Paananen 2020

J. Account.
Public Policy xxx (xxxx) xxx
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J. Account. Public Policy

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Full length article
Determinants of audit report modifications in Finnish

municipalities
Mikko Paananen a,⇑, Jaakko Rönkkö a, Mikko Zerni b,y, David Hay c
a
Tampere University, Faculty of Management and Business, 33014 Tampere, Finland
b
University of Vaasa, P.O. Box 700, 65101 Vaasa, Finland
c
The University of Auckland Business School, 12 Grafton Road, Auckland, Private Bag 92019, Auckland 1142, New Zealand
a r t i c l e i n f o a b s t r a c t
Article history: Although municipalities are major economic and social actors in most countries, remark-
Available online xxxx ably little is known about their audits, particularly the determinants of their audit report
modifications. The existing evidence is ambiguous at best and scarce, which provides
Keywords: opportunities for further accounting studies in this area. Therefore, based on an agency
Municipality theory framework, we fill this important research gap by exploring three determinants
Auditing of audit report modifications in municipalities: (1) economic performance, (2) decentral-
Audit report modifications
ization of decision-making across different decision-making bodies, and (3) political com-
Economic performance
Decentralization of decision-making
petition between political parties in local councils. These determinants are examined based
Political competition on a large panel of data on Finnish municipalities for the period from 2009 to 2013, cover-
ing virtually all of the country’s municipalities. We find that a striking 33 percent of audit
reports had modifications during this period, which raises serious concerns about the state
of municipal management, accounting, and auditing in Finland. Regarding the above deter-
minants, the following conclusions can be made based on our analyses. First, we find par-
tial evidence that weak economic performance increases the likelihood of audit report
modifications. Second, the lower the competition among political parties in a local council,
the lower the likelihood of audit report modifications. Finally, the more decentralized deci-
sion making is across the different decision-making bodies under the local council, the
higher the probability of audit report modifications. These results are consistent with
agency theory’s explanations regarding the value of auditing.
Ó 2020 Elsevier Inc. All rights reserved.
1. Introduction
This study investigates the determinants of audit report modifications in Finnish municipalities, namely municipalities’
economic performance, the decentralization of decision making across different decision-making bodies, and the relative
political competition between parties in local councils. Despite the economic and social importance of municipalities,1
few studies have hitherto examined the determinants of audit report modifications for municipalities—a considerable limitation
⇑ Corresponding author.
E-mail address: mikko.paananen@thl.fi (M. Paananen).
y
Deceased.
1
Regarding the economic importance of municipalities, in 2013, Finnish municipalities employed over 439,000 individuals or 20 percent of the total Finnish
workforce, while the annual employment expenditure of 46 billion euros in 2013 represents 22.8 percent of the Finnish GNP (OECD, 2017).
https://doi.org/10.1016/j.jaccpubpol.2020.106777
0278-4254/Ó 2020 Elsevier Inc. All rights reserved.
Please cite this article as: M. Paananen, J. Rönkkö, et al., Determinants of audit report modifications in Finnish municipalities, J. Account.
Public Policy, https://doi.org/10.1016/j.jaccpubpol.2020.106777
2 M. Paananen et al. / J. Account. Public Policy xxx (xxxx) xxx
of the related literature. A recent exception, Paananen (2016) explored the determinants of audit report modifications in joint
municipal authorities in Finland. This study builds on and extends this previous research, and is an important starting point for
the research on the audit opinions of municipal organizations.
This study contributes to the nascent literature and recent research on the determinants of modifications in municipal
administration in the following ways. First, we extend the prior research on joint municipal authorities2 to the municipalities
themselves, as the entities that provide most statutory functions of local government. This is important because municipalities
and joint municipal authorities are fundamentally different organizations in terms of, for example, legislative obligations, orga-
nizational decision making, amplitude of operations, financing, and selection mechanism of decision makers. Some of these
areas have implications for audit report modifications, as will be subsequently shown. In Table 1, we outline the main differ-
ences between municipalities and joint municipal authorities. Generally, the operations of municipalities are much more ample
and complex and according to a recent survey by the Ministry of Finance, municipalities have 535 statutory functions, while
joint municipal authorities have no such functions (Valtiovarainministeriö, 2013). Recently, the operations of Finnish munici-
palities have undergone diverse and complex changes (including increased cooperation, incorporation. and outsourcing), which
has posed significant challenges for their internal control and risk management (Government Proposal, HE 268/, 2014;
Oulasvirta et al., 2014), as well as administration and governance. These changes are relevant, as prior research has suggested
that complexity (e.g., that comes with organizational size) tends to increase the risk of material errors (Ireland, 2003). From
Table 1, it is evident that the research on joint municipal authorities does not allow for far-reaching conclusions on the auditing
of municipalities, meaning separate research on the auditing of municipalities is needed.
Second, in contrast with the prior empirical-based research on the determinants of modifications in municipal adminis-
trations (Paananen, 2016), we conduct our analyses based on agency theory, an approach that has been found useful in audit-
ing studies (Wallace, 1980; Chow, 1982). Recent studies, such as those of Goddard (2010) and Hay and Cordery (2018), have
called for the wider application of this theory to public-sector auditing research. Further, agency theory is well-suited to this
setting because previous research has already used it to understand auditing in public-sector settings (Zimmerman, 1977;
Baber, 1983; Ingram, 1984, Blume and Voigt, 2011; Baber et al., 2013). However, agency relationships in the public sector
are more complex than those in the private sector because there are numerous principal–agent relationships (Streim,
1994). This point is also elaborated in the following quotation:
Democratic politics are easily viewed in principal–agent terms. Citizens are principals, politicians are their agents. Politicians are
principals, bureaucrats are their agents. The whole of politics is therefore structured by a chain of principal–agent relationships,
from citizen to politician to bureaucratic subordinate and on down the hierarchy to the lowest-level bureaucrats who actually
deliver services to citizens. (Moe, 1984, p. 765)
Third, to develop our hypotheses, we draw on three different areas: (1) economic performance, (2) relative political com-
petition between the parties in a local council, and (3) decentralization of decision making. Prior research has indicated that
economic performance is a major determinant of modifications for business firms (e.g., Dopuch et al., 1987; LaSalle et al.,
1996) and that economic performance also determines audit report modifications for joint municipal authorities
(Paananen, 2016). Nevertheless, the effects of economic performance on the modifications for municipalities in general
are unknown. We thus argue that municipalities require a distinct approach, as they do not pursue superior economic per-
formance; instead, they exist to produce statutory services for municipal citizens. Specifically, the present study presents
new, more appropriate measures to explore the economic performance of municipalities, while considering population size.
The other two hypotheses on political competition and decentralization were not previously tested in this municipal setting,
which is why it is important to examine them, especially since previous studies have provided some preliminary indications
that both political factors (Baber, 1983; Baber et al., 1987; Cohen and Leventis, 2013; Peterson, 2018) and decentralized deci-
sion making (Simunic, 1980) are associated with auditing in other settings.
Finally, we strengthen the prior empirical examinations of municipal administrations, which were based on cross-
sectional data with a relatively small number of observations (Paananen, 2016) as follows. The larger sample in our study
provides more convincing evidence. Additionally, we introduce more control variables in an empirical model relevant to
the context of municipalities, namely whether a municipality is a crisis municipality under the terms of the Ministry of
Finance, average age of the population, and level of government contributions. The additional control variables take account
ofconsider issues that could be expected to have an impact.
