Investment in Human Capital and External Reporting Quality

Abstract

Ensuring that firms devote sufficient resources to the reporting process is important for quality reporting. To explore the effects of resources invested in the reporting function, we use a regulatory intervention in South Korea that led to an increase in human capital invested in the reporting process. The new regulation required firms to file internally prepared, pre-audited financial statements before the start of the year-end field audit process. Using the staggered adoption of this regulation, we confirm that the regulation leads to an increase in internal accounting employees at firms, and that the increase in rank-and-file accounting employees is more pronounced than the increase in top executives. Using difference-in-differences tests, we find improvement in external reporting quality (i.e., fewer restatements) for treatment firms relative to similar-size control firms that were not subject to the regulation. The effects are greater when an increase in accounting employees is accompanied by an increase in external audit effort, measured using audit hours. Treatment firms also show a drop in their hiring of non-accounting employees suggesting reallocation of labor inside the firm. The findings suggest that regulatory efforts to increase investment in internal accounting employees lead to improved reporting quality but can reduce labor forces in other non-accounting functions.