While prior research has investigated audit effects in for profit industries, this study investigates audit effects at nonprofit organizations. Nonprofits in general and PHAs in particular are largely served by smaller auditors frequently classified in prior research as lower quality. Further, nonprofits in general represent low litigation risks for the auditors and the threat of litigation and associated economic loss is generally considered one motive for an audit firm to perform a high quality audit. The evidence suggests that audits matter in the nonprofit industry. So even in a setting where research would suggest there would be low audit quality, when the auditor is smaller and the risk of litigation is low, auditors make significant adjustments to pre-audited data and help to constrain management bias toward meeting pre-established financial thresholds.

For more information on this study, please contact Barbara Grein.

Grein, B. M., and S. L. Tate. 2011. Monitoring by Auditors: The Case of Public Housing Authorities. The Accounting Review 86 (4):1289-1319.

Audits are widely believed to be a means of improving financial reporting and mitigating management bias, although determining the actual effect of an audit is exceptionally difficult. In most cases, only the final results – audited financial statements and the audit report – are available. The authors take advantage of the unique setting of Public Housing Authorities (PHAs) where both pre-audit and post-audit data at the general ledger level are available. The study investigates

• the number, dollar amount, and direction of audit adjustments to common financial statement line items and to financial ratios that were integral in the monitoring system established by the Department of Housing and Urban Development (HUD), PHA overseer;
• whether audits result in significant adjustments to pre-audited data, both in terms of numbers of engagements with adjustments and the dollar amount of adjustments;
• whether auditors’ adjustments act to reduce potential management bias when PHAs have greater incentives to meet financial targets that were part of the HUD monitoring system; and
• whether auditors constrain overstatement bias differently than understatement bias.

The pre- and post-audit general ledger level data for nonprofit public housing authorities used in this study was obtained from HUD under the Freedom of Information Act. The study uses data from September 2001 through December 2007 as this was the period during which HUD enforced this specific monitoring system, Public Housing Assessment System.

• The authors find that for key accounts and ratios (e.g., total expenses, tenant revenue, current ratio) the percentage of observations with audit adjustments ranges from a low of 15% to a high of 69%.
• Further the study finds that audits result in material (economically significant) adjustments in PHA audit engagements.
• Overall, audit adjustments are consistent with auditors attempting to reduce management bias in the financial statements.
• In addition, the authors find that auditors appear to attend more to potential overstatements of quality scores than understatements.

http://www.auditingresearchsummaries.org

Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

For more information on this study, please contact

Anthony D. Holder, PhD, CPA

Assistant Professor, Department of Accounting - MS 103

University of Toledo

Toledo, OH 43606-3390

Email: Anthony.Holder@utoledo.edu

Web:    http://homepages.utoledo.edu/aholder4/

Phone: 1.419.530.2560

Fax: 1.419.530.2873 

Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

• Post-SOX reporting gains achieved by large firms (accelerated filers).
• Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.

We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

http://www.auditingresearchsummaries.org