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

Abstract

I evaluate 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 CEO-to-employee pay ratio. While I find no evidence that audits increase independence of the board of directors, the results are more pronounced for organizations (1) that already have an independent board, (2) whose audit is overseen by an audit committee, and (3) that face high charity-level demand for oversight. Collectively, these findings shed light on how financial audits shape the governance practices of small, less sophisticated organizations like nonprofits, in ways that go beyond financial statements’ direct use in decision making and contracting.

Keywords: auditing, governance, real effects, nonprofit organizations

JEL Classification: M42, G34, M48, L31