The Effect of Financial Audits on Governance Practices: Evidence from the Nonprofit Sector

Abstract

I investigate the effect of financial statement audits on the governance practices of nonprofit organizations. Using a regression discontinuity design that exploits revenue-based exemption thresholds, I find that financial audits cause organizations to implement governance mechanisms such as conflict-of-interest policies, whistleblower policies, and formal approval of the CEO’s compensation by a committee. Consistent with these governance practices curtailing managers’ private benefits, I document reductions in nepotism and in the CEO-to-employee pay ratio. These results are more pronounced for organizations with an independent board of directors and with an audit committee, suggesting that audits mitigate agency costs through governance reform primarily when the auditor reports directly to the governing body (as opposed to management). Collectively, my findings imply that financial audits considerably affect organizations beyond financial reporting by shaping their governance practices.

Keywords: auditing, governance, real effects, nonprofit organizations

JEL Classification: M42, G34, M48, L31