[The Faded Accounting Reform]② Half of Listed Companies Subject to 'Auditor Designation System'... Audit Fees Soar

Accounting Association Also Raises Need to Ease Designated Audit
Financial Services Commission: "Corporate Burden Increases, Considering Relief Measures"

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Among the three major accounting reform systems, companies have reported many difficulties with the auditor designation system, including the periodic designation system. This is because audit fees, audit hours, and hourly audit fees have all increased compared to before the system was introduced. The periodic designation system requires publicly listed companies and large unlisted companies where ownership and management are not separated to receive audits from freely appointed auditors for six fiscal years, and then receive designated audits for the following three fiscal years. The discretionary designation system is a system where auditors are designated to ensure fair audits for investor protection in cases such as audit designation measures following the Securities and Futures Commission's inspection results, failure to appoint an auditor within the appointment deadline, companies scheduled to be listed, management status companies, and companies with three consecutive fiscal years of operating losses (financial criteria), among 27 discretionary designation reasons.

Companies' Negotiation Power Weakened Due to Periodic Designation System

According to the 'Study on Evaluation and Improvement Measures of Accounting Reform Systems' by the Korean Accounting Association, exclusively obtained by Asia Economy, as of 2021, the number of companies under the periodic designation system was 593, and the number of companies under the discretionary designation system was 663, indicating that 50.5% of all listed companies had designated auditors. In 2020, the number of periodic designation companies was 220, and discretionary designation companies were 513, with a designation rate of 30.4%.

The audit fees for designated auditors under the periodic designation system were recorded as 136.221 million KRW, 197.311 million KRW, and 229.733 million KRW in 2019, 2020, and 2021, respectively. The largest increase of 44.85% occurred from 2019 to 2020.

The hourly audit fees for designated auditors under the periodic designation system increased by 19.64% in 2020 compared to the previous year and rose by 13.45% in 2021 compared to 2020. Notably, before the application of the periodic designation system, audit fees for periodic designation companies were lower than those for non-designated companies, but after designation, fees reversed. This supports the claim that the periodic designation system weakened companies' negotiation power, leading to increased audit fees.

The audit fees for discretionary designated auditors were 296.705 million KRW, 215.592 million KRW, and 227.836 million KRW in 2019, 2020, and 2021, respectively. Audit fees for discretionary designated companies are higher than those for periodic designation and non-designated companies. However, in 2020, as the number of designated companies increased due to the expansion of discretionary designation, the average audit fee decreased.

Audit hours for designated auditors under the periodic designation system increased consecutively in 2020 and 2021 after the system's introduction. From 1,696 hours in 2019, it rose by 19.37% to 2,025 hours in 2020 and increased by 8.28% to 2,193 hours in 2021. Before designation, audit hours for periodic designation companies were less than those for non-designated companies (1,903 hours in 2019). The input hours for discretionary designated auditors showed a decreasing trend from 2020 (2,688 hours in 2019, 1,807 hours in 2020, and 1,880 hours in 2021). As the number of designated companies increased due to the expansion of the designation system, average audit hours tended to decrease.

Hourly audit fees for designated auditors increased by 19.64% in 2020 and 13.45% in 2021 compared to the previous years. Periodic designation companies had higher audit fees than non-designated companies in 2020 and 2021, but fewer audit hours, indicating higher hourly fees. Hourly fees for discretionary designation were higher than those for non-designated and periodic designation companies. Hourly audit fees for non-designated companies remained at a consistent level.

Quality Improves Only Just Before 'Replacement,' Not 'Designation'

How was the audit quality? The improvement in audit quality for periodic designation companies mainly appeared just before the designation period rather than after. In 2019, the year immediately before designation, the discretionary accruals of companies subject to periodic designation were zero, down from 0.016 in 2018. Audit adjustments for companies scheduled for periodic designation also tended to increase in the year before designation. However, comparative analysis by discretionary designation reasons found no evidence that audit quality was higher for designated auditors due to financial criteria violations.