The rest of this paper is organized as follows. The Finnish system for municipal audits is explained in Section 2. The
hypotheses are developed in Section 3 and the empirical model is described in Section 4. The data employed and descriptive
statistics are presented in Section 5. The results of the empirical analyses are presented in Section 6, while Section 7 con-
cludes the study.
2. Municipal auditing in Finland
In Finland, municipalities are self-governing local units with wide-ranging local decision-making power (Local
Government Act 365/1995), being responsible for the provision of services to their inhabitants, such as social welfare and
2
A joint municipal board is a form of permanent collaboration between municipalities in some operational field.
M. Paananen et al. / J. Account. Public Policy xxx (xxxx) xxx 3
Table 1
Main differences between municipalities and joint municipal authorities.
Topic Municipality Joint municipal authority

Number of units
Number of units 320 (The Association of Finnish Local and Regional 138 (The Association of Finnish Local and Regional
(Continental Finland, Authorities) Authorities)
2012)
Governance
Owners Not applicable Municipalities
Highest decision-making A local council elected by the residents (political) for a A joint municipal authority’s power of decision shall be
body four-year period (Local Government Act 410/2015) exercised by the joint municipal authority council or the
general assembly. Joint municipal authority councils shall
be subject to the provisions laid down on local councils.
The members of a joint municipal authority council shall
be elected by the municipalities in the manner agreed in
the charter. If a joint municipal authority’s power of
decision is exercised by a general assembly, the assembly
must convene at least twice a year. Each member
municipality’s local executive or other decision-making
body of the member municipality as decided by its local
council shall elect a general assembly representative
separately for each meeting (Local Government Act 410/
2015)
Mechanism to elect the Local elections every four years (Local Government Act Elected by the member municipalities (Local Government
highest decision-making 410/2015) Act 410/2015)
bodies
Governance structure Each municipality must have a local council, a local A joint municipal authority’s power of decision shall be
executive, and a local authority audit committee. The exercised by the joint municipal authority council or the
local council may also establish local authority general assembly. In a joint municipal authority with a
committees to operate under the local executive, or, single decision-making body, the power of decision is
alternatively, 1) standing committees for managing divided between the member municipalities and the joint
functions of a permanent nature; 2) management boards municipal authority’s decision-making body in the
for managing a municipally owned company or for a manner agreed in the charter. The members of a joint
particular function; 3) sub-committees for the local municipal authority council shall be elected by the
executive, for a local authority committee, for a standing municipalities in the manner agreed in the charter (Local
committee, or for a management board. (Local Government Act 410/2015).
Government Act 410/2015)
Management’s liabilities According to Local Government Act 410/2015, tasks in According to the Local Government Act (410/2015), tasks
which public authority is exercised shall be performed in in which public authority is exercised shall be performed
a public-service employment relationship. These persons under a public-service employment relationship. These
are subject to liability for acts in office and to the persons are subject to liability for acts in office and are
provisions of the Criminal Code (39/1889) concerning subject to the provisions of the Criminal Code (39/1889)
offenses in office. concerning offenses in office.
Finance
Main sources of finance Bank lending, retained earnings, leases, original capital Municipalities shall be responsible for the financing of
their functions, even if the service arranging
responsibility has been transferred to a joint municipal
authority (Local Government Act 410/2015).
Main sources of income Taxes, central government transfers Operating income
Organizational characteristics
Role in a municipality group Parent (prepares consolidated financial statement) Subsidiary
structure
Purpose of existence Promote the welfare of residents (Local Government Act Municipalities may agree on transferring service
410/2015) arranging responsibilities to a joint municipal authority
(Local Government Act 410/2015). Typically, joint
municipal authorities operate in healthcare or education.
Profit motive No No
Going concern assumption Not applicable (according to Bankruptcy Act 120/2004, a Not applicable (according to Bankruptcy Act 120/2004, a
municipality cannot be declared bankrupt). joint municipal authority cannot be declared bankrupt).
Statutory functions Yes (535 statutory functions) (Valtiovarainministeriö, No
2013)
Governing act Local Government Act 410/2015 Local Government Act 410/2015
(organization)
Audit regulation
Governing act (auditing) Local Government Act 410/2015), Act on Chartered Public Local Government Act 410/2015, Act on Chartered Public
Finance Auditors 1142/2015 Finance Auditors 1142/2015
Auditing standards National: good auditing practice in public administration National: good auditing practice in public administration
(Local Government Act 410/2015) (Local Government Act 410/2015)
(continued on next page)
Table 1 (continued)
Topic Municipality Joint municipal authority

Auditor For the audit of administration and finances, the local For the audit of the administration and finances, the joint
council shall appoint a firm of authorized public municipal authority council or the general assembly shall
accountants, which must be a firm approved by the Board appoint a firm of authorized public accountants, which
of Chartered Public Finance Auditing (CPFA corporation). must be a firm approved by the Board of Chartered Public
The CPFA corporation must appoint a chartered public Finance Auditing (CPFA corporation). The CPFA
finance auditor (CPFA auditor) as the responsible auditor. corporation must appoint a chartered public finance
Auditors shall, in their duties, be subject to liability for auditor (CPFA auditor) as the responsible auditor.
acts in office (Local Government Act 410/2015). Auditors shall, in their duties, be subject to liability for
acts in office (Local Government Act 410/2015).
Content of audit The auditors must audit 1) the administration, 2) The charter of a joint municipal authority must include
accounting, and 3) financial statements for the respective agreement on the auditing of the joint municipal
accounting period. In addition, the auditors are required authority’s administration and finances (Local
to 4) examine whether the information provided about Government Act 410/2015).
the basis for central government transfers to the local
government is correct and 5) whether the internal control
and risk management of the municipality and oversight of
the local authority corporation have been properly
arranged. Moreover, the auditor must state whether the
members of the decision-making bodies and the senior
local government officers for the relevant areas of
responsibility of the decision-making bodies (parties
liable to render accounts) can be discharged from liability
(Local Government Act 410/2015).
healthcare services, education and culture facilities, and managing and maintaining the operating of local environmental and
technical infrastructures. The audit of municipalities is regulated by Local Government Acts (365/1995 and 410/2015), which
specify that the auditors of municipalities must be persons, Certified Public Finance Auditors (CPFAs), or audit firms autho-
rized by the Board of Chartered Public Finance Auditing (BCPFA). When an audit firm is appointed, it must designate a CPFA.
The Local Government Act requires auditors to comply with good auditing practices in public administration, as approved by
the Chartered Public Finance Auditor Association (Julkishallinnon ja -talouden tilintarkastajat ry, 2006). The guidelines for
good auditing practices approved by the Finnish Institute of Authorized Public Accountants are from the International Fed-
eration of Accountants (IFAC). These standards increase the comparability of our setting to other public organization settings.
The Local Government Act (365/1995) states that CPFAs must audit the administration, accounting, and financial state-
ments of municipal organizations for the respective accounting period, in accordance with good auditing practices. Specif-
ically, in their issued audit report, CPFAs are required to ascertain that:
(1) The administration of the municipality has been structured in accordance with the law and the decisions of the local
council;
(2) The municipality’s financial statements and consolidated financial statements have been prepared in accordance with
the provisions concerning the preparation of financial statements and provide accurate and sufficient information on
activities, finances, financial trends, and financial obligations;
(3) The information on the basis for and use of central government transfers to local government is correct; and
(4) The internal controls for the municipality, the local authority corporation, and the oversight of the local authority cor-
poration have been appropriately organized.
