yoon (2006) used the same data-set, but they examined only the one-year cross-sectional data provided by the KCGS.

6. Shareholders’ primary interest is to get what they deserve via dividend payments (and capital gains). Distributing excess cash flows to shareholders in the absence of attractive investment opportunities constitutes the most fundamental device that alleviates conflicts between corporate insiders and external stockholders (Jensen and Meckling 1976). Sound corporate governance systems at work can facilitate wealth redistribution process (La Porta et al. 2000).

7. We redo all the conservatism regressions using the Dichev–Dechow model (2002), Basu model (1997), and Givoly and Hayn model (2000). The results remain qualitatively unchanged.

8. According to Black, Jang, and Kim (2006), since Korean government reformed the corporate governance systems of large firms with assets of more than 2 trillion won, the asset size dummy can be an ideally exogenous variable under Korean law. For a more detailed explanation, see Black, Jang, and Kim (2006). Another motive for using an asset size dummy is that prior study already provides evidence of the meaningful differences between small firms and large firms classified by a 2 trillion won assets dummy.

9. KIS is a professional credit rating agency in Korea. Its database includes financial statement information.