Spillover Effect of FSS Audit Reviews on Quality of Accounting at Peer Firms

This study examines whether a negative outcome for an industry-leading firm (i.e., a sanction) in the Financial Supervisory Service audit review affects the accounting quality of other firms in the same industry. We estimate accounting quality proxied by discretionary accruals, and run the OLS regression to test the prediction that the changes in peer firm discretionary accrual subsequent to regulatory audit review by the FSS will decrease. Test results shows peer firms reduce discretionary accruals in the next period, and this relationship amplifies according to the intensity of enforced disciplinary action and the materiality of errors in financial statement. This finding contributes to the literature by providing the first evidence of the spillover effect from regulatory review, and has important implications for regulators, investors, and scholars. First, this study shows that financial reporting regulations can affect the overall quality of an industry by increasing not only the sanctioned firm s accounting quality, but also that of its peers. Second, this study can be a fruitful venue for future research that investigates the effect of other regulations on the accounting quality of peer firms.