Economic policy uncertainty, audit quality, and earnings manipulation

Abstract

ABSTRACT This study examines how audit quality is related to the risk of earnings management when economic policy uncertainty increases. After analyzing 10,524 firm-year samples in Korea from 2012 to 2019, we find that when economic policy uncertainty is high, audit quality, measured by audit fees, audit hours, revised disclosure of financial reports, and discretionary accruals, increases. This implies that auditors increase audit quality at a time of economic policy uncertainty, which results in the improvement in financial information quality. Also, we find that during periods of high economic policy uncertainty, companies with high risk of earnings manipulation disclose higher quality financial information, but pay less audit fees. This suggests that auditors who audit firms with high risk of earnings manipulation adjust to increased audit risk by putting more effort into improving financial information quality, but such increased audit efforts are not reflected in audit fees. The results of the study imply that auditors’ efforts to control audit risks contribute to improving financial information quality in the presence of earnings manipulation risk where information asymmetry increases due to economic policy uncertainty.