The effect of the dependence on the work of other auditors on error in analysts’ earnings forecasts

• Pages: 110-136
• Published date: 06 March 2017
• DOI: https://doi.org/10.1108/IJAIM-11-2015-0077
• Date: 06 March 2017
• Author: Minyoung Noh,Hyunyoung Park,Moonkyung Cho

The effect of the dependence on

the work of other auditors

on error in analysts’

earnings forecasts

Minyoung Noh

College of Business, Hawaii Pacic University, Honolulu, Hawaii, USA

Hyunyoung Park

Yonsei University, Seoul, South Korea, and

Moonkyung Cho

Texas A&M International University, Texas, USA

Abstract

Purpose –This paper aims to examine the effect of audit quality of consolidated nancial statements on the

accuracy of analysts’ earnings forecasts from the viewpoint of users of nancial statements.

Design/methodology/approach –This paper investigates the effect of dependence on the work of other

auditors on error in analysts’ earnings forecasts based on samples from 2011 to 2012 (the period since

implementation of the International Financial Reporting Standards in Korea). In addition, this paper examines

the effects of use of Big 4 auditors, use of auditors with industry expertise and the proportion of overseas

subsidiaries in relation to all subsidiaries on the association between dependence on the work of other auditors

and error in analysts’ earnings forecasts.

Findings –This paper nds a positive relation between dependence on the work of other auditors and error

in analysts’ earnings forecasts, suggesting that more dependence on the work of other auditors decreases the

quality of the audit of consolidated nancial statements; thus, to the extent that low-quality audits decrease

reporting reliability, analysts’ forecasts are less likely to be accurate. This paper also nds that the positive

relationship between dependence on the work of other auditors and error in analysts’ earnings forecasts is

weakened when the principal auditor is a Big 4 auditor or one with industry expertise, because such auditors

provide higher-quality audit services. However, the positive relationship between dependence on the work of

other auditors and error in analysts’ earnings forecasts is further strengthened in cases where the proportion

of overseas subsidiaries to all subsidiaries is higher. These results suggest that the complexity of the

consolidation process increases as the proportion of overseas subsidiaries increases.

Originality/value –The ndings are useful in analyzing the effects of adoption of the New ISA,

implemented in 2014, which does not allow the division of audit responsibilities between principal auditors

and other auditors. This paper also provides insights for regulators and practitioners to improve the auditor

appointment system in the future.

Keywords Audit quality, Forecast error, Analysts, Other auditors, Principal auditors

Paper type Research paper

1. Introduction

Listed companies in Korea are required to prepare and disclose consolidated nancial

statements in accordance with the International Financial Reporting Standards (IFRS) as of

2011. The most remarkable feature in the IFRS is that it denes consolidated nancial

This paper has not been submitted elsewhere and is not under consideration with any other publication.

The current issue and full text archive of this journal is available on Emerald Insight at:

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IJAIM

25,1

110

Received 11 November 2015

Revised 1 February 2016

Accepted 16 February 2016

InternationalJournal of

Accounting& Information

Management

Vol.25 No. 1, 2017

pp.110-136

©Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-11-2015-0077

statements as the primary nancial statements of a controlling company holding one or more

subsidiaries; this is a major change compared to the previous accounting standards.

Following IFRS adoption, listed companies are required to prepare and disclose consolidated

nancial statements not only for annual reports but also for quarterly and semi-annual

nancial reports. For nancial statement users, IFRS adoption brought a fundamental shift

in the notion of consolidated nancial statements as a source of primary information, in

addition to non-consolidated (i.e. individual) nancial statements. In the past, nancial

analysts announced earnings forecasts based on non-consolidated nancial statements.

However, now that nancial analysts must use consolidated nancial statements to forecast

earnings because of the implementation of the IFRS, consolidated nancial statements have

become critical for future investment decision-making.

The major advantage of consolidated nancial statements is that they deliver systematic

information on the nancial condition and performance of an economic entity, which consists

of a controlling company and its subsidiaries. These are regarded as one economic entity

based on their interdependent and organic relationship, although they are legally separate,

independent entities. Prior to implementation of the IFRS, users of nancial statements in

Korea paid more attention to non-consolidated nancial statements than to consolidated

nancial statements, treating the former as primary nancial statements. Research on

consolidated nancial statements has therefore been focused on either their usefulness or

their audit quality. In relation to their usefulness, prior studies have shown that consolidated

nancial statements present incrementally useful information, in addition to that provided

by non-consolidated nancial statements. This information is based on trade volume or

analysis of excess returns and value relevance (Chun, 1994;Hwang, 1995;Kim et al., 2001;

Kim and Na, 2002;Shin, 2008;Park and Ji, 2009;Ji et al., 2010).

In preparing consolidated nancial statements, the principal auditors are responsible for

direction, supervision and performance of the consolidated nancial statements audit in

accordance with the revised Korean Auditing Standard 600 “Audits of Group Financial

Statements” (including the Work of Subsidiary Auditors) in the light of IFRS[1]. This revision

requires the principal auditors to obtain sufcient audit evidence from subsidiaries auditors. The

purpose of Korean Auditing Standard 600 is to establish concrete standards and detailed

guidance for audit procedures in consolidation process from a risk-based approach. Earlier

studies on the quality of audits of consolidated nancial statements demonstrate that audit

quality increases as the ratio and size of the principal auditor’s[2] audit coverage increases, and

also that increased audit complexity of consolidated nancial statements decreases audit quality

(Choi et al., 2009;Park and Park, 2010;Ji et al., 2010;Choi et al., 2010;Lee et al., 2011,2013). This

study focuses on the inuence of the quality of consolidated nancial statements on error in

analysts’ earnings forecasts. Specically, we investigate the relation between dependence on the

work of other auditors and error in analysts’ earnings forecasts. In addition, we provide evidence

that audit quality (measured in terms of the principal auditor’s size and industry expertise)

weakens the positive relation between dependence on the work of other auditors and error in

analysts’ earnings forecasts. On the other hand, the proportion of overseas subsidiaries to all

subsidiaries strengthens the positive relation between dependence on the work of other auditors

and error in analysts’ earnings forecasts.

In general, there is a positive relation between audit quality and forecast accuracy (Behn

et al., 2008;Kim et al., 2008;Lim et al., 2009). It is critical to have an in-depth understanding

of the consolidated economic entity, its diverse accounting issues and audit risk to audit

consolidated nancial statements successfully. Accordingly, relevant information must be

clearly communicated between the principal auditor of a controlling entity and other

auditors to ensure high-quality audits of consolidated nancial statements (Choi et al., 2009;

111

Earnings

forecasts