Auditors' noneconomic bonds to a nonprofit client: impairments to the air of independence.

Author:Flynn, R. Steve
Position:Report
 
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  1. INTRODUCTION

    Auditor independence has drawn increased attention in recent years largely due to the well-publicized financial failures of major firms and the resultant passage of the Sarbanes-Oxley Act in 2002. In attempts to strengthen both the auditor's independence-in-fact and independence-in-appearance, the Public Company Accounting Oversight Board (PCAOB) currently limits the type of nonaudit work the auditor can perform for audit clients. While most legislative and regulatory efforts have centered on the for-profit area, auditor independence is also crucial for nonprofit organizations. With evidence indicative of donors' use of financial information in their contribution decision process (Keating et al., 2008; Parsons, 2003; Tinkelman, 1999; Greenlee and Brown, 1999; Weisbrod and Dominguez, 1986), an independent audit offers assurances to donors of the reliability of a nonprofit organization's financial statements. Reflecting this assertion, the recently redesigned Form 990, the annual informational return that many nonprofit organizations must file with the Internal Revenue Service (IRS), now requires entities to indicate if their financial statements have been audited by an independent accountant.

    Most measures to ensure an auditor's independence in the for-profit sector have focused on eliminating all financial ties that the auditor might have with the client. Although such concerns are relevant in nearly all contexts, additional factors may also influence an auditor's behavior in a nonprofit setting. For example, because nonprofit organizations' missions are typically centered on fulfilling some humanitarian need, an auditor may feel strong emotional bonds to a nonprofit client. These connections, like financial ties to a for-profit firm, could compromise the auditor's ability to objectively evaluate evidence (independence-in-fact). Knowledge of these bonds could also lead donors to perceive impairments to the auditor's independence (independence-in-appearance) and corresponding declines in financial statement reliability.

    Recognizing the potential significance of the above issues, this paper examines in an experimental setting the effects of auditors' emotional, nonfinancial ties to a nonprofit client on donors' perceptions of financial reporting quality. This investigation, the first known study of its kind, is important for two primary reasons. First, individual donors are critical to many nonprofit organizations' continued financial viability. Their contributions, amounting to well over one percent of annual American gross domestic product each year, typically account for the vast majority of all donations received by the nonprofit sector (AAFRC, 2008; Tong, 2008), one of the fastest growing segments of the American economy (American Institute of Philanthropy, 2010; Neely et al., 2007). Second, the accounting literature has well documented the relevance of financial information to donors when making contribution decisions (Keating et al., 2008; Parsons, 2003; Tinkelman, 1999; Greenlee and Brown, 1999; Weisbrod and Dominguez, 1986).

    Moreover, a recent study by GuideStar (2011), a leading Internet provider of nonprofit information, found that individual donors currently base one-third of their contribution decisions on some type of organizational research, and that over 50 percent of individual donors would like to have access to financial and nonfinancial information when deciding their contribution amounts. If donors perceive nonfinancial auditor-client ties as rendering the external reporting process less dependable, then they might decrease their level of reliance on an entity's financial statements and adjust their contribution amounts accordingly. While it is true that individual donors may not currently be aware of emotional bonds between auditors and their clients, their calls for greater nonprofit reporting transparency and accountability (GuideStar, 2011), combined with the ever expanding dissemination of nonprofit information over the Internet, could make all types of disclosures, including ones revealing auditors' nonfinancial bonds to their clients, commonplace in the future.

    Several sections comprise the remaining portions of this paper. The next section reviews the literature surrounding auditor independence. It is followed by discussions of the study's hypothesis and research methodology. The statistical analysis of the hypothesis and an explanation of its results and implications are then presented. The paper concludes with a delineation of the study's limitations.

  2. LITERATURE REVIEW

    In the audit process of both for-profit firms and nonprofit organizations, the auditor faces two types of independence: independence-in-fact and independence-in-appearance. Independence-in-fact is largely a mental attitude, requiring the auditor to objectively consider evidence from all sources and to refrain from actions resulting in personal financial gain at the expense of...

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