1. Introduction
Corporate transparency is an important factor in maintaining the sustainable market economy in which business can operate. Companies carry out various activities such as operations, investment, and finance to sustain the business. These business activities are reported as a form of financial statements. As market participants rely on financial information provided by firms, they demand effective monitoring associated with the quality of financial reporting. External auditors play the most important role in corporate monitoring by providing independent and professional assurance services for financial reporting (Rodgers et al. [
1]). This service reduces the information asymmetry between the users and providers of financial information. Knowing that external auditors play a key role in reducing information asymmetry, labor unions, one of the most significant stakeholders of firms, are likely to demand high-quality audits. Prior studies have often emphasized the role of the board of directors, external auditors or corporate social responsibility on corporate transparency to ensure sustainability (Jin et al. [
2], Islam [
3], Dhaliwal et al. [
4]). Prior studies have also provided evidence that unions play a role in improving the quality of financial reporting. However, very few studies have examined the role of unions in enhancing the effectiveness of the monitoring mechanism. In this paper, we examine whether labor unions enhance the effectiveness of the monitoring mechanism provided by external auditors. To be specific, we investigate whether the presence and strength of unions reduce auditor tenure and affects the direction of auditor change in the circumstances of the change of the auditor.
Labor unions play a significant role in representing employees’ interest and protecting employees’ rights. After labor unions officially obtained the right to represent employees under union acts (e.g., the National Labor Relations Act (NLRA) in 1935 in the United States and Trade Union Act in 1953 in Korea), the influence of unions over management has dramatically increased. Labor unions play an important role in firms’ productivity and profitability. Additionally, labor unions create either positive or negative publicity about their firms during collective bargaining processes, which in turn can heavily affect firm value (In Korea, the Seoul Economy Daily reported that based on Motors Industry Association data, for the last 5 years, Hyundai Motors and Kia Motors lost 11,890 trillion won (USD 10,809 million with an exchange rate of 1100) due to under-production during union strikes [
5] and thus sustainability (Connolly et al. [
6]).
Politicians and regulators also regard labor unions as important because they are aware of the power labor unions have in influencing political interests (Kau and Rubin [
7]; Box-Steffensmeier et al. [
8]; Jansa and Hoyman [
9]; Becher et al. [
10]). As labor unions have become more influential over management, investors and other stakeholders have become more interested in labor unions’ governance roles in monitoring management (Chyz et al. [
11]; Choi and Bae [
12]). Among the various governance mechanisms, this study examines the role of labor unions in external auditor changes—specifically, it examines the association between the presence/power of labor unions and external auditor tenure and the direction of external auditor changes.
The role of labor unions is to protect the rights of employees and demand improvements in benefits and wage increases based on the financial performance of their firms. For example, labor unions negotiate wages and employee benefits with management based on financial information. To demand a more favorable share and increase their bargaining power, labor unions require more information that is accurate and transparent (Kleiner and Bouillon [
13]; Leung et al. [
14]; Appelbaum and Hunter [
15]). However, prior studies have reported that management has incentives to hide accurate information about resources and/or financial performance in order to obtain the upper hand in the process of negotiating wage contracts (Kleiner and Bouillon [
13]; Hilary [
16]; Bova [
17]). Since companies have other stakeholders, such as shareholders, investors and financial analysts, managers may have incentives to provide favorable accounting results. Unlike other developed countries, however, the monitoring role of labor unions is much stronger in Korea due to the difference in a sociological and historical environment. Chung et al. [
18] and Cheng et al. [
19] both investigate the effect of unions in two different countries, Korea and the US, respectively, on the selection of a high-quality auditor, and they find conflicting results. We acknowledge that the difference in the results of the two studies can be attributable to differences in the environment of the two countries.
External auditors have professional knowledge and expertise in evaluating the effectiveness of accounting systems and internal control over financial reporting, which affect the quality of financial reporting. They enter at the last step of the financial reporting process, verifying whether financial statements are fairly prepared according to generally accepted accounting standards. As an independent outside governance mechanism, they are expected to play one of the most important roles as a financial information watchdog. When they find an error or a violation of standards, they discuss the problems with management in order to fix them. Labor unions expect high-quality external auditors to minimize the risk of inaccurate financial information and thus reduce the information asymmetry between them and management. In other words, labor unions that prefer to rely on financial statements audited by high-quality external auditors in the process of wage negotiation are highly likely to demand that management not use external auditors whose independence is questionable.
Long external auditor tenure has received negative publicity during a series of corporate scandals (Blouin et al. [
20]). As a long tenure is perceived as causing a loss of independence, the European Union and several Asian countries have started to implement mandatory auditor changes (Chen et al. [
21]; Catanach and Walker [
22]). An increase in audit quality when an auditor changes may also reflect the demand for high-quality auditors by labor unions. To minimize the risk of labor-management conflicts, management also has incentives to respond to this demand by switching from external auditors with long tenures to new auditors that are perceived as high quality.
