Abstract

Recently, the defense industry in South Korea has been regarded with strong suspicion since a company responsible for producing parts for the aviation sector is being investigated for cost irregularities. Many people are concerned about these issues and the government is distrustful of defense industries. If the current situation continues, the defense industry market in South Korea (henceforth “South Korea”) will be hard to maintain. The South Korean government will have to rely on importing from abroad instead of buying products in the local market. This study looked at the sustainability of earnings management adopted in the defense industry of South Korea, exploring options for the government to maintain the scheme’s soundness. In particular, we used Kothari’s discretionary accrual as a proxy of earnings management and OLS method to analyze the relationship between them. The results are as follows. Firstly the firms with a high percentage of defense sales showed significant discretionary accruals; the higher the profit, the more likely it was that earnings adjustments were made; secondly, firms that had been certified by the government for defense cost-management were proven to be effective, because the earnings management activities were low compared to those of firms that did not have the defense cost-management certification; lastly, based on the accounting rules for the cost of defense products, it was found that significant results confirming defense firms were exercising their influence, through earnings management, on the improvement of the government system.

Introduction

In South Korea, defense scandals have recently become problematic [1]. The company that produces parts for the aviation sector is being investigated for cost irregularities. There is mounting suspicion that illegal costs in the defense industry are rising. Many people are concerned about these issues and the government is distrustful of defense industries. If the situation continues, the defense industry market in South Korea will be hard to sustain. Preventing earnings management in the defense industry is thought to be the first step to achieving transparency to help strengthen South Korean military power. The South Korean government will need to rely on importing instead of buying products in the local market. In this study, the relationship between the characteristics of domestic defense firms and earnings management in South Korea were examined.

We studied the unique cost structure of the defense industry, which compensates for profits based on the costs incurred, and examined the cost-management certification system in terms of the share of defense sales, the political cost hypothesis, and the characteristics of defense firms arising from the asymmetry of cost information between the government, which is the consumer, and the defense industry, which is the supplier.

Conclusions

This study aimed to examine the earnings management behavior of firms in the defense industry in South Korea and find a solution for the government to reduce the earnings management. The results of the study are as follows.

First, firms with higher defense product sales increased their degree of earnings management. This differs from the study by Kim et al. [13] that showed that the higher the reliance on the defense industry is, the lower the reported profit is recorded. That is, for defense firms, a profit-centered system does not produce only one result, but creates different earnings management systems that can increase and/or reduce reported profit.

Second, the defense industry cost-management system, which shares cost management information about defense firms, was examined in relation to earnings management. We found that the level of earnings management was lower for the companies with the certified system than those without the system. This can be interpreted in two ways. Firstly, for a company that has the certified defense cost-management system, due to the information asymmetry between the government and the company about the decrease in costs after the implementation of the system, the level of earnings management decreased; secondly, the firms with the certified system have already received the cost-related certification from the government because they did not engage in earnings management activities. Of these two interpretations, the latter is valid because the system for cost control in defense firms has been in effect since 2012. However, because there is not enough data (4 firms in 2012, 9 in 2013, and 12 in 2014), the effectiveness of the test could not be measured.