Additionally, auditors are required to issue a separate opinion about whether financial statements can be approved and
whether the members of decision-making bodies and the senior local government officials designating the areas of respon-
sibility of the decision-making bodies can be discharged from liability. These opinions cannot be modified if there are no
modifications in the audit results.
3. Hypotheses development
We draw on the agency theory perspective, which was deemed useful in auditing research (Wallace, 1980; Chow, 1982;
Hay and Cordery, 2018). Previous studies have found that political competition is related to auditing (Baber, 1983), that
accounting and auditing by state governments are related to economic incentives (Ingram, 1984), and that an agency
approach to public-sector auditing research can help standard-setters improve government accounting through regulation
(Ingram et al., 1987). Municipalities have various stakeholders, including municipal citizens, local councils (or municipal
councilors or political parties represented in the councils), and municipal officials. Fig. 1 illustrates the main conflicts among
stakeholders in municipalities.
First, municipal citizens periodically elect municipal councilors to local councils to represent them in decision making.
Since the councilors act on behalf of the citizens, there exists a conventional principal–agent relationship between them.
Municipality
Municipal citizens
elect
Councilors as principals
(principal–principal conflicts
between councilors of different
parties)
Officials as agents
(principal–agent conflicts
between councilors and
officials)
Municipality's auditor (mitigates

conflicts between: 1) councilors
and officials and 2) political
parties by designating auditor's
report to the local council)
Fig. 1. Agency conflicts in municipal organizations. This figure illustrates the two main conflicts of interest that the municipal auditor pursues to mitigate:
(A) The finance-related principal –agent conflicts between councilors and officials and (B) The administrative principal–principal conflicts between different
political parties and individual politicians. These conflicts of interest are illustrated by lightning bolts, while the potential effects of the external auditor are
illustrated by suns. The independent municipal auditor mitigates the conflicts of interest by generating reliable and objective information for the municipal
council in the form of an auditor report. The various colors of the principals represent the different political parties.
However, this relationship is not relevant from an auditing perspective because citizens do not become directly involved in
the administration of municipalities. Therefore, auditors do not deal with citizens directly, but have instead audit-related
engagements with local councils. Second, municipal officials act on behalf of the local councils, forming a principal–agent
relationship with the elected councilors. These councilors are then responsible for the municipality’s activities and finances.
In turn, officials are responsible for taking action according to the decisions of the council. Clearly, the relationship between
councilors and officials is subject to the agency conflicts related to economic performance. Third, local councils consist of
municipal councilors from different political parties and are elected through municipal elections. Since political decision
making is based on the group decisions of political parties, it emphasizes the role of these parties over individual municipal
councilors in terms of municipal decision making. As parties have different political agendas, there are obvious conflicts
between them in the local council. Theoretically, the relationships between political parties can be defined as principal–prin-
cipal relationships and are comparable to the relationships between minority shareholders and majority shareholders in the
context of business firms (Peng and Sauerwald, 2013). Using the above theoretical framework, we hypothesize that the
determinants of audit report modifications are: (1) economic performance, (2) relative political competition between the
parties in local councils, and (3) decentralization of decision making.
3.1. Economic performance
Prior research has shown that weak economic performance increases the likelihood of audit report modifications (e.g.,
Dopuch et al., 1987; LaSalle et al., 1996). We suggest the following potential agency-theory-based reasons for the correlation
that can be explored in the public sector. Generally, local councils are responsible for municipalities’ budgets and financial
plans (Local Government Act 410/2015), while municipal officials are responsible for executing these plans on behalf of the
councils. We argue that weak economic performance creates conflicts of interest between the above parties, thus increasing
the likelihood of audit report modifications (Frost, 1997). As such, it is in the interests of municipal officials to improve the
economic performance of a municipality to retain their public offices and many municipalities have recently had to make
significant staff reductions due to their weak economic performance (recent examples include Imatra; Joensuu; Kemi; Kuo-
pio; Kouvola; Mikkeli; Riihimäki; Rovaniemi; Vaasa). Based on the above discussion, we posit the following hypothesis:
H1: A weaker (stronger) economic performance is positively (negatively) associated with the likelihood of audit report
modifications.
In other words, the risk of losing public office is a real threat to municipal officials. Similarly, it is the duty of municipal
councilors to ensure the municipality is in a good financial position to be able to provide statutory services to municipal cit-
izens. However, previous research suggests that councilors also have their own interests, which contradict the interests of
officials. Specifically, because councilors have a vested interest in re-election, they tend to over-use municipal funds prior
to an election to show they have kept their election promises. For example, Bastida et al. (2014) observed that incumbent
councilors tend to either overestimate revenues or exceed the budgeted expenditures to gain popularity and electoral sup-
port. Such behaviors tend to degrade the economic performances of municipalities, thus contradicting the goals of the
municipal officials. Since municipal councilors ultimately decide on the municipal economy, officials are rarely able to
defend their interests. These different interests expose the parties to a conflict, which can be expected to evoke audit report
modifications. As Frost (1997) put it: ‘‘. . . modified audit reports signal accounting and auditing deficiencies and other
adverse conditions which themselves might cause serious conflicts between the objectives of managers and their firms’ own-
ers” (p. 168). As a result, we argue that a weaker economic performance creates conflicts of interests between municipal offi-
cials and councilors, which is likely to increase the likelihood of accounting and auditing deficiencies, which will in turn lead
to audit report modifications.
3.2. Relative political competition between parties in the local council
Previous studies have found that political factors impact public-sector auditing. For instance, Baber (1983) found a cor-
relation between relative political competition and audit budgets in state governments, while Baber et al. (1987) identified
significant associations between political factors and audit fees for county governments. Ward et al. (1994) investigated the
impact of political competition on audit fees but found no significant relationship between them. Cohen and Leventis (2013)
discovered that strong political opposition to a mayor and mayoral re-election tend to increase audit delay. Bradbury and
Scott (2015) reported that higher-than-expected expenditure and other measures of accounting performance of local coun-
cils are associated with increased voter turnout and an increased probability for the re-election of councilors. Recently,
Peterson (2018) observed that election policies have a meaningful effect on governance quality, thus shaping the effective-
ness of internal controls. While political factors have been identified as influencing auditing and governance, their impact on
audit report modifications is not yet known. Therefore, following prior research, we examine the impact of political factors
on auditing.
We argue that political competition is likely associated with modified audit opinions. Municipalities are self-governing
entities governed by politically elected local councils. In Finland, the councils consist of municipal councilors (politicians)
that are elected by municipal citizens every fourth year. The number of councilors is determined by the population of a
municipality (Local Government Act 365/1995, 410/2015) and they represent different parties that compete for the political
power that is unevenly distributed among them. As parties drive their own political agendas, the competition between them
gives rise to principal–principal conflicts between them in the local council. This level of competition affects the ease of deci-
sion making in municipalities. Since political decision making requires majority decisions, strong political competition
would make it more difficult to push through decisions in the council, thus increasing the conflicts between the parties. This
is consistent with the view that increasing the diversity of principals creates agency conflicts and increases the demand for
auditing (Carey et al., 2000).