While prior studies find evidence that board characteristics are associated with audit quality (O’Sullivan [
23]; Carcello et al. [
24]; Carcello and Neal [
25]; Klein [
26]) and the likelihood and/or direction of auditor change (Lee et al. [
27]; Beasley and Petroni [
28]), few studies focus on the role of labor unions in audit quality. Chung et al. [
18] report that firms with labor unions are likely to have Big 4 auditors (Big4 auditors indicate the four biggest global audit firms. They are Deloitte, PricewaterhouseCoopers (PwC), Ernst and Young (EY), and KPMG. According to Audit Analytics Report in February 2017, Big4 auditors audit 99.4% of S and P 500 companies.). They also provide evidence that unionization is negatively (positively) associated with positive (negative) abnormal audit fees and abnormal audit hours, suggesting that departures from normal audit fees and hours in either direction impair audit quality. They suggest that labor unions affect the improvement of audit quality, but do not examine auditor replacement that affects tenure or the direction of auditor changes (There are cases where labor unions affect audit quality and auditor change decisions. For example, “The labor union of Hyundai Motors demanded management change external auditors since the auditor has audited their firm for a long time. The labor union raised a strong concern that a long tenure with an auditor decreases objectivity and the independence of the auditor. While the selection of external auditors is primarily management’s decision, the motion must be seconded at the shareholders meeting. A representative of the labor union states that it has a collective agreement with management regarding auditor selection. The representative also states that the union will clearly demand that management change its external auditors after discussion with the employee stockholders association (Yonhap News, 24 December 2002).” Additionally, according to Bloomberg, the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO) recommended that shareholders of Sprint Corporation oppose the selection of E and Y as the firm’s new external auditor. AFL-CIO argues that E and Y has long provided tax consulting for top executives of Sprint. This may cause a conflict of interest in conducting financial statement audits (Blumberg, 23 April 2003).). Labor unions demand high-quality audits to ensure transparent and reliable financial information. An external auditor working for a long period of time for a specific client develops a close relationship with the client’s management (Blouin et al. [
20]). Additionally, economic bonding between management and the auditor increases as the tenure increases, which may, in turn, lower the audit quality (Carey and Simmett [
29]; Davis et al. [
30]; Dopuch et al. [
31]). Thus, influential labor unions are likely to push firms to change their long-term external auditors in order to ensure auditor independence. This push will eventually reduce auditor tenure when labor unions play a significant monitoring role. If an auditor change occurs, labor unions are likely to influence their firms to select high-quality auditors. At the same time, when firms with influential labor unions change auditors, they are expected to appoint higher-quality auditors to signal high-quality financial information.
Korea provides an ideal setting for testing the effect of labor unions, as it has experienced severe labor disputes over time. Also, labor unions in Korea are extremely strong and have gained political influence (Jung [
32]). Many Korean firms have experienced severe labor disputes over the past decades because of strong unions, causing huge losses (In Korea, most unions are affiliated with Minju or Hanguk federation. Labor White Paper of 2008 in Korea states that about 89 percent of unions are affiliated with these two federations. These two federations are very powerful and more influential than those in other countries. This powerful nature of labor unions in Korea may be attributed to the fact that the rapid democratization of Korean society after the sudden end of the military regime in the early 1990 s. This democratization has empowered organized labor strongly increasing the effectiveness of their corporate monitoring role. Minju is known as more aggressive, while Hanguk is relatively less aggressive. About 87 percent of strikes are supported by Minju while 11 percent is by Hanguk around 2005–2008 (Labor White Paper of 2008). Labor disputes with management are also of great concerns among Chaebols, family-run business conglomerates in Korea. Labor unions have increased aggressiveness against these Chaebol firms.). As a result, developing good labor-management relations has been of great concern to firms to avoid labor disputes, and thus labor unions play a critical monitoring role (Chen et al. [
33]; Choi and Bae [
12]). Thus, firms are more likely to incorporate the demands of labor unions associated with auditor change that directly affect the information asymmetry between employees and management. The results indicate that the demands of labor unions for higher-quality external audits are considered when the auditor tenure is long and when firms change their auditors. Using 4568 firm-years listed on the Korea Stock Exchange, we find that the presence and power of labor unions decrease external auditor tenure. We also find that firms with labor unions, especially powerful labor unions, are more likely to change their auditors to industry specialists from non-industry specialists and from non-large audit firms to large audit firms. For the robustness test, we control for the characteristics of firms with unions or powerful unions using propensity score matching, and the results remain qualitatively the same.
This study contributes to the extant literature in several ways. First, it adds to the few extant studies on the monitoring role of labor unions. In particular, it is increasingly important to understand the monitoring role of labor unions because workers’ rights and the role of employees as a major stakeholder group are increasingly important now more than ever before. Second, by empirically examining how the presence of labor unions and the strength of their influence are associated with auditor tenure and the direction of auditor changes, this study provides useful implications for investors and regulators by showing that the role of labor unions must be considered in their decision making. To the best of our knowledge, this research question has not yet been examined, mainly because of the lack of data availability. Third, our paper provides an explanation for how unions affect audit quality. A previous study (Chung et al. [
18]) documented that companies with unions are more likely to have higher-quality auditors. Our paper provides additional evidence that unions may influence changes in auditors, which can improve auditor independence, leading to higher audit quality. Lastly, different from US studies, which estimate unionization by industry-level data due to data limitations (Hilary [
16]; Chyz et al. [
11]; Hsieh et al. [
34]), this study provides comprehensive results on the impact of unions by using unique data available in Korea up to 2008, which includes firm-level union data (The influence of labor unions over management has increased over time in Korea. Thus, the inclusion of more recent data is likely to strengthen the conclusion of our study. The influence and power of labor unions have increased with the support of the government. For example, the Koreatimes (7 January 2019) indicated that “the nation’s two umbrella labor organizations have strengthened the power and influence drastically thanks to current president’s pro-labor policies and a sharp increase in the number of labor union”.).
The paper proceeds as follows. In
Section 2, we review the relevant literature and develop our hypotheses. In
Section 3, we describe the research design and the sample selection process. In
Section 4, we describe the empirical results, and
Section 5 concludes the paper.