Are Foreign Donors Good Monitors?

By | June 28, 2021

Economic and accounting literature has long found that foreign investments provide a multitude of benefits to local stock markets and economies. Foreign inflows to for-profit firms are found to harvest not only capital but also managerial and marketing skills in addition to business connections and human resource development. For-profit foreign institutional investors have also been documented as improving firm performance, corporate governance, firm value, and corporate transparency. For example, prior research has shown that for-profit firms with international institutional investors have better corporate governance practices, suggesting that governance travels around the world with these institutional investors. Despite this, little is known about whether and how such an effect exists in the nonprofit sector.

This is surprising given that nonprofit organizations play such an important role in developing societies and promoting welfare on a global scale. To fill this void in our collective understanding, our research examines whether foreign institutional donors play an active monitoring role in the Chinese nonprofit sector. Based on similarities between for-profit foreign institutional investors and foreign donors, we expect that foreign donors actively engage in monitoring to ensure that their international philanthropy is carried out in an accountable and responsible manner.

Specifically, we argue that foreign institutional donors are similar to their for-profit peers in three ways. First, foreign institutional donors, like foreign investors, are less likely to have business dealings with local foundations. Therefore, they do not need to be more accommodating to nonprofit insiders and are in a position to be more effective as external monitors. For example, prior literature finds that privatized firms worldwide become more likely to appoint a Big Four auditor with increasing foreign ownership, while an increase in state ownership is associated with being less likely to use a Big Four auditor.

Second, foreign investors and donors alike, have better monitoring aptitude. They have a deeper understanding of a broader set of governance tools due to their global knowledge and experience, which places them in a better position to prod firms to adopt better governance practices. They are also better able to deploy superior monitoring technologies given their access to the global talent pool and the latest analytical tools. These advantages allow them to perform their monitoring more effectively and efficiently.

Third, they demand more control mechanisms in order to counter geographic, language, and cultural distance, leading to more effective monitoring. For example, U.S. institutional ownership is positively associated with subsequent changes in emerging market firms’ accounting comparability to their U.S. industry peers. Foreign institutional investors have also been found to have a larger positive impact on firms’ voluntary disclosure than domestic peers, leading to an increase in likelihood, frequency, and informativeness of firms’ management forecasts. Similarly, research shows that foreign institutional investors are likely to demand high-quality audits to mitigate the information asymmetry they face and to facilitate their monitoring.

In sum, we hypothesize that organizations with foreign institutional donors will demonstrate better reporting quality than organizations without such oversight. To address this research question, we use a sample of Chinese nonprofit organizations (called foundations or funds) to examine foreign donor monitoring. China provides a rich setting given that foreign donor investments are a relatively new phenomenon. Like the overall economy, the Chinese nonprofit sector experienced a reform and opening up process over the last two decades. More and more nonprofit foundations were established and many foreign institutional donors began supporting and monitoring Chinese foundations. Compared to other countries with a long history of foreign donor interaction, the sizable number of new foreign donors in our sample period provides a unique and powerful opportunity to separate the effect of foreign donors from other concurrent events.

Specifically, we test whether foreign institutional donors play a role in developing and monitoring financial reporting at Chinese nonprofit foundations. We focus on financial reporting for two main reasons. First, absent detailed governance information, nonprofit organizations’ financial reporting quality has been established by prior literature as a practical measure of good governance and monitoring which can affect donors’ decisions. Second, international giving, and therefore the use of international financial reports for donation decisions is becoming more common and important in recent years. Despite this, we are still in the early stages of understanding the role of reporting quality in an international setting, especially in developing countries. Thus, investigating factors affecting the reporting of these nonprofit foundations has the potential to further our understanding of this understudied market.

Using a sample of 2,567 unique nonprofit foundations in China over the period 2005-2014, we find that Chinese nonprofit foundations with foreign institutional donations are associated with higher quality reporting. Specifically, the presence of foreign institutional donors is associated with a 3% decrease in reporting zero fundraising expenses, a common measure of poor reporting quality in nonprofit organizations. These results are stronger for foundations without large domestic donors or sophisticated donors, consistent with the notion that nonprofit foundations with weaker prior governance benefit more from increased monitoring. We also find that the effect of foreign donors on reporting quality is only significant for nonprofit foundations without oversight from the national government, also in-line with a reduced need for additional outside monitoring from foreign institutional donors.

Based on these results, our study makes two major contributions to the literature. First, our paper adds to the understanding of the economic impact of foreign ownership and institutions. Literature shows that foreign institutional ownership can affect firm’s value and performance, promote governance, and enhance corporate transparency in the for-profit sector. Our study extends the capital market literature to the nonprofit setting by providing the first evidence of the complementary monitoring role foreign institutional donors’ play in promoting nonprofit organizations’ reporting quality. Given that a more transparent information environment resulting from higher reporting quality can facilitate the monitoring and contracting activities of different parties within the organization, our results provide insights into the question of to what extent foreign institutional donors bring positive externalities to other stakeholders.

Second, our paper contributes to the emerging literature on factors affecting nonprofit organizations’ reporting quality. While these studies focus on U.S. organizations, it is interesting and important in the pace of increasing globalization to evaluate and understand whether governance travels around the world in nonprofit settings as it does in the for-profit sector. Our results show that monitoring provided by foreign institutional donors can be an important driver of reporting quality improvement in Chinese foundations. These findings make important first steps in understanding the role of foreign donors at nonprofit organizations in the international setting, especially in developing countries where strict national regulations and domestic corporate donors’ monitoring are already in place.

In sum, we believe these are interesting findings given recent increases in Chinese nonprofit foundation regulations as well as monitoring pressure from domestic corporate donors. One interpretation for our results is that while foreign donors are aware of regulations in place, recent scandals signal that effective enforcement of strict regulations is not yet in place. This is common in developing countries and sheds additional light on the monitoring environment of the Chinese nonprofit sector. With the accelerating globalization of business, accounting researchers have increasingly conducted research in international contexts. While many studies exist in the context of for-profit organizations, there is little research on foreign nonprofit organizations. In this study we seek to stimulate empirical research in this important research area. By documenting the role of foreign institutional donors in Chinese nonprofit foundations our findings make important first steps in understanding the impact of foreign donors on nonprofit organizations in emerging markets.

Erica Harris is an Associate Professor at Florida International University – School of Accounting

Hsihui Chang is the KPMG Professor of Accounting at Drexel University 

Shushu Jiang is a PhD student at the University of Toronto – Rotman School of Management 

Zhiming Ma is an Associate Professor of Accounting at Peking University

This post is adapted from their paper, “Are Foreign Donors Good Monitors?”, available on SSRN.

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