The Effect Of Changes In The Audit Systems On Earnings Management Of Korean IPO Firms

We examine whether audit regulations by the Financial Supervisory Services of Korea for initial public offering (IPO) firms prevent them from managing earnings. We investigate eighty‐three IPO firms after the introduction of the auditor designation system, which applies regulatory‐body auditor assignments, in 1995 and compared them with three control samples. We document that the auditor designation system successfully reduces the earnings management practices by IPO firms. Compared to the control samples, the IPO firms, in general, have smaller accruals, stronger correlation coefficients between cash from operations and net income, and lower ratios of sign‐changes reporting positive earnings when cash from operation is negative or vice versa. The regression analysis also reveals that the IPO sample is less prone to manage earnings. In sum, the results are consistent across different test methods in supporting the effectiveness of the auditor designation system in deterring IPO firms from taking income‐increasing strategies.