Hence, we argue that the political competition between parties increases the problems caused by conflicts, exposing
municipalities to audit report modifications. Conflicts mostly appear on municipal spending issues, which involve politically
ideological choices. After all, one of the main tasks of a local council is to approve the budget (Local Government Act
410/2015), that is, decide how the financial resources of the municipality will be spent. Following prior research, we state
that competing political parties will find themselves under pressure to support the additional expenditure that will benefit
some voters, who will then vote in accordance with their self-interest (Bradbury and Scott, 2015). Elected councilors in
municipalities with stronger competition will be motivated to increase spending and thus their appeal to voters. This will
again give rise to conflicts of interest, with municipal officials striving to reach the unrealistic goals set by councilors, and
to an increased likelihood of accounting, administrative, and governance failures. In summary, where there is political com-
petition, there are greater incentives for elected councilors to spend more and attract votes; however, this can lead a munic-
ipality into financial difficulty, which is known to cause audit report modifications (e.g., Paananen, 2016). The recent ‘‘Kittilä
case” in Finnish municipal administration supports the above theoretical reasoning, in that the changes from low relative
political competition (a single party has a majority of the votes in the council) to high relative political competition (no single
party has the majority of the votes in the council) led to significant conflicts between parties in the council, causing several
audit report modifications over the years.3 The above discussion leads to our next hypothesis:
H2: High relative political competition in local councils is positively associated with the likelihood of audit report
modifications.
3
A separate clearing group was set up to investigate the difficult situation in this municipality, whose report described a situation which largely resulting
from the change in political competition, as follows: ‘‘The municipal administration has encountered extraordinary difficulties in the form of divergent decision
making, a climate of mistrust, key personnel exchanges, staff stress, and sick leave. The administrative challenges mainly concern the activities of the municipal council
and council, as well as the central administration. The organization of stewards is strongly divided into two camps, which is reflected in voting decisions, complaints,
and lack of common will, and inability to negotiate common lines. There is a climate of fear in the administration regarding numerous and possibly future prosecutions
or requests for investigation. The accusations and the resulting publicity have caused distress to the trustees and have even been perceived as a threat to health. Decision
making is controversial. There is a risk that municipal development and development will be stalled due to controversy and confusing administrative situation. All the
time and energy seems to be spent on legal investigations and there is not enough time left for the issues that are important for the operation and development of the
municipality” (Kittilän kunnan selvitysryhmän arviointi ja toimenpide-ehdotukset 27.2.2018, pp. 11–12). The above description shows that conflicts of interest
between parties can lead to modifications in audit reports. In Kittilä, the audit report has been modified for various reasons in every year of the last decade.
3.3. Decentralized decision making
Municipal decision making is commonly decentralized to several different decision-making bodies. While there are obli-
gatory bodies such as the local council, local executive, and local authority audit committee (Local Government Act
365/1995), virtually all local councils also establish voluntary local authority committees, management boards for managing
municipally owned companies or particular functions, sub-committees, and others to facilitate the management of the
municipality. This system disperses widely the decision making of municipalities and the degree of decentralization varies
considerably among municipalities.
First, there exist principal–agent conflicts between the local council and the decision-making bodies operating under the
council (Jensen and Meckling, 1976). Building on Simunic’s (1980) arguments on the complexity of auditees’ operations, we
argue that organizational decentralization tends to increase complexity in an organization and also the potential agency con-
flicts (Jensen and Meckling, 1976) between local councils and other hierarchically lower-level decision-making bodies.
Simunic (1980) stated that the complexity resulting from organizational decentralization increases the number of decision
centers in an organization (i.e., decision-making bodies in municipalities) that need to be monitored. Further, Hay (2003)
reported the increased relevance of accounting for activities that were decentralized to a greater extent. This is particularly
relevant in municipal auditing because it involves auditing the implementation of decisions from institutions and officials,
including the content of these decisions, compliance with power, appropriateness of the minutes, notification of decisions
and notification of appeals, implementation of decisions, and archiving of records and other material (Leppänen, 2015).
Second, a decentralized decision-making system causes increased internal control requirements for organizations
(Simunic, 1980), which we argue expose organizations to an increased likelihood of audit report modifications especially
in a municipal auditing context, where an auditor must issue an opinion on whether internal control is properly arranged.
As Paananen and Rönkkö (2015) showed, internal-control-related modifications are common in municipalities. The agency
theory literature examined organizations comprised of numerous stakeholders with multiple diverse, complex, and some-
times conflicting interests and agendas (Shapiro, 2016). The diverse and conflicting interests between these various stake-
holders need to be monitored, incurring monitoring costs (Jensen and Meckling, 1976). Conclusively, greater
organizational decentralization with multiple decision-making bodies increases monitoring costs, exposing organizations
to an increased risk of material errors if the monitoring is not adjusted to their required needs. Based on the above discus-
sion, we formulate our third hypothesis as follows:
H3: High organizational decentralization is positively associated with the likelihood of audit report modifications.
4. Empirical model and variables
As in Finland the audit report of municipalities has a two-stage structure, we propose two parallel logit models with dif-
ferent dependent variables to test our hypotheses:
Model ð1Þ MODIFIED A ¼ INCOMEF þ CASH þ DEBT þ ELECTED þ MAJOR þ CRISIS þ PORTFOLIO þ SIZE þ LAG
þ AUTH þ GENDER þ BIG4 þ AGE þ PORTFOLIO þ TRANSFERS þ TENURE
þ annual fixed effects þ e
and
Model ð2Þ MODIFIED B ¼ INCOMEF þ CASH þ DEBT þ ELECTED þ MAJOR þ CRISIS þ PORTFOLIO þ SIZE þ LAG
þ AUTH þ GENDER þ BIG4 þ AGE þ TRANSFERS þ TENURE þ annual fixed effects þ e;
where
MODIFIED_A (TYPE A) = equal to 1 if the ‘‘results of the audit” of the audit report of a municipality were modified, and 0
otherwise (see Section 2 for details);
MODIFIED_B (TYPE B) = equal to 1 if the ‘‘results of the audit” of the audit report of a municipality were modified and also
includes auditor’s statement that either the financial statements cannot be approved or the members of the decision-
making bodies or the senior local government officers for the relevant areas of responsibility of the decision-making bod-
ies (parties liable to render accounts) cannot be discharged from liability, and 0 otherwise (see Section 2 for details);
INCOMEF = annual contribution of parent municipality per municipal citizen;
CASH = cash and cash equivalents of parent municipality per municipal citizen;
DEBT = loan stock of group municipality per municipal citizen, where loan stock is calculated as: liabilities - (advances
received + accounts payable + adjusting entries for liabilities + other liabilities) from the balance sheet of the group
municipality;
ELECTED = number of elected boards in a municipality;
MAJOR = equal to 1 if a one political party has more than 60 percent of the votes in the council, and 0 otherwise;
CRISIS = equal to 1 if a municipality has been determined as a crisis municipality in accordance with the Local Govern-
ment Act, and 0 otherwise;
PORTFOLIO = number of municipal auditing clients (including joint municipal authorities), where the auditor of this
entity is a principal auditor;
SIZE = natural logarithm of the number of municipal citizens in a municipality;
LAG = natural logarithm of the days from December 31 to the issuance date of the audit report.
AUTH = equal to 1 if the principal auditor has an additional qualification as either a KHT or HTM auditor, and 0 otherwise;
GENDER = equal to 1 if the principal auditor was male, and 0 if the principal auditor was female;
BIG4 = equal to 1 if the principal auditor represents a Big 4 auditing firm, and 0 otherwise.
AGE = average age of the population in a municipality;
TRANSFERS = government contribution per municipal citizen;
TENURE = number of consecutive years the audit firm has been engaged by the municipality.
