Impact of the 2018 External Financial Audit Law on Private Companies in South Korea
The External Audit Act (New External Audit Act), which includes private companies as target companies, was fully revised and implemented in 2018. However, a study has found that private companies are avoiding external audit obligations by changing their entity to limited liability companies(유한책임회사).
Global corporations in Korea have mainly carried out such organizational changes. In the second half of last year, Bottega Veneta Korea, Balenciaga Korea, and Kering Watch and Jewelry Korea (formerly Boucheron Korea) also changed their corporate form from a joint-stock company(주식회사) to a limited liability company.
According to a paper titled "Introduction of the New External Audit Act and Limited Liability Companies from a Policy Perspective" published in the latest issue (end of December 2022) of 'Accounting, Taxation and Audit Research' issued by the Korean Institute of Certified Public Accountants, 32 companies applied for incorporation registration in 2012 when the limited liability company was introduced. The numbers increased significantly to 154 in 2015, 346 in 2016, and 445 and 504 respectively in 2019 and 2020. This is more than a 15-fold increase compared to 2012.
Professors Jung Do-jin of Chung-Ang University's Business Administration Department, Lee Yong-seok of Hannam University's Accounting Department, and Jang Seok-jin of Daejin University's Business Administration Department, who wrote the paper, said, "The reason for the increase in limited liability companies is speculated to be due to discussions on the revision of the New External Audit Act starting from 2016." They also pointed out that "Even considering that the regulations on limited liability companies were introduced in 2012, the result was a very rapid increase compared to private companies and joint-stock companies."
According to the New External Audit Act, private companies(유한회사) that meet three or more of the following criteria: total assets of 12 billion won or more, total liabilities of 7 billion won or more, sales of 10 billion won or more, 100 or more employees, or 50 or more members, are subject to external accounting audits.
In relation to including private companies as subjects of external audits, financial authorities said, "We expect that inducing more reliable accounting information production from private companies will enhance protection for stakeholders (creditors, consumers, etc.)" They also stated that "Our goal is to make global companies that have established or converted into private companies disclose financial information at the same level as joint-stock companies to implement a fair competitive environment."
However, eBay Korea, Adidas Korea, and Walt Disney Company Korea changed their organization from a joint-stock company to a limited liability company. Gucci Korea, Job Korea, L'Occitane Korea, Amazon Web Services Korea and others also changed their corporate form to a limited liability company.
Private companies and limited liability companies, unlike joint-stock companies, cannot issue bonds, making it relatively difficult to raise funds from outside.
Also, private companies and limited liability companies have relatively strict requirements for changing articles of incorporation for additional investment compared to joint-stock companies. In particular, all members must agree in case of limited liability companies. Despite this, these companies have managed to escape the application of the New External Audit Act and the obligation to disclose financial statements by changing their corporate form.
The current Commercial Act does not allow private companies to directly convert to limited liability companies. Therefore, they must first change their organization from a private company to a joint-stock company, and then change from a joint-stock company to a limited liability company. This is why all companies that have changed their organization to a limited liability company have done so after converting from a private company to a joint-stock company.
Professors Jung and others pointed out that "If a private company changes its organization to a limited liability company through the organizational change system under the Commercial Act, it will not be included in the external audit target." They said, "In other words, there is a possibility that some companies seeking to avoid external audits could exploit this legislative loophole by using organizational changes."
The proposed systemic alternatives to prevent legislative deficiencies include strengthening the management of financial authorities.
This involves establishing and managing a system that allows the Financial Supervisory Service to check companies that have been excluded from external audit targets through organizational changes. If a company terminates an audit contract for organizational change reasons, there should be a systemic device or obligation for the external auditor to report this reason to the Financial Supervisory Service.
The fundamental improvement is to expand the external audit targets in the New External Audit Act not only to private companies but also to limited liability companies, or to create a separate item in the New External Audit Act for limited liability companies, imposing external audit and disclosure obligations while excluding small businesses.
Professors Jung and others pointed out that "If foreign companies change their organization to a limited liability company and avoid external audits, there will be no way for the supervisory authority to manage the company." They added, "This means not only will it degrade accounting transparency in Korea, but there will also be no way to detect if foreign companies repatriate profits earned in Korea through large dividends."
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