MIT Sloan study shows negative effects of Sarbanes Oxley on nonpublic entities

CAMBRIDGE, Mass., Nov. 16, 2017––While it’s common knowledge that the passage of Sarbanes-Oxley (SOX) in 2002 impacted public companies, a recent study by MIT Sloan School of Management Prof. Andrew Sutherland found it also had significant effects on private companies and nonprofits. After SOX, the demand for auditors by public companies increased, leaving fewer auditors available for private companies and nonprofits. As a result, audit fees for nonpublic entities increased significantly and private companies applying for bank financing decreased their use of independent auditors.

Most of the discussion and analysis about SOX has focused on publicly-held companies, but private companies and nonprofits also have substantial financial reporting needs, says Sutherland. “For example, many organizations in a banking relationship will need an audit to establish creditworthiness. Financial reporting may also be required to establish payment plans with vendors and suppliers. And charities need to show they are responsibly spending donors’ money.”

In this study, Sutherland and his colleagues examined how shifts in the public company audit market from SOX affected the nonpublic audit market. They examined two U.S. nonpublic settings: private companies and nonprofit organizations, including charities and governmental entities. “We found that SOX decreased the common pool of auditors, causing shocks in the market that affected supply across other types of organizations,” he says.

For nonprofits, they found that annual auditor fee increases more than doubled. The study also revealed that the likelihood of a nonprofit losing its current auditor doubled after the passage of SOX due to fewer available auditors. These switches in the nonprofit market changed the audit supply structure, with the usage of large audit firms – the “Big 4” market – decreasing by half.

Private firms reduced their use of independent financial reports in bank financing by 12%, instead relying 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 by the regulation, as many previously served both the public and private markets. After SOX, the increasing complexity in accounting rules caused many auditors to specialize in just one market, contributing to the labor shortage problem.

“Our study shows that the audit markets were very connected. A development that affected one of the three segments of public, private and nonprofit, had negative spillover effects on the other two,” says Sutherland.

He notes that these effects can be part of the conversation about future regulation, concerning both public equity markets and occupational licensing standards that restrict the entry of new labor into the market. “When the regulators of public firms implement new accounting rules, they don’t tend to consider the effects on unregulated parties, even though those effects can be significant.”

The good news is that the pool of independent auditors is now back to a sufficient level, adds Sutherland. “As is the case with many professions, it takes several years for people to obtain the training and certifications required. The labor shortage is less of an issue today, but this is still a cautionary tale for future regulatory changes.”

Sutherland is the Ford International Career Development Professor of Accounting and an Assistant Professor of Accounting at the MIT Sloan School of Management. He also is a coauthor of “Regulatory Spillovers in Common Audit Markets.”

About the MIT Sloan School of Management

The MIT Sloan School of Management is where smart, independent leaders come together to solve problems, create new organizations, and improve the world. Learn more at mitsloan.mit.edu.