Since we are studying the determinants of two types of modifications, we have two dependent variables as follows. First,
MODIFIED_A indicates whether a municipality received a modified audit report and equals 1 if there were modifications in
the ‘‘results of the audit” in the audit report (see Section 2 for details), and 0 otherwise. This was named a ‘‘Type A” mod-
ification. Second, MODIFIED_B also indicates whether a municipality received a modified audit report and equals 1 if ‘‘results
of the audit” in audit report of a municipality were modified and also includes the auditor’s statement that either (a) the
financial statements cannot be approved or (b) the members of the decision-making bodies or the senior local government
officers for the relevant areas of responsibility of the decision-making bodies (parties liable to render accounts) cannot be
discharged from liability, and 0 otherwise (see Section 2 for details). This was named a ‘‘Type B” modification. Generally,
a Type B modification requires serious misconduct by the municipal officials or decision-making bodies.
The main focus of the models are the variables related to economic performance, decentralization of decision making, and
political competition between parties, which are subsequently used to test hypotheses H1–H3. The three key economic vari-
ables that measure strong or weak performance are common indicators in the context of municipal administration
(Kirjanpitolautakunnan kuntajaosto, 2013) as follows. First, we included the annual contribution of the parent municipality
per municipal citizen in the model (group municipality-level data were not available, since they are not collected by Statis-
tics Finland). This is a key measure indicating the level of income financing (INCOMEF) of municipalities. A higher contribu-
tion represents stronger performance, and we predict its negative association with audit report modifications. In some cases,
the annual contribution is negative, as income financing does not cover the running costs of the municipality, which indi-
cates the municipality needs to contract debt. A similar measure was used previously in the context of municipalities
(Paananen, 2016). The annual contribution of a municipality is comparable to the EBITDA used in the context of business
firms, except it includes financing income and expenses. Second, we also included a cash adequacy (CASH) variable, defined
as cash and cash equivalents of the parent municipality per municipal citizen. Higher CASH represents stronger economic
performance, and we predicted it will have a negative association with the modified audit opinions. Third, we added a vari-
able of the debt level (DEBT), which is common in the studies examining the determinants of audit report modifications (e.g.,
Gul et al., 2013). DEBT is measured as the loan stock of a group municipality per municipal citizen. A higher DEBT represents
weak economic performance and is expected to be positively associated with modified audit opinions. The three measures
(INCOMEF, CASH, and DEBT) are each divided by the number of municipal citizens to make them comparable between
municipalities. The economic performance variables were used to test H1, while H2 was tested using a variable that reflects
significant political power concentration. This variable indicates a stipulated majority of the votes for a single political party
in a local council (MAJOR) and is equal to 1 if a political party had more than 60 percent of the voting power4 in the council,
and 0 otherwise. This measure indicates when there is little political competition, which we predict will be negatively associ-
ated with modified audit opinions. Previous studies (Baber, 1983; Baber et al., 1987; Cohen and Leventis, 2013; Bradbury and
Scott, 2015) found that greater political competition is associated with variables such as higher audit fees, longer audit delay,
and greater expenditure. H3 was tested using the number of elected boards (ELECTED) in a municipality to measure the extent
of decentralization. A greater number of elected boards indicates more decentralized decisions, and we expect it to be positively
associated with modified audit opinions. Previous studies (Hay, 2003; Leppänen, 2015; Shapiro, 2016) have shown associations
between more decentralization and the increased use of accounting information for monitoring, which is likely to lead to mod-
ified audit opinions.
Apart from the independent variables, we also included a large set of control variables in the models. We formulated a
binary variable to reflect whether a municipality had been considered a crisis municipality (CRISIS) in accordance with
the Act on Restructuring Local Government and Services (169/2007).5 The data on the variable were obtained from a publi-
cation of the Association of Finnish Local and Regional Authorities (Antila et al., 2015), and it equals 1 if the municipality met the
criteria for a crisis municipality, and 0 otherwise. We also controlled for the size of municipalities (SIZE). Prior research sug-
gested that a large size tends to decrease the likelihood of audit report modifications because large organizations are prone
4
The percentage was set to 60, which is a clear majority of the votes. A clear majority was considered important for two reasons: (1) municipal councilors are
often unable to attend the meetings of local councils and (2) individual municipal councilors may diverge from party discipline on some questions.
5
Six criteria for a crisis municipality are set in the Act on Restructuring Local Government and Services (169/2007). Of these six criteria, the most important
is whether the balance sheet accumulated deficits.
to be less risky, produce better quality financial statements, and have more stable operations, as well as a higher bargaining
power over their auditors (Li et al., 2008), among others. Therefore, size was added as a control variable in our models, measured
as a natural logarithm of the number of municipal citizens. We controlled for audit report lag (LAG), since there is strong evi-
dence that a long lag increases the likelihood of modifications (e.g., Mutchler et al., 1997; Basioudis et al., 2008), measured as a
natural logarithm of the number of days from December 31 to the date that the audit report was issued. The information on
issuance dates of audit reports was drawn from the audit reports.
Other control variables measure auditor-related issues. Audit firm size was also controlled for in the model, as prior
research indicates that large audit firm size tends to increase the likelihood of audit report modifications (Knechel and
Vanstraelen, 2007; Li et al., 2008). It has also been commonly argued that large audit firms may have more specialized
resources, better quality systems, and more developed audit methodologies (among other things) that may help them iden-
tify the material errors reported in the audit reports more effectively than smaller audit firms. Hence, we created a binary
variable (BIG4) to measure whether the audit firm was large, which equals 1 if a municipality was audited by one of the Big 4
audit firms, and 0 otherwise. We also controlled for the gender of principal auditors since the literature argued there are sig-
nificant behavioral differences, including problem-solving abilities, risk preferences, and cognitive styles, between males and
females (Gul et al., 2013). For example, the gender of the audit engagement partner is associated with the quality of financial
reporting—the firms of female audit engagement partners had smaller absolute abnormal accruals in their reported earnings
(Ittonen et al., 2013). To measure the potential gender impact, we propose a dummy variable (GENDER), which equals 1 if the
auditor-in-charge is male and 0 if the auditor-in-charge is female.
We then controlled for the ‘‘additional professional authorizations” of principal auditors. The principal auditors of munic-
ipalities must be authorized by the Board of Chartered Public Finance Auditing (CPFA auditors) and specialize in public
finance auditing. Although private-sector auditing experience is not required for the auditors of municipalities, the organi-
zational structures of municipalities have become increasingly multifaceted and a large share of their services are increas-
ingly provided by organizations such as limited liability companies, joint municipal authorities, and associations that are
separate from the parent municipalities. Therefore, we expect that if the principal auditor of a municipality has either
KHT or HTM authorization, audit quality will increase and the likelihood of receiving a modified audit report will be affected
(DeAngelo, 1981). To control for the effects of additional authorizations, a separate dummy variable was created (AUTH),
being equal to 1 if the principal auditor of a municipality has either KHT or HTM authorization in addition to CPFA autho-
rization, and 0 otherwise.
We also controlled for the size of client portfolios of principal auditors (PORTFOLIO) by a count variable based on the
number of municipal clients of the principal auditor, including municipalities and joint municipal authorities. We further
controlled for the average age of the population in a municipality (AGE) because a high average age tends to be associated
with a higher amount of services required, being thus a burden on the finances of municipalities. Specifically, elderly indi-
viduals are the largest consumer group of social and healthcare services, representing roughly half of the annual budget of
municipalities. Therefore, a high average age of municipal citizens may lead to financial difficulties and resource defects,
especially in small municipalities. Data on the average age were drawn from the Statistics Finland database on municipal-
ities. We added another variable to measure the amount of financial aid from the central government to municipalities,
defined as the government contribution per municipal citizen (TRANSFERS). Finally, we controlled for audit firm tenure,
as in prior studies (e.g., Geiger and Raghunandan, 2002), using a variable that reflects the number of consecutive years an
audit firm has been engaged by a municipality (TENURE).
