How financial regulation of public companies can negatively impact nonpublic entities – Andrew Sutherland

Andrew Sutherland

MIT Sloan Assistant Professor Andrew Sutherland

The passage of Sarbanes-Oxley (SOX) was big news for public companies, but there was little discussion or analysis about what it meant for private firms, nonprofits and governmental entities. Yet those nonpublic entities needed to purchase accounting services from the same pool of independent auditors. It turns out that shocks to public companies from SOX significantly affected supply for the entire audit services market.

In a recent study, my colleagues and I looked at these developments and found that SOX had several negative spillover effects for nonpublic entities. Overall, audit fee increases for nonpublic entities more than doubled. Many others were forced to switch to a different auditor.

Why is this a big deal if those groups aren’t legally required to hire independent auditors? It’s important because nonpublic entities still have substantial financial reporting needs. For example, organizations use audits to establish payments plans with vendors and suppliers or to demonstrate creditworthiness to banks. Charities use audits to show they are responsibly spending donors’ money.

Here is a breakdown of the spillover effects:

When auditors became busier with SOX work, fee increases for nonprofits more than doubled. If that wasn’t a big enough impact, the likelihood of losing an existing auditor doubled for nonprofits due to the increased demand for auditors by public companies.

As nonprofits were forced to switch to smaller auditors – the bigger ones tended to stick with SOX clients — it dramatically changed the supply structure in the nonprofit market. After SOX, the usage of large audit firms – the “Big 4” market – decreased by half.

It may not seem consequential to have to switch auditors, but nonprofits care a lot about their public image. Switching auditors may raise questions as to whether a nonprofit is responsibly spending money.

Private firms didn’t make out much better. Facing large increases in audit fees, they reduced their use of independent financial reports in bank financing by 12%. Instead, they relied on documents such as tax returns or unverified reports, both of which lack the timeliness and neutrality of an independent audit.

Auditors were also impacted. In addition to an increased demand for their services, the complexity of the new rules led many to specialize in one market or the other. This further compounded the labor shortage problem.

Our study shows just how connected audit markets are. If you have a development that affects one of the three segments of public, private and nonprofit, it can have negative spillover effects on the other two.

This is an important finding because when regulators of public firms implement new accounting rules, they don’t typically consider the effects on unregulated parties. However, those consequences can be significant.

While the supply and demand issues from the implementation of SOX are less of an issue today, this study serves as a cautionary tale for future regulatory changes. Securities laws and occupational licensing requirements can combine to impose unintended costs on unregulated client segments.

Andrew Sutherland is the Ford International Career Development Professor of Accounting and an Assistant Professor of Accounting at the MIT Sloan School of Management. He is a coauthor of “Regulatory Spillovers in Common Audit Markets,” with Raphael Duguay and Michael Minnis of the University of Chicago Booth School of Business.

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