The Economic Consequences of Financial Audit Regulation in the Charitable Sector

• Published date: 01 September 2022
• Author: RAPHAEL DUGUAY
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/1475-679X.12417

DOI: 10.1111/1475-679X.12417

Journal of Accounting Research

Vol. 60 No. 4 September 2022

Printed in U.S.A.

The Economic Consequences of

Financial Audit Regulation in the

Charitable Sector

RAPHAEL DUGUAY ∗

Received 1 May 2020; accepted 7 December 2021

ABSTRACT

I provide evidence on the effects of financial audit mandates in the charitable

sector, in particular their influence on donor behavior. My empirical strategy

relies on variation in size-based exemption thresholds across states and dif-

ferences in size driven by the nature of charities’ activities. Consistent with

audit mandates reducing donors’ reliance on charity reputation, I find au-

dit mandates are associated with a lower concentration of donations on the

∗Yale School of Management, CIRANO

Accepted by Rodrigo Verdi. This paper is based on my dissertation at the University of

Chicago. I am grateful to my dissertation committee: Marianne Bertrand, Hans Christensen,

Christian Leuz (chair), and Michael Minnis. I also appreciate helpful comments from an

anonymous associate editor, an anonymous reviewer, Daniel Aobdia, Ray Ball, Jean Bédard,

Philip Berger, Jonathan Bonham, Matthias Breuer, John Gallemore, Rachel Geoffroy, Karen

Kitching (discussant), Anya Kleymenova, Miao Liu, Maria Loumioti, Charles McClure, Mark

Maffett, Thomas Rauter, Haresh Sapra, Douglas Skinner, Abbie Smith, and workshop par-

ticipants at Boston College, the University of Chicago, Columbia, the University of Illinois

at Chicago, INSEAD, Laval University, McGill University, McMaster University, the University

of Michigan, MIT, New York University, Northwestern University, Stanford, the University of

Southern California, the University of Texasat Dallas, the University of Toronto, Yale, and the

AAA GNP Midyear Meeting. I thank multiple regulators, charity managers, and auditors for

providing helpful institutional insight. I gratefully acknowledge financial support by the Rus-

tandy Center for Social Innovation as well as the Accounting Research Center at the University

of Chicago Booth School of Business, Yale School of Management, and the Social Sciences

and Humanities Research Council of Canada. Any errors or omissions are my own. An on-

line appendix to this paper can be downloaded at https://research.chicagobooth.edu/arc/

journal-of-accounting-research/online-supplements.

1463

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

This is an open access article under the terms of the Creative Commons Attribution License, which

permits use, distribution and reproduction in any medium, provided the original work is properly cited.

1464 r. duguay

largest, most well-known charities. I show this reallocation of resources allows

the charitable sector to serve more diverse geographic areas and social needs.

In terms of the effect on willingness to give, I document that audit mandates

are associated with a higher proportion of taxpayers who donate. However,

I only observe a sizable impact on total contributions in dollars for charities

with high inherent information asymmetry. Collectively, these results suggest

financial audit regulation reduces information frictions and thereby affects

resource allocation in the market for charitable giving.

JEL codes: L31, L38, M42, M48, M49

Keywords: financial-reporting regulation; auditing; resource allocation;

nonprofit organizations

1. Introduction

Financial audit regulations lie at the heart of major policy debates. Con-

cerns range from the scope of mandatory audit engagements (e.g., impos-

ing internal-control attestations on public companies) to the requirement

to obtain an audit in the first place (e.g., the audit mandate for European

limited-liability companies). Regulation mandating that charities have their

financial statements audited is also contentious. On one hand, such audit

mandates could solve potential market failures or externality issues. For ex-

ample, they could help regulators identify illegitimate charities that prey on

naïve or apathetic donors and squander taxpayers’ money by taking advan-

tage of tax subsidies. On the other hand, mandatory audits can represent

a financial and administrative burden for charities. In the mid-2000s, the

Senate proposed a reform that would have required charities throughout

the United States to obtain an audit (U.S. Senate [2005]). Various parties,

including representatives of the nonprofit sector, were divided in their view

of the proposal. In the end, the federal government did not pass the na-

tionwide audit mandate and instead continued to allow the states to decide

whether to impose such regulation.1

In this paper, I evaluate the economic consequences of financial audit

regulation in the charitable sector by exploiting variation in size-based ex-

emption thresholds across states and differences in size driven by the nature

of charities’ activities. The entities I study are public charities, which are tax