5. Data and descriptive statistics
5.1. Data
This study is based on a panel of data on the municipalities in continental Finland between 2009 and 2013.6 Data were
drawn from various sources. First, we utilized audit report data of these municipalities, collected via email and phone inquiries
from each municipality during 2012–2015, as in Finland, there is no centralized authority from which the municipal audit
reports could have been drawn. The number of municipalities changed during the research period due to municipal mergers,
decreasing from 332 in 2009 to 304 in 2013.7 The initial data consisted of 1599 municipality-year observations, representing
99.8 percent of the full population of all municipalities. The number of observations decreased by 167 observations due to out-
liers and missing values, resulting in a final sample of 1432 observations that subsequently were used in the statistical analyses.
A detailed analysis of the sample selection is described in Table 2.
The reports received from the municipalities were carefully analyzed and the information in them relevant to this study
transformed into numeric form. Second, all financial statement data, political competition data between parties, decentral-
ized decision-making data, and data on the average population age of the municipalities were obtained from Statistics Fin-
6
There are 16 municipalities in the Åland Islands, which is a self-governing territory outside continental Finland. These municipalities were excluded from
the study due to the fact that the municipal auditing system in Åland differs somewhat from the one in continental Finland.
7
The yearly numbers of municipalities over the research period were:2013 = 304 municipalities2012 = 320 municipalities2011 = 320 municipalities2010 =
326 municipalities2009 = 332 municipalities
Table 2
Sample selection.
Panel: Sample selection criteria for municipalities Total

Municipal year observations with audit report information 1599
Minus observations with no information on average age of the community members in a municipality (AGE) 129
Minus observations with no information on number of elected board members (ELECTED) 3
Minus observations with no information on political power relations (MAJORITY) 3
Minus observations with no information on loan stock per community member (SOLVENCY) 31
Minus observations with no information on (BIG4) 1
1432
land. Third, data on crisis municipalities were drawn from a publication of the Association of Finnish Local and Regional
Authorities (Antila et al., 2015).
5.2. Descriptive statistics
Table 3 presents the descriptive statistics for the variables in our model, indicating that 33.1 percent of the audit reports
during the period of interest had a Type A modification (MODIFIED_A), that is, some kind of modification in the results of the
audit (see Section 2 for details). This is a strikingly high proportion compared to the typical level of audit report modifica-
tions among business-sector firms.8 There may be various reasons for the high proportion. For example, municipalities have
much larger scope of audits than business firms. As explained in Section 2, the modifications are divided into different cate-
gories and our in-depth analysis of the modifications showed significant variation between these categories: on average,
19.5 percent of municipalities had modifications related to administration; 17.7 percent had modifications related to internal
controls; 6.0 percent had modifications related to the preparation of financial statements; 1.9 percent had modifications related
to accurate and sufficient information on the activities, finances, financial trends, and financial obligations of the municipalities;
and 0.2 percent had modifications related to the correct use of central government transfers. Table 3 also shows Type B mod-
ifications (MODIFIED_B) were found in 7.6 percent of the audit reports, meaning that either the financial statements could not
be approved or that the members of the decision-making bodies or the senior local government officers for the relevant areas of
responsibility of the decision-making bodies (parties liable to render accounts) could not be discharged from liability.
Table 3 also presents the statistics on other variables of model (1). Namely, the average annual contribution of parent
municipality per municipal citizen is 0.296 (thousands euros), ranging from 0.817 to 2.799 (INCOMEF) (H1). The average
cash adequacy per municipal citizen is 0.599 (thousands euros) (CASH), ranging from 0.136 to 5.668 (H1). Again, the aver-
age loan stock of group municipality per municipal citizen is 2.006 (thousands euros), ranging from 0.006 to 6.111 (H1).
Regarding political competition, 14.4 percent of municipalities have councils with more than 60 percent of the voting power
in local councils (MAJOR). Table 3 further shows that municipalities have, on average, 16.17 elected boards (ELECTED).
Table 4 presents the Pearson correlation coefficients between the variables employed in our logit model. The dependent
variable (MODIFIED_A) shows a positive and significant (p < 0.05) correlation with the following variables: DEBT (0.094),
LAG (0.138), and SIZE (0.101). By contrast, the correlation is significantly negative (p < 0.05) with the following variables:
INCOMEF (-0.087), MAJOR (0.103), ELECTED (0.112), PORTFOLIO (0.107), GENDER (0.108), and TRANSFERS
(0.054). The directions of the relationships with INCOMEF, DEBT, MAJOR, and ELECTED are as expected. The highest VIF
value between the explanatory variables is below 3, indicating no multicollinearity.
6. Results
6.1. Results for Models 1–7
Table 5 presents the results for Models 1–7 on the determinants of Type A modifications (see the variable descriptions for
details). Models 1a and 1b are the main models and Models 2–7 are based on yearly samples and presented as robustness
checks. First, we hypothesized that weak economic performance increases the likelihood of modifications (H1) and it was
measured based on three measures of economic performance commonly used in the context of municipalities: income
financing, debt level, and cash adequacy. From Table 5, two out of the three economic performance-related variables sup-
ported the hypothesis. First, INCOMEF was estimated as negative and highly significant (coefficient = 0.974, p < 0.01).
As expected, the result supports H1, indicating that the lower the level of income financing in relation to municipal citizens
is, the higher is the likelihood that a municipality received a Type A modified audit report. Second, CASH was estimated as
insignificant. This result does not support H1, in that we find no evidence that the cash position of the municipality would
8
For example, first, Laitinen and Laitinen (1998) examined 111 audit reports for 37 publicly listed firms on the Helsinki Stock Exchange over a three-year
period and found that 7.2 percent of them had modified audit reports. Second, Chan et al. (2012) explored a sample of 5268 nonfinancial company-years drawn
from the China Securities Markets and found that 9.4 percent of the audit reports had modifications. Third, Li et al. (2008) researched a sample of 2969 firm-
year observations of publicly listed Chinese firms over 2001–2003 and found that 10.9 percent of the audit reports had modifications.
Table 3
Descriptive statistics (N = 1,432).
Variable Mean Std. dev. Min Max

MODIFIED_A 0.331 0.470 0 1
MODIFIED_B 0.076 0.265 0 1
INCOMEF 0.296 0.267 0.817 2.799
CASH 0.599 0.678 0.136 5.668
DEBT 2.006 1.089 0.006 6.111
MAJOR 0.144 0.351 0 1
ELECTED 16.17 12.30 2 147
CRISIS 0.010 0.101 0 1
PORTFOLIO 10.12 5.821 1 30
LAG 4.885 0.167 4.248 6.756
SIZE 8.947 1.139 6.665 13.31
AUTH 0.451 0.497 0 1
GENDER 0.340 0.474 0 1
BIG4 0.227 0.419 0 1
TRANSFERS 2287 919.4 81 5357
AGE 44.26 4.033 30.1 54.6
TENUREy 2.220 1.210 0 4
a
y = (N = 1,145).
