High investor sentiment and initial engagement discounts: evidence from Korea

Abstract

ABSTRACT This study examines whether high sentiment affects auditors’ risk assessment in a less litigious environment. Specifically, we use a Korean setting with relatively low litigation risks and investigate whether audit fees are lower when firms change auditors during high sentiment times. Lower audit fees responding to high sentiment in a weak legal environment may indicate that auditors perceive the overall audit risk including reputation risk and regulation risk as low within the given period, increasing the possibility of their failure to detect managerial opportunistic behaviour. Using 17,469 Korean public firm-year observations from 2003 to 2017, we find that initial audit fees are significantly lower when investor sentiment is high, while changing auditors has no influence on audit fees when investor sentiment is low. Furthermore, this result is maintained even when auditors are changed to Big4 or industry specialist auditors (SPEC), which are known to have high ability and risk sensitivity. We also find that Big4 and SPEC initial auditors input significantly less audit hours during high investor sentiment periods, suggesting that optimistic bias caused by high sentiment makes auditors expect that relaxed audits are tolerable regardless of the legal environment.