[Viewpoint] The New External Audit Act and Corporate Financial Reporting Transparency

Recently, the KOSPI has surpassed 2700 points, and it is expected to rise to even higher levels next year. The development of a country's capital market is an indispensable factor for national progress, but it is frequently pointed out that South Korea's capital market is undervalued. Experts attribute this to backward corporate management activities, low levels of financial reporting transparency, and corporate-unfriendly systems and laws.

Since the late 1990s foreign exchange crisis, South Korea has introduced institutional and legal policies from the early 2000s to improve corporate governance and enhance financial reporting transparency. The outside director system and audit committee system were introduced, and the "Act on External Audit of Stock Companies" (hereinafter referred to as the External Audit Act) was applied. Additionally, a securities class action system was introduced as a means to compensate for losses caused by managerial decisions that infringe on shareholder interests. In 2011, international accounting standards were fully adopted for listed companies, followed by the introduction of new international auditing standards.

However, despite the introduction of such institutional and legal policies, accounting transparency in South Korea has rather deteriorated. According to the country-by-country accounting transparency evaluation by the Swiss International Institute for Management Development (IMD), based on corporate board supervisory effectiveness and audit adequacy, South Korea ranked 41st out of 63 countries in 2012, dropped to 58th in 2013, and plummeted to the lowest rank of 63rd in 2017. This worst accounting transparency rating, despite the institutional and legal policies introduced since the early 2000s, is the result of exploiting loopholes in corporate management and financial reporting audit environments. For example, recent statistics and research show that outside directors appointed to improve governance have almost completely lost their deliberation and check functions on board agendas, with unanimous approval of board agendas becoming customary. In the case of internal accounting control systems, as seen in frequent accounting fraud cases among large business groups, they have not been operated under independent authority and responsibility. Small and medium-sized enterprises have not been able to establish and operate effective internal accounting control systems due to the costs of system construction and management as well as a lack of appropriate personnel.

South Korea's national competitiveness ranking also fell from around 22nd in the early 2010s to 28th in 2019. Issues such as corruption in institutional, corporate, and social conditions, as well as managerial trustworthiness in business activities, were highlighted in evaluations of government efficiency and corporate efficiency. To improve this decline in national competitiveness and the lowest-tier accounting transparency, the government fully revised the External Audit Act in October 2017 (hereinafter referred to as the New External Audit Act) and announced plans to implement it comprehensively for all companies subject to the External Audit Act by 2024. The New External Audit Act entails significant changes across the entire system, from the operation of internal accounting control systems to external financial reporting audits and post-accounting supervision. The reporting responsibility of a company's top management regarding the operation status of internal accounting control systems has been strengthened, and the evaluation of internal accounting control systems has been upgraded from review to audit. The appointment of external auditors has shifted from company management to the audit (committee). For listed companies, a periodic designation system has been introduced, mandating that after a maximum of six consecutive years of audit, the external auditor must be changed to a designated auditor appointed by financial authorities, limiting the risk of poor audits due to collusion between companies and auditors. The scope of designation reasons has been significantly expanded to include companies with frequent management changes and those with deteriorating financial conditions.

As the New External Audit Act has been implemented and gradually expanded, South Korea's accounting transparency ranking improved from 62nd in 2018 to 46th in 2020. The New External Audit Act has provided an opportunity to elevate the transparency of corporate management activities and financial reporting in South Korea to an international level. Transforming into economic agents that internalize this opportunity will serve as a stepping stone to enhance accounting transparency and to propel the KOSPI to even higher levels than now.

Choi Gukhyun, Professor, College of Business Administration, Chung-Ang University