b
MODIFIED_A (TYPE A) is a dummy variable equal to 1 if the ‘‘results of the audit” field in the audit report of a municipality was modified, and 0 otherwise
(see Section 2 for details); MODIFIED_B (TYPE B) is a dummy variable equal to 1 if the ‘‘results of the audit” field in the audit report of a municipality was
modified and also includes auditor’s statement that either the financial statements cannot be approved or the members of the decision-making bodies or
the senior local government officers for the relevant areas of responsibility of the decision-making bodies (parties liable to render accounts) cannot be
discharged from liability, and 0 otherwise (see Section 2 for details); INCOMEF is the annual contribution of the parent municipality per municipal citizen;
CASH represents the cash and cash equivalents of parent municipality per municipal citizen; DEBT is the loan stock of group municipality per municipal
citizen, where the loan stock is calculated as: liabilities - (advances received + accounts payable + adjusting entries for liabilities + other liabilities) from the
balance sheet of the group municipality; MAJOR is a dummy variable equal to 1 if a one political party has more than 60 percent of the votes in the council,
and 0 otherwise; ELECTED is the number of elected boards in a municipality; CRISIS is a dummy variable equal to 1 if a municipality has been determined as
a crisis municipality in accordance with the Local Government Act, and 0 otherwise; PORTFOLIO is the number of municipal auditing clients (including joint
municipal authorities) where the auditor of this entity is a principal auditor; LAG is the natural logarithm of days from December 31 to the issuance date of
the audit report; SIZE is the natural logarithm of the number of municipal citizens in a municipality; AUTH = is equal to 1 if the principal auditor has an
additional qualification as either a KHT or HTM auditor, and 0 otherwise; GENDER is a dummy variable equal to 1 if the principal auditor is male, and 0 if
female. BIG4 is a dummy variable equal to 1 if the principal auditor represents a Big 4 auditing firm, and 0 otherwise; TRANSFERS is the government
contribution per municipal citizen; AGE is average age of the population in a municipality; TENURE is the number of consecutive years that the audit firm
has been engaged by the municipality. No other control variables are included.
have any effect on audit report modifications. This is in line with prior findings in the municipal context (Paananen, 2016).
Third, DEBT was estimated as positive and highly significant (coefficient = 0.139, p < 0.01). This result also supports H1 and
can be interpreted to mean that the higher the loan stock of group municipality per municipal citizen is, the higher is the
likelihood that a municipality receives a Type A modified audit report. This is similar to prior firm-data-based findings on
the debt level (e.g., Li, 2009) and on joint municipal authorities (Paananen, 2016). However, Model 1b shows that if audit
firm tenure is controlled for, DEBT becomes marginally insignificant. Overall, the estimated results are in line with the
hypothesis on income and debt, suggesting that weak financial performance increases the likelihood of audit report
modifications.
Second, we hypothesized that low political competition would decrease the likelihood of audit report modifications (H2),
which hypothesis was supported. The coefficient on MAJOR was estimated to be negative and highly significant
(coefficient = 0.686, p < 0.01), indicating that those municipalities with one strong political party were less likely to receive
Type A modified audit reports. Since our analyses are based on five-year panel data (2009–2013) and the local council term is
four years, MAJOR includes information from two different local election periods (2009–2012 and 2013–). To determine
whether the change of local council and in the relative political competition between parties had an impact on our results,
we conducted a separate differences-in-differences analysis (results not reported separately) for MAJOR. We did not find the
election to have a statistically significant impact on the results. Third, we also hypothesized that a high level of decentralized
decision making— specifically, the number of elected boards—in the municipality tends to increase the likelihood of audit
report modifications (H3). H3 is thus supported. ELECTED was estimated to be positive and highly significant
(coefficient = 0.014, p < 0.01), that is, the more decentralized the decision making in terms of the number of elected boards
in a municipality is, the higher is the likelihood that the municipality received a modified audit report.
The following observations were made based on the control variables. As expected, crisis municipalities (CRISIS) have a
higher likelihood of receiving modified audit reports (coefficient = 1.000, p < 0.05). PORTFOLIO was estimated to be negative
and significant (coefficient 0.045, p < 0.05), while the size of the municipality (SIZE) measured by the number of municipal
citizens was estimated as positive and significant (coefficient = 0.220, p < 0.01), indicating that the larger the size, the higher
the likelihood of receiving a modified audit report. Further, LAG was estimated as positive and highly significant
(coefficient = 1.889, p < 0.01). This result is in line with prior studies, in that the longer it takes for the auditor to issue
the audit report after the year-end (LAG), the more likely it is that the municipality will receive a modified audit report. Audi-
12
Table 4
Pearson’s correlation coefficients among research variables (N = 1,432).
M. Paananen et al. / J. Account. Public Policy xxx (xxxx) xxx

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16.
1. MODIFIED_A 1.000
2. INCOMEF 0.087 1.000
3. CASH 0.012 0.337 1.000
4. DEBT 0.094 0.076 0.040 1.000
5. MAJOR 0.103 0.014 0.073 0.038 1.000
6. ELECTED 0.112 0.071 0.088 0.047 0.064 1.000
7. CRISIS 0.044 0.118 0.008 0.129 0.035 0.040 1.000
8. PORTFOLIO 0.107 0.029 0.007 0.085 0.057 0.091 0.031 1.000
9. LAG 0.138 0.017 0.034 0.069 0.058 0.011 0.064 0.037 1.000
10. SIZE 0.101 0.014 0.121 0.098 0.257 0.537 0.070 0.078 0.055 1.000
11. AUTH 0.012 0.000 0.012 0.010 0.049 0.066 0.052 0.315 0.061 0.158 1.000
12. GENDER 0.108 0.044 0.048 0.046 0.077 0.074 0.016 0.011 0.056 0.181 0.149 1.000
13. BIG4 0.031 0.036 0.066 0.068 0.014 0.069 0.006 0.041 0.054 0.203 0.035 0.217 1.000
14. TRANSFERS 0.054 0.036 0.205 0.010 0.306 0.378 0.105 0.177 0.152 0.655 0.026 0.190 0.047 1.000
15. AGE 0.010 0.014 0.134 0.165 0.090 0.303 0.020 0.105 0.027 0.481 0.023 0.162 0.130 0.596 1.000
16. TENUREy 0.029 0.200 0.049 0.114 0.025 0.041 0.015 0.034 0.039 0.049 0.071 0.017 0.152 0.078 0.072 1.000
a
y = (N = 1,145).
b
Bolded values are significant at the 5 percent level.
c
Please refer to the notes of Table 3 for variable definitions.
Table 5
Determinants of Type A modifications of audit reports.
Variable (Expected sign) (Hypothesis) Model 1a Model 1b Model 2 Model 3 Model 4 Model 5 Model 6 Model 7
Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff. Coeff.