Companies argue, "Although discretionary accruals decreased in the 'year immediately before designation,' suggesting the possibility that audit quality improved due to the accounting reform system, this change occurred due to the possibility of auditor replacement 'before designation' and is unrelated to 'mandatory designation.' Ultimately, this proves that the effect can be achieved by 'replacement' rather than 'designation' of auditors."

Following these research results, the Accounting Association has also taken a step back. While the association claims, "Since the introduction of the periodic designation system, designated companies have seen increases in audit fees and hours, and audit quality has improved in terms of discretionary accruals and audit adjustments," it also states, "As of 2021, the proportion of designated auditors (periodic and discretionary) among listed companies exceeds 50%, and there are opinions that audit fees have sharply increased and auditors' excessive and unreasonable demands have risen due to designated auditor appointments. Considering that auditor appointment is fundamentally a free appointment system, there is a need to ease the designated auditor system, which exceeds 50%." Additionally, it emphasized the need to establish measures to prevent inappropriate behavior by designated auditors. The Accounting Association requested the Financial Services Commission to reanalyze based on accumulated data after a full cycle of the periodic designation system has been implemented and to conduct a comprehensive review based on this.

Companies Call for 'Abolition' vs. Accounting Industry Proposes 'Period Adjustment'

The Accounting Association proposed methods to ease designated audits, including ▲adjusting the free appointment period ▲adjusting the designation period ▲adjusting discretionary designation reasons. The association argued, "Since there is no difference in audit quality between six and nine years of free appointment periods, expanding the free appointment period from the current six years to nine years is not expected to significantly undermine accounting transparency. Therefore, expanding the free appointment period of the periodic designation system (currently six years) to nine years should be considered." Regarding discretionary designation, empirical analysis showed that the three-year designation sample did not have the highest audit quality compared to one- or two-year designations, so reducing the designation period (currently three years) should also be considered.

Companies argue that the basis for the Accounting Association's alternatives?▲expanding free appointment period (6 years → 9 years), ▲shortening designation period (3 years → 2 years), and ▲reducing discretionary designation reasons?fails to prove the effectiveness of the accounting reform system. Kang Kyung-jin, Head of Policy Division 2 at the Korea Listed Companies Association, said, "It is impossible to measure that the periodic auditor designation system independently improved audit transparency. Although the efficiency of the designation system was analyzed in advance, cost analysis was not conducted. To minimize side effects, it seems necessary to change the current 6 years (company-appointed auditor) + 3 years (designation system applied) to 9 years + 3 years or to review the system again after 3 to 5 years."

Kim Jun-man, Head of Research Policy Division at the KOSDAQ Association, said, "Due to excessive audit fees and unreasonable document submission demands, companies face significant time and cost burdens. We should consider extending the auditor appointment period from the current six years to ten years or reducing the designated audit period from the current three years." Lee Soo-won, a team leader at the Korea Chamber of Commerce and Industry, said, "The auditor designation system weakens competitive incentives and lowers auditor capabilities. Instead of the auditor designation system, strengthening internal control mechanisms such as enhancing internal whistleblowing and audit committees is the fundamental solution."

The Korea Accounting Standards Board and accounting firms conducting corporate audits emphasize that companies should first improve their financial statement preparation capabilities and establish systems for frequent communication with auditors. Park Se-hwan, a standing member of the Korea Accounting Standards Board, said, "The person responsible for each company's financial statements is primarily accountable, and no other institution can replace this responsibility. It is difficult to promptly handle each company's inquiry responses, but going forward, we will disclose the basis for judgments, discussion processes, and provide integrated databases of various materials and cases when responding."

A Financial Services Commission official said, "We are considering easing the criteria for large unlisted companies and expanding the use of the SME Accounting Support Center. Since the burden on companies has indeed increased, we will strive to announce measures to reduce this burden within the second quarter."