exempt under section 501(c)(3) of the Internal Revenue Code. These orga-

nizations rely on financial support from the public to fulfill their mission.2

1The United States is not an isolated case. For example, Australia, Canada, and the United

Kingdom also had recent debates over nonprofit audit regulation.

2Examples of missions pursued by public charities include providing relief to the poor, the

distressed, or the underprivileged, preventing cruelty to children or animals, lessening the

burdens of government, etc. (IRS [2018a]). Organizations in the healthcare and education

sectors are exempted from the state-level regulations studied in this paper, because they are

subject to industry-specific audit mandates (Neely [2011], Desai and Yetman [2015]).

consequences of financial audit regulation 1465

However,the separation between the charity managers and the donors gives

rise to an agency tension.

In the context of agency issues in the charitable-giving sector, investi-

gating the consequences of nonprofit audit regulation is particularly im-

portant, given its sheer economic significance. Indeed, the United States

counts approximately 300,000 public charities that collectively receive over

$1.7 trillion in annual income (McKeever [2015]). Charitable donations

alone amount to 2% of the gross domestic product (List [2011]). Further-

more, approximately 10% of employed Americans work for nonprofit orga-

nizations (Blackwood, Poliak, and Wing [2008]). In addition to the sheer

size of aggregate donations, the practice of giving to charities is prevalent

among households: between 67% and 89% of U.S. households do so in

given year (Sullivan [2002], List [2011]).

Moreover,agency problems are especially difficult to address in the chari-

table sector (Core, Guay, and Verdi [2006]). For instance, private litigation

is not a prevalent disciplining mechanism, because entering into formal

private contracts with small and dispersed donors is generally unfeasible

for charities. Similarly, class-action lawsuits against charities are nearly in-

existent because donors rarely incur the damage from misappropriation of

donated funds (the beneficiaries do). Given these frictions, research shed-

ding light on whether financial audit regulation can alleviate the agency

problem becomes salient.

I propose that state-level audit mandates reduce donors’ moral-hazard

concerns for four reasons.3First, in the charitable sector, audited financial

statements provide assurance over the extent to which donated funds are

spent toward charitable programs (AICPA [2017], FASB [2018]). Second,

an audit can prompt organizations to improve their governance practices

(Duguay [2021]). Third, audit mandates facilitate oversight by third par-

ties like state regulators, the press, and nonprofit watchdogs (e.g., Charity

Navigator).4Many donors indeed implicitly rely on third-party oversight be-

cause performing their own due diligence would be too time consuming.

Fourth, audit mandates guarantee that charities will obtain an audit ex post

and thereby provide a reliable account of how they spent donated funds.

Through these mechanisms, I predict that audit mandates not only raise

individuals’ willingness to give, but also shape how donors allocate their

contributions among charities. Specifically, I hypothesize that audit man-

dates lead donors to shift part of their donations toward smaller, lesser

3This paper seeks to evaluate the overall effect of nonprofit audit mandates on resource

allocation. In other words, I do not to aim to isolate the regulatory component of audit man-

dates from the generic effects of obtaining a financial audit. (See Kausar et al. [2016] for a

paper whose objective is to separate the effects of an audit depending on whether it is obtained

voluntarily or mandatorily.)

4This explanation is consistent with motives cited by policy makers. For example, Hawai-

ian legislators state that requiring charities to file audited financial statements would “help

enforcement officials spot red flags” and would help donors “find out if an organization is a

legitimate charity” (Hawaii Senate [2008]).