The effect of ex-ante inspection risk on financial reporting quality*

This study examines how the regulator's thematic audit review policy, which began in year 2013, affected the financial reporting quality of the theme-related firms. The thematic audit review policy is a new regulatory framework that forewarns the nature of the financial statements items, industries, or businesses, i.e., theme, that would be monitored intensively in the following year. The purpose of the thematic audit review policy is to induce the theme-related firms and the auditors to perceive the ex-ante inspection risk and so to improve voluntarily the financial reporting quality. Our empirical evidence, based on the Korean sample of 8,706 observations between year 2012 and year 2017, indicates that the theme-related firms significantly reduced their overall discretionary accruals after the announcement of theme. However, the thematic audit review policy seems to fail to prevent the theme-related firms from conducting their income-increasing earnings manipulation. To our knowledge, this is the first empirical study to examine how the perceived inspection risk affects the financial reporting quality. In addition, this study provides several useful policy implications for the regulators to implement the thematic audit review policy.