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Market Measures Under New Audit Environment: Current State and Implications
2020 Mar/31
Market Measures Under New Audit Environment: Current State and Implications Mar. 31, 2020 PDF
Summary
Since Korea strengthened its external audit regulation, there has been a jump in non-clean audit opinions on listed companies. As those audit opinions could lead to delisting from the market, concerns are mounting over a possible auditing crisis when audited financial statements are released. An analysis on administrative issues designated in 2019 reveals that auditors issue non-clean opinions primarily due to an auditee’s failure to submit sufficient and appropriate evidence for major transactions, and weak internal controls. To alleviate the frequent administrative issues, effort is needed to ensure completeness of financial statements throughout the entire accounting cycle. This requires self-imposed measures by those charged with governance, as well as focused support by policy authorities.
Since the amended Act on External Audit of Stock Companies took effect in November 2018, financial auditing has faced a new environment. Among others, the amended Act granted stronger independence to auditors than ever before by introducing two systems—standard audit hours and mandatory auditor designation. Such changes mainly result from policy authorities’ drastic measures against a series of large-scale accounting frauds in 2013 involving Daewoo E&C, Moneual, and DSME, to name a few. Those policy measures have brought about immense changes in Korea’s accounting environment. It’s only two to three years ago when the industry was concerned over audit fee lowballing, but the major concern now is a surge in audit fees.1)  Another change worth noting is a toughening of sanctions against shoddy auditing. 

As policy authorities and auditors are striving to enhance the quality of auditing, concerns are mounting over an increase in stock market measures such as the designation of administrative issues, trading suspension, listing eligibility review, etc.2) Those in concern point out that under tougher auditing regulation more firms are likely to receive non-clean (qualified, adverse, or disclaimer) audit opinions and thus to be exposed to excessive risk of being delisted. Those concerns are being echoed even by investors who benefit the most from enhanced transparency of accounting. Investing during audit seasons, according to them, could be risky because audit opinions are hardly predictable. With regard to this, this article tries to figure out whether the recent change in Korea’s auditing environment risks even sound firms being driven out of the market, and then discusses the need for policy improvements to the issue.


Administrative issue designation on the rise

Among the listed stocks, there has been a steady increase in the number of administrative issues since 2016 (Figure 1). For the causes of being designated as administrative issues, non-clean audit opinions increased significantly while a slight decrease was seen in earnings-related reasons such as long-term operating loss, massive loss from continuing operations, etc. Among the stocks designated as administrative issues between 2010 and 2018, about 25% received non-clean audit opinions. But the figure shot up to 49% after the amended Act on External Audit of Stock Companies took effect in 2019. Notably, the cases of designation sharply rose in audit seasons: Auditors issue their audit opinion for the previous year’s annual report in March and for a semi-annual report in August. A listed firm that receives a non-clean audit opinion will be delisted unless it gets an unqualified opinion in the subsequent year.
  

   
 
Lack of information leading to non-clean audit opinions

In 2019, almost half of administrative issues received non-clean audit opinions. This evidences the concerns about tougher auditing standards driving firms out of the stock market. However, the above figure alone cannot prove that excessive audit procedures are a primary cause of a more number of administrative issues. To reach a reasonable conclusion, it’s necessary to figure out why auditors issued non-clean audit opinions, and whether those opinions were sufficiently corroborated. 

For a qualitative approach, I examined all of the 66 stocks that were designated as administrative issues due to non-clean audit opinions in 2019 (Table 1). In most cases, firms failed to present corroborating evidence to support their accounting decisions. In one listed company, for example, about 74% of assets were derivatives instruments whose recoverability was insufficiently supported. The firm’s current liabilities were 19.83 times higher than current assets, with the debt to equity ratio of 323%. Due to limitation on the scope of audit, the auditor issued a qualified opinion as follows: 

“We were unable to obtain sufficient and appropriate audit evidence regarding the collectible amounts of bonds with warrant and convertible bonds that were issued by affiliated parties and acquired by the client firm. This made us unable to decide whether the recognized value needs adjusting or not (…)”

 More concretely, about 11% of audit findings are regarding new accounting standards - IFRS 9 Financial Instruments, IFRS 15 Revenue from Contracts with Customer, IFRS 16 Lease, etc. Most cases are found to involve the auditee firm’s failure to corroborate the amounts in the financial statements, rather than a conflict between the auditor and the auditee in interpreting accounting standards. Although some of the cases are regarding estimations used in some accounts, accounting judgements were not the main issue. More often than not, the problem was the auditor’s failure to acquire corroborating evidence that is necessary for carrying out an audit. 

Among non-clean opinions, about 44% of the cases were regarding a doubt about a firm’s ability to continue as a going concern. Setting aside other reasons such as insufficient evidence, five cases fall under this category. What’s notable is that those cases are also associated with actual credit events, e.g., capital impairment, massive losses, bankruptcy filing, the commencement of rehabilitation procedures, substantial defaults, etc. 

Also pronounced is that 32% of the cases had findings about transactions between a firm’s affiliated parties and its subsidiaries. In one case, a firm with equity capital of KRW 10 billion provided the affiliate a short-term loan worth of billions of Korean won, and then wrote off the entire amount from its books in the same fiscal year. Although such a transaction is hardly likely in a fair deal between independent third parties, the firm failed to provide any corroborating evidence to back up the transaction. Also found in the audit procedure was the lack of internal accounting controls that are supposed to be in place to monitor the whole transaction cycle.
   

   
 
Requirements on long-term operating losses need revisiting

A more in-depth look at why firms receive non-clean audit opinions shows the necessity for those charged with governance having to devise self-imposed measures to enhance accounting quality from the book entry stage. Furthermore, it’s important to link two facts together. First, many audit findings are regarding transactions between a firm’s related parties and subsidiaries. Second, the KOSDAQ market rule designates firms with operating losses for four consecutive years as an administrative issue. Operating losses for five consecutive years constitute a delisting criterion, and the operating loss here is determined based on stand-alone, not consolidated, financial statements. Even if one affiliated firm incurs operating losses, it can simply turn the loss into profit in its financial statements by forcing its subsidiaries to buy its services or products. Such a detour doesn’t constitute as a reason for administrative issue designation.      

Indeed, there has been a steady decrease in the percentage of firms reporting stand-alone operating losses among KOSDAQ-listed firms reporting consolidated operating losses for four consecutive years (Figure 2). The figure recorded 91% in 2008 when the rule first came into effect in 2008, but it later fell to 52% as of 2018. This arguably raises a suspicion that listed firms are trying to avoid administrative issue designation by abusing their power over affiliates or subsidiaries. Among KOSDAQ-listed firms that reported stand-alone operating losses for four consecutive years to be designated as an administrative issue, about 86% also reported consolidated operating losses for four consecutive years (Figure 3). This makes a stark contrast where such a systematic gap between consolidated and stand-alone operating losses never exists in KOSPI-listed firms sitting outside the 4-year operating loss rule. 

On top of altering the timing of a firm’s recognition of revenues or losses, an earnings management based on actual economic activity has an adverse impact on the firm’s long-term performance.3) Auditors should be more meticulous about any ill-founded effort firms make to turn to a regulatory loophole and neuter the market’s early warning system. Also notable is that the amended Act mandates an auditor to be designated for a firm reporting consolidated operating loss for three consecutive years. In line with that, the Korea Exchange should reconsider changing the long-term operating loss rule from the current stand-alone base to a consolidated base, which will enhance supervisory and regulatory consistency. 
 

 
 
Stronger oversight over leakage of audit opinions

An analysis of returns on administrative issues for 21 trading days including ten days before and after designation and the date of designation in 2019 (Figure 4) shows an 11.5% cumulative loss from stocks that received  non-clean audit opinions. This is widely different from the 2.54% cumulative loss from other stocks designated as administrative issues.4) Different from other requirements for administrative issue designation such as financial ratios and stock price levels, audit opinions are highly unpredictable and thus could lead to a particularly high market shock.

What’s important in this analysis is that the prices of stocks began falling abruptly four days before receiving non-clean audit opinions and being designated as administrative issues. This requires supervisory authorities to monitor those firms and the market more thoroughly to find out signs of abnormal trading arising from any leakage of audit opinions. 

Unfortunately, there’s no proper strategy investors could turn to when their investment is designated as an administrative issue due to a non-clean audit opinion. Past data show that an administrative issue on average sees its short-term low on the next trading day after designation, and a series of limited rebounds up to five trading days after designation. However, it’s important to be wary of the pitfalls of average. Among those firms, eight firms in 2019 voluntarily chose to be reaudited, finally receiving an unqualified audit opinion. Also notable is a regulatory change: Starting from 2019, the immediate delisting of a stock with a non-clean opinion could be deferred, which made the average return on administrative issues higher than before during the period. Moreover, half of the firms with administrative issues recorded market-excess returns. This reminds investors of the need to go over the audit report carefully and make prudent decisions, rather than being swayed by short-term volatility. 
 

 
 
Conclusion and implications

Recently, a drastic change took place in Korea’s external audit regulation with the aim to enhance accounting transparency. However, the whole industry is now exhausted by a wide array of new measures being implemented simultaneously, e.g., standard audit hours, periodic auditor designation, more conditions for auditor designation, auditor registration, m  andated auditing of internal controls over financial reporting, stronger rights for those charged with governance, etc. It’s unfortunate that those changes took effect in an all-at-once-manner because it’s hard to precisely assess the positive and negative effects of each measure. However, such a haste is somewhat understandable in view of Korea’s crave for more reliable accounting information.  

Admittedly, more stringent auditing came to increase the number of firms receiving non-clean audit opinions, and also market measures leading to delisting, e.g., designation of administrative issues, listing eligibility review, etc. A closer look at the reasons behind non-clean audit opinions, however, signals an imminent need for action by those charged with governance towards higher quality of financial statements. For individual firms that are unable to make such effort, policy authorities should think about how to provide effective assistance.
 
Among the requirements for administrative issue designation, the rule on stand-alone operating loss needs revisiting as it’s possibly circumvented by failing firms. On another front, supervisory authorities should also carry out thorough monitoring to identify any unfair trade involving a leak of audit-related information.

Capital market innovation is neat at hand. Creating a market well-trusted by investors will inarguably help investments seamlessly flow into innovative firms with growth potential. In this regard, independence in auditing is an essential tool to alleviate information asymmetry between the management and external investors. 
 
1)  Korea Economic Daily, June 3, 2019, A surge in audit fees leads to fears of the new External Audit Act; 
Mail Business Newspaper, February, 18, 2020, Listed companies poised for collective action against excessive audit fees.
2)  Korea Economic Daily, January 13, 2019, An auditing crisis ahead; Joseilbo, August 21, 2019, More stringent auditing, more administrative issues, more delisting?; Money Today, February 19, 2020, A March auditing turmoil with audit opinions at the previous levels?
3)  Chun, H.M. & Cha, S.M (2012), Real earnings management and cost of equity capital: Evidence from Korean firms, Journal of Taxation and Accounting 13(1): 99-130.
4)  Cumulative losses were computed by measuring three-factor abnormal returns taking into account market, firm size, and growth factors. Standardized t-statistics stood at –4.64 and -1.11, respectively. The 11.5% cumulative loss is found significant at the 1% level, whereas the 2.54% cumulative loss is statistically insignificant (to a level of 10%).