Abstract
AbstractWe examine whether firms with higher relative efficiency (operational performance) require additional audit effort (hours) to signal audit quality to demonstrate that their financial reporting systems are robust. Therefore, we use a Korean sample of publicly listed firms because of the Korean audit hour policy which mandates that audit hour information be made available for market participants. We find that client firms with higher relative efficiency have higher audit hours, suggesting that management has an incentive to demand additional audit hours for signalling purposes, and that shareholders, amongst other stakeholders, have an incentive to demand external monitoring to reduce potential agency problems. The results show that relative efficiency is a unique measure of firm performance that can provide insights into a client firm's business and audit risk. We also find evidence suggesting that audit firms do not subject clients to a fee (fee per hour) premium based on relative efficiency, supporting our finding that client firms require audit effort for signalling purposes. Thus, our results have important implications for policymakers about audit effort demand.
Highlights
We examine whether firms with higher relative efficiency require additional audit effort to signal audit quality to demonstrate that their financial reporting systems are robust
We find that client firms with higher relative efficiency have higher audit hours, suggesting that management has an incentive to demand additional audit hours for signalling purposes, and that shareholders, amongst other stakeholders, have an incentive to demand external monitoring to reduce potential agency problems
We find evidence suggesting that audit firms do not subject clients to a fee premium based on relative efficiency, supporting our finding that client firms require audit effort for signalling purposes
Summary
Audit quality has been defined as the ‘joint probability that a given auditor will both be able to detect a breach in a client’s accounting system and report the breach’ (DeAngelo 1981: 186). Based on the incentives of various groups, additional audit effort can be considered a potential signal for increased audit quality that legitimises a firm’s efficiency performance. Because audit hour information is known to market participants in South Korea, audit hours (input) can be considered a direct and felicitous measure of audit/financial reporting quality (output). Firms with low levels of relative efficiency have no incentive to request additional external audit scrutiny This relationship would be captured empirically as a positive association between relative efficiency and audit hours. The derived optimal values of u and v are multiplied by output (numerator) and inputs (denominator) to estimate our efficiency score for each individual DMU Using this approach, it is possible to develop a relative measure to derive an efficiency score for each firm independently within a specific year and industry.
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