INCOMEF () (H1) 0.974*** 0.860*** 1.488** 0.492 0.504 1.664*** 1.602*** 1.082***
CASH () (H1) 0.028 0.063 0.188 0.191 0.203 0.044 0.167 0.094
DEBT (+) (H1) 0.139*** 0.101 0.383*** 0.285** 0.077 0.293** 2.306** 0.187***
MAJOR () (H2) 0.686*** 0.578** 1.096** 0.860** 0.442 0.349 0.496 0.515**
ELECTED (+) (H3) 0.014*** 0.011** 0.027** 0.018* 0.009 0.018* 0.029* 0.012**
CRISIS (+) 1.000** 1.463** 0.517 1.162 omitted 1.270 omitted 0.523
PORTFOLIO (?) 0.045*** 0.032*** 0.867*** 0.857*** 0.002 0.004 0.056** 0.042***
LAG (+) 1.889*** 2.546*** 0.461 2.984** 1.877** 3.596*** 3.159*** 1.966***
SIZE (+) 0.220*** 0.288*** 0.063 0.255 0.505*** 0.093 0.314* 0.436***
AUTH (?) 0.143 0.138 0.206 0.400 0.602** 0.622** 0.149 0.071
GENDER (?) 0.529*** 0.577*** 0.422 0.721** 0.512* 0.053 1.318*** 0.640***
BIG4 (+) 0.154 0.065 0.529* 0.523* 0.223 0.282 0.588* 0.135
TRANSFERS (?) 0.084 0.000 0.000 0.000 0.000 0.000 0.000 0.000
AGE (?) 0.026 0.025 0.055 0.009 0.033 0.027 0.053 0.064***
TENURE (+) 0.115* 2.027** 0.436 0.861 0.166**
ANN. FIXED EFFECTS yes yes na na na na na yes
Obs 1432 1145 286 284 284 287 288 1015
Pseudo R2 0.073 0.072 0.013 0.127 0.079 0.096 0.146 0.100
LR chi-square 134.13*** 102.91*** 50.95*** 44.49*** 28.21** 35.61** 51.28*** 130.75***
Years 2009–2013 2010–2013 2009 2010 2011 2012 2013 2009–2013
a
⁄⁄⁄, ⁄⁄, and ⁄ denote statistical significance at the 1, 5, and 10 percent levels, respectively. This table presents one- and two-tailed results, depending on
the variable. If a variable has an expected sign, the one-tail result is reported. If a variable has no expected sign, the two-tail result is reported. One-tailed
results are in bold.
b
tor gender (GENDER) was also estimated as positive and significant (coefficient = 0.529, p < 0.01), suggesting that male prin-
cipal auditors are more likely to modify the audit reports of municipalities. The other control variables had insignificant coef-
ficients (AUTH, BIG4,9 TRANSFERS, and AGE).
Robustness was tested in several ways. First, we estimated Model 1a for each year from 2009 to 2013 (Models 2–6). The
results provided partial support for the main model results. INCOMEF had the same results for three out of the five models
for individual years (H1), CASH had identical results for all individual years (H1), DEBT had the same result for four out of the
five models (H1), and MAJOR received statistically significant support from two out of the five models for individual years
(2009, 2010). In turn, ELECTED received statistically significant support from three out of the five models for individual years
(2009, 2010, and 2013). Model 7 excluded municipalities that changed auditors during the period: 1,015 observations. The
model had identical results to the independent variables in the main model. The other checks are not reported here due to
space limitations. Among them, we estimated five separate models based on random samples that included 50 percent of the
main model sample. No significant deviations were observed. Further, we ran several estimations based on different size cat-
egories: population below 5,000, 10,000, 20,000, 30,000, 40,000, and 50,000. No significant variations related to results for
our hypotheses were found compared to the main model. Considering all these checks, we are confident that the results of
the main model are reliable.
6.2. Results for Type B modifications
Table 6 presents the results for Models 8a and 8b, where we investigated the determinants of Type B modifications (mis-
conduct by officials). There was no reason to expect different results. First, for H1, one of the three economic performance
variables supported the hypothesis. First, INCOMEF was estimated to be negative and significant (coefficient = 0.982,
p < 0.05), which supports H1 by indicating that the weaker the income financing per municipal citizen is, the higher is
the likelihood that a municipality received a Type B modified audit report. However, the result deviates from prior findings
on joint municipal authorities (Paananen, 2016). The other economic performance-related variables did not support H1: both
CASH and DEBT had statistically insignificant coefficients. Therefore, we only found partial support for the hypothesis that
weak economic performance per municipal citizen increased the likelihood of Type B modifications. Second, we found sup-
port for H2. MAJOR was estimated as negative and highly significant (coefficient = 1.148, p < 0.01), indicating that if there is
low political competition among the parties in the local council or one highly powerful party in the council, it is less likely
that the municipality would receive a Type B modified audit report. Third, H3 was measured by the number of elected boards
in the municipality. ELECTED was estimated to be positive and significant (coefficient = 0.016, p < 0.05), supporting H3. This
suggests that the more elected boards a municipality has, the more likely it is it will receive a modified audit report.
9
We also estimated a model where the BIG4 dummy was replaced by audit firm dummies. No significant changes were observed in the results.
Table 6
Determinants of Type B modifications of audit reports.
Variable (Expected sign) (Hypothesis) Model 8a Model 8b

Coeff. Coeff.
INCOMEF () (H1) 0.982** 1.127**
CASH () (H1) 0.241 0.265
DEBT (+) (H1) 0.031 0.039
MAJOR () (H2) 1.148*** 1.417***
ELECTED (+) (H3) 0.016** 0.018**
CRISIS (+) 1.955*** 2.568***
PORTFOLIO (?) 0.098*** 0.095***
LAG (+) 1.582*** 1.968***
SIZE (+) 0.234* 0.228*
AUTH (?) 0.237 0.262
GENDER (?) 0.003 0.151
BIG4 (+) 0.764*** 0.743***
TRANSFERS (?) 0.000** 0.000**
AGE (?) 0.077** 0.070**
TENURE (+) 0.056
ANNUAL FIXED EFFECTS yes yes
Obs 1432 1145
Pseudo R2 0.145 0.139
LR chi-square 111.82*** 94.58***
Years 2009–2013 2010–2013
a
⁄⁄⁄, ⁄⁄, and ⁄ denote statistical significance at the 1, 5, and 10 percent levels, respec-
tively. This table presents one- and two-tailed results, depending on the variable. If a
variable has an expected sign, the one-tail result is reported. If a variable has no expected
sign, the two-tail result is reported. One-tailed results are in bold.
b
Apart from the independent variables, the model included a number of control variables. CRISIS was estimated as positive
and significant (coefficient = 1.955, p < 0.01). Therefore, a crisis municipality was more likely to have a modified audit report.
PORTFOLIO had a negative and statistically significant coefficient (coefficient = 0.098, p < 0.01), meaning that the smaller
the client portfolio of the principal auditor is, the lower is the likelihood that a municipality had a modified audit report. LAG
was estimated as positive and significant (coefficient = 1.582, p < 0.01), that is, the higher is the number of days between the
financial year-end and the date the audit report was issued, the higher is the likelihood that the municipality received a mod-
ified audit report. This result is in line with many prior studies (Habib, 2013). Further, BIG4 had a significant and positive
coefficient (coefficient = 0.764, p < 0.01), meaning that if a municipality has a Big 4 auditor, it is more likely to receive a mod-
ified audit report. Studies based on firm data that investigated audit quality present similar results (Habib, 2013). TRANS-
FERS was estimated as positive and significant (coefficient = 0.000, p < 0.05), indicating that the more central government
transfers a municipality receives, the higher is the likelihood that it has a modified audit report. This might relate to the fact
that transfers tend to be higher in municipalities with weaker financial conditions. Finally, AGE was estimated as negative
and significant (coefficient = 0.077, p < 0.05). The other control variables—SIZE, AUTH, and GENDER—had statistically
insignificant coefficients. Model 8b included TENURE as an additional control variable, which received a statistically insignif-
icant coefficient.
6.3. Additional empirical model
Since our descriptive data showed that audit report modifications are highly common in Finnish municipalities (as much
as 33 percent of the audit reports over the research period had some modification), we explored separately the determinants
of multiple modifications during 2009–2013. That is, we investigated factors that explain why some municipalities tend to
have more modifications than others. To do that, we created a sum variable for Type A modifications, which indicated how
many modifications a municipality received during the period of interest. Table 7 presents the descriptive statistics for this
variable and indicates that 30.4 percent of the municipalities had no modifications during the period of interest, 23.2 percent
had one modification, 18.