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2024 Feb/05
Effect of Mandatory Auditing of Internal Control over Financial Reporting on Preventing Fraud in the Korean Capital Market Research Papers 24-03 PDF
Jung Tae Jin
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Kang Chang Hee
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Since 2019, Korea has strengthened the external verification of the effectiveness of internal control systems following the amendments to the External Audit Act. To be more exact, the verification level of the internal control over financial reporting(hereafter, ICFR) was raised from 'review' to 'audit' for listed companies with total assets of more than 2 trillion KRW. Despite the effort, there have been several large-scale embezzlement cases where the internal control system has been overrode at firms and government agencies, such as Osstem Implants and Woori Bank. Based on these events, it seems necessary to examine the effect of mandating an audit of ICFR. Furthermore, we intend to gain a comprehensive understanding of the regulation and how it should be pursued.

This study aims to investigate the effect of the mandatory audit of ICFR, introduced in 2019, in deterring the likelihood of corporate fraud, especially regarding embezzlement and breach of trust. In addition, this report intends to identify improvement measures for the effective operation of the advanced internal control system. We thereby evaluate the effectiveness of the current system and provide policy implications supported by empirical evidence.

First, we compare Korea's intensified internal control system with those of the United States and Japan and find that Korea's internal control system is the most stringent in terms of procedural rigor. However, among the significant weaknesses of the internal accounting control system, a high proportion of cases fell under the category of "insufficient funds," indicating the need for improvement of the effectiveness of ICFR.

Next, we examine the trend of embezzlement and breach of trust before and after the mandatory audit of ICFR using the staggered difference-in-differences model. We find that the incidence of embezzlement and breach of trust in the overall capital market has been declining since 2019, and the decline has been more pronounced among companies with total assets of more than 2 trillion KRW, which were initially subject to the mandatory audit of ICFR. This suggests that the regulatory reformation that reinforced the assurance level of the ICFR from 'review' to 'audit' may have the impact of enhancing the effectiveness of the internal control system and deterring the occurrence of fraud.

Based on the empirical results, this study suggests several policy implications for a more effective internal control system. First, it is necessary to further refine and quantify the sentencing guidelines for large-scale embezzlement cases to deter employees' motivation to commit violations. Next, it is necessary to grant tax benefits to ease the cost burden of designing and implementing the ICFR for a limited period. Furthermore, the incentives for executives and employees to actively contribute to the effective operation of the ICFR and to whistle-blowing need to be expanded.