[Exclusive] New External Audit Act Increases Corporate Burden... "Audit Fees Rose 84.1% Over 4 Years, but Quality Remains 'Minimal'"

[Dimmed Accounting Reform] ①
Korean Accounting Association Announces Research Results on Three Major Accounting Reform Systems
No Clear Improvement in Audit Quality Confirmed
Companies Complain of Side Effects Like Increased Costs Due to Frequent Auditor Changes

[Photo by Unsplash]

More than four years after the full revision of the External Audit Act (October 2017) initiated accounting reforms, which were fully implemented in November 2018, the effects of the three main systems introduced under the new External Audit Act (amended External Audit Act)?the standard audit hours system, internal accounting control audit, and periodic auditor designation system?have been found to be minimal. This is according to research conducted by the Korean Accounting Association commissioned by the Financial Services Commission. No clear improvements in audit quality were confirmed.

While there are positive assessments regarding enhanced accounting transparency, negative views that the reforms have only increased corporate burdens have led to conflicts between companies and the accounting industry. Financial authorities have attempted to revise the accounting reform systems, but due to sharp disagreements between both sides, the matter has effectively been put on hold. Although a 'Accounting Reform Evaluation and Improvement Task Force' was formed in September last year, no improvement proposals have yet been presented.

In this situation, the emergence of research results that fail to prove the effectiveness of the introduced systems deepens the financial authorities' concerns. Practical improvement measures must be sought to increase the acceptability of accounting systems without undermining accounting transparency, while also establishing consensus between the accounting industry and companies.

Clear conclusions on audit quality improvement remain elusive

According to the 'Study on Evaluation and Improvement Measures of Accounting Reform Systems' obtained exclusively by Asia Economy on the 14th, major indicators introduced by the accounting reforms?such as audit fees, audit hours, and audit fees per hour?all increased. This confirmed the difficulties companies had claimed. However, no clear conclusions were reached regarding improvements in audit quality, leaving room for ongoing debate between both sides. This was the reason the Korean Accounting Association took a step back during the 'Symposium on Evaluation and Improvement Measures of Accounting Reform Systems' held on February 10, stating that the effects of the accounting reform systems should be regularly re-examined and improvement measures explored. Based on current research results, it was judged that the voices of the accounting industry are difficult to fully persuade, and thus the search for improvement measures and discussions were proposed as follow-up tasks.

The Korean Accounting Association measured improvements in audit quality using 'discretionary accruals' and 'audit adjustments.' Discretionary accruals were interpreted as indicating improved audit quality the closer they are to '0.' For audit adjustments, the standard audit hours system and periodic designation system were seen as effective because audit adjustments tended to increase before their introduction. For the internal accounting control system, if the degree of audit adjustments decreased after its introduction, it was interpreted as an improvement in audit quality due to the system. A representative from the Korean Accounting Association explained, "Discretionary accruals reflect management’s estimates or judgments regarding revenue recognition timing or asset and liability valuations, which can make a company’s financial performance appear more favorable. The closer this value converges to '0,' the less management has adjusted the financial statements, so it is used as an indicator of improved audit quality." He added, "The larger the difference in net income before and after the audit?such as adjustments exceeding 5%?the lower the reliability of the financial statements prepared by the company."

Based on this, the Korean Accounting Association only suggested that discretionary accruals decreased in 2019 and 2020 compared to previous years, implying that the accounting reform systems might have led to improved audit quality. Audit adjustments also accounted for a large proportion (57%) in 2019, when the reforms were introduced, and the average comparison before and after the introduction showed a higher proportion of audit adjustments after implementation.

The corporate side held a different view. They argued, "If the empirical result that discretionary accruals sharply declined is interpreted as an improvement in audit quality, it could mean that after the implementation of the periodic auditor designation system, auditors minimized alternative treatments and enforced only generally accepted alternatives." They also pointed out, "Discretionary accruals are statistical values derived from regression analysis, so the safety of the results cannot be fully guaranteed." Regarding the increase in audit adjustments, they added, "It is natural for companies and auditors to have differing opinions on accounting treatments. However, considering companies’ complaints about inefficiencies caused by overly conservative audit methodologies of designated auditors, this study could not determine whether the increase in audit adjustments was due to corrections of corporate accounting fraud or the application of conservative audit methodologies." They further claimed, "The Korean Accounting Association’s one-sided interpretation of the analysis results of 'discretionary accruals' and 'audit adjustments,' which can be interpreted in various ways, is a fundamental limitation of this study."

Audit hours and fees increased significantly

The overall conclusion regarding the impact of the accounting reform systems is the change in audit hours and audit fees before and after implementation. The increase rate of audit fees was more than twice that of audit hours (hours up 38.4%, fees up 84.1%). The greater increase in audit fees compared to audit hours is due to the rise in audit fees per hour (up 30.2%). This is interpreted as auditors exploiting their dominant position as designated auditors to charge excessively high audit fees.

Compared to before the introduction of the new External Audit Act (2017), audit hours increased from 1,553 hours to 2,149 hours in 2021, a 38.4% rise. Audit fees rose from 115.793 million KRW to 213.115 million KRW, an 84.1% increase. In terms of audit cost per hour, it increased from 774,000 KRW to 1,008,000 KRW, a 30.2% rise. For the Big Four accounting firms (Samil, Samjong, Han Young, Anjin), the hourly rate increased from 71,800 KRW to 99,500 KRW, a 38.4% increase, while firms outside the Big Four saw a 23.5% increase. The corporate side argued, "Improvements in audit quality can only be discussed when sufficient audit hours are invested. The increase in audit fees is not directly related to audit quality. It is reasonable for audit fees to increase proportionally with audit hours, but the fact that audit fees increased at twice the rate of audit hours suggests that auditors exploited their dominant position as designated auditors to charge excessively high fees."

"Effects achievable by auditor 'replacement' rather than 'designation'"

What were the results of the analysis on audit quality improvement? For the standard audit hours system, implemented from 2019, the only confirmed findings were that accountants’ monetary compensation increased and that audit quality tended to improve as audit hours increased. It did not clarify whether the standard audit hours system was related to audit quality improvement. Before the introduction of the standard audit hours system, audit hours showed a positive relationship with audit fees and a negative relationship with fees per hour, but after its introduction, both showed a significant positive relationship. This means that monetary compensation for auditors’ efforts increased significantly compared to the past.

The corporate side criticized, "Contrary to its intended purpose, the mandatory minimum audit hours rule is mechanically applied, resulting in very low corporate acceptance. Designated auditors with strong bargaining power tend to mechanically calculate and unilaterally apply standard audit hours."

The internal accounting control system, which has been gradually implemented since 2019, also did not clearly show that strengthening certification levels improved audit quality. This is because, although the internal accounting control system imposes the greatest cost burden, the most important expected effect?whether embezzlement occurred?was found to have no significant correlation. The Korean Accounting Association claimed that partial effects were found in companies with assets over 2 trillion KRW, but the same trend was not observed in samples of companies with assets over 500 billion KRW. Ultimately, the effectiveness of this system could not be proven.

The periodic designation system and other designation systems, gradually implemented since 2020, were concluded to have eliminated corporate bargaining power and caused a sharp increase in audit fees. Audit fees charged by designated auditors under the periodic designation system increased by the largest margin of 44.85% in 2020 compared to 2019. Before the application of the periodic designation system, audit fees for companies subject to periodic designation were lower than those for non-designated companies, but fees reversed after designation. The Korean Accounting Association noted that discretionary accruals decreased in the 'year immediately before designation,' suggesting that the accounting reform system might have improved audit quality. However, the corporate side argued, "This change was due to the possibility of auditor replacement before designation and has nothing to do with mandatory designation," adding, "Ultimately, the effect was achieved by auditor 'replacement,' not 'designation.'"

The corporate side emphasized, "No analysis was conducted on the social costs resulting from the system’s introduction, but the tangible and intangible costs companies must bear are significant and cannot be overlooked. Therefore, supplementary designs to minimize side effects within the framework of the system are urgently needed." They also stressed, "A fundamental limitation of this study is that it did not analyze the 'inefficiencies and cost burdens' caused by frequent auditor replacements." The Korean Accounting Association stated, "The significance of this study lies in laying the groundwork for discussions on improving the current accounting system in a more rational direction," and added, "We hope it will be usefully applied when improving laws and systems related to the External Audit Act and establishing supervisory policies." A Financial Services Commission official said, "We are listening to various opinions through the task force and other channels, but no measures have been finalized yet."

[Terminology Explanation]

*The periodic auditor designation system requires listed companies that have autonomously appointed auditors for six years to have auditors designated by the Securities and Futures Commission under the Financial Services Commission for the next three years.

*Standard audit hours refer to the appropriate audit hours auditors must invest. They are calculated based on company size, industry, and listing status. As audit hours increase, audit fees also increase.

*The internal accounting control system is an internal control system that manages and controls company operations related to financial reporting to prevent errors, fraud, and irregularities in financial statements.

*Discretionary accruals refer to the portion of accounting profits that depend on management’s discretion.

*Audit adjustments indicate the extent to which financial statements prepared by a company are modified during the audit process. The larger the difference in net income on the financial statements?such as differences exceeding 5%?the lower the reliability of the financial statements prepared by the company.