Financial Disclosure Incentives and Organizational Form Changes

• Date: 01 December 2016
• Published date: 01 December 2016
• DOI: http://doi.org/10.1111/ajfs.12154

Financial Disclosure Incentives and

Organizational Form Changes*

Heesun Chung**

Department of Business Administration, Sejong University

Woon-Oh Jung

Business School, Seoul National University

Received 2 July 2015; Accepted 4 October 2016

Abstract

This study investigates the factors that induce an organizational form change in a private cor-

poration into a limited company (LC) from the disclosure incentive perspective. Using 1500

firm-year observations from 2007 to 2012, we find that private corporations with low lever-

age, non-clean audit opinions, high foreign ownership, high abnormal profits, and high-tech-

nology industry membership are more likely to change their organizational form into LCs.

This finding suggests that if private corporations have low incentives for financial disclosure,

then they initiate organizational form changes into LCs to avoid the costs incurred from the

disclosure requirement mandated by law.

Keywords Corporation; Financial disclosure; Limited company; Organizational form change;

Private firm

JEL Classification: G32, K22, M40

1. Introduction

Recently, there has been a significant increase in public criticism in South Korea

regarding organizational form changes into limited companies (LCs) initiated

mostly by private corporations. The media has covered the issue extensively, for

example, under the heading “private corporations escape the external surveillance

through organizational form changes into LCs.”

1

In South Korea, a for-profit orga-

nization, the ownership of which is not publicly traded in the equity market can

choose its form from among several alternatives, namely, corporation, LC, limited

*Professor Jung was financially supported by the Institute of Management Research at Seoul

National University.

**Corresponding author: Heesun Chung, Department of Business Administration, Sejong

University, 209, Neungdong-ro, Gwangjin-gu, Seoul 05006, Korea. Tel: +82-2-3408-3994, Fax:

+82-2-3408-4310, email: hschung@sejong.ac.kr.

1

http://shindonga.donga.com/

Asia-Pacific Journal of Financial Studies (2016) 45, 839–863 doi:10.1111/ajfs.12154

©2016 Korean Securities Association 839

liability company, partnership, and sole proprietorship. Out of these alternative

forms, corporation and LC have many common characteristics: owners ar e entitled

to limited financial liabilities and can freely transfer ownership interests to third

parties.

2

These two organizational forms are also subject to taxes on earnings at the

entity level. However, a critical difference is that the ownership interests of corpora-

tions can be offered publicly and traded in the stock market, whereas those of LCs

are transferrable only privately. Another crucial difference lies in legal requirements

regarding information disclosure. The “Act on External Audit of Corporations

(AEAC)” in South Korea stipulates that corporations, whether they are private or

public firms, should publicly disclose their financial statements prepared in accor-

dance with the generally accepted accounting principles (GAAPs) and attested by an

independent external auditor. By contrast, LCs are exempt from such disclosure

requirements. Therefore, if an initial public offering (IPO) is not in its best interest,

a private corporation can potentially benefit from switching its organizational form

into an LC, thereby curtailing disclosure-related costs. Although criticized in the

media, the recent surge of organizational form changes in South Korea offers a rare

opportunity to test the relation between firms’ disclosure incentives and choices of

organizational form. More specifically, we postulate that a private corporation will

switch into an LC if it does not see the benefits of remaining in a corporate form

outweighing the cost incurred from the AEAC-mandated disclosure requirements.

In this study, we examine whether our postulation is empirically supported.

Prior empirical studies show that firms have incentives to disclose private infor-

mation when the benefits of doing so exceed the related direct and indirect costs

(Meek et al., 1995; Depoers, 2000). Conversely, when information disclosure is

costly and when non-disclosure entails only limited amounts of penalties, firms will

avoid disclosing because they can achieve high payoffs from non-disclosures (Beyer

et al., 2010; Hyun et al., 2013). In identifying such disclosure incentives for private

corporations in our study, we rely on the following theories in the literature on vol-

untary disclosures: agency theory, theory of political costs, and theory of proprietary

costs.

First, from the agency perspective, given that a private corporation, which can-

not access the stock market, raises funds mainly in the debt market, its potential

agency problem will take the form of wealth transfer from debt-holders to share-

holders and/or managers (Meek et al., 1995). One possible solution to this agency

problem is that the principal (debt holders) monitors the behavior of the agent (a

private corporation). Nevertheless, such direct monitoring can be prohibitively

costly. Prior studies suggest that financial disclosures by the agent can replace

(although incompletely) direct monitoring, thereby enabling the principal to reduce

2

Prior to 2011, the transfer of ownership of an LC was constrained because such action

required the approval of all the other owners. This constraint was lifted in the 2011 Amend-

ment of the Korean Commercial Act. Currently, the ownership of an LC is liberally trans-

ferrable.

H. Chung and W.-O. Jung

840 ©2016 Korean Securities Association