Does Hiring a Local Industry Specialist Auditor Matter to Nonprofit Organizations?

Abstract

Prior literature on auditor choice in the nonprofit market has largely focused on auditor size as a measure of audit quality. We extend this literature by examining a more refined definition of nonprofit audit quality which incorporates the twelve mission industries defined by the National Taxonomy of Exempt Entities (NTEE). Different from prior studies, we investigate audit firm industry specialization based on these twelve industry categories rather than classifying the nonprofit sector as a whole as an industry, highlighting that different types of nonprofit organizations require specialized auditor knowledge. We also measure industry specialization at a local metropolitan service area (MSA) level, taking into account the varying state regulatory environments and the more localized audit market for nonprofit organizations. We use this improved measure to study both the determinants and consequences of nonprofit auditor choice. We find that industry specialist auditor choice among nonprofit organizations is associated with higher governance quality (higher governance index, larger boards, and more independent boards), poorer financial health, and greater complexity. Moreover, nonprofits audited by industry specialist auditors issue more timely financial reports to stakeholders and see a future increase in direct donations than nonprofits audited by non-specialist auditors and Big 4 auditors.

Keywords: Nonprofit Audit Quality, Auditor Specialization

JEL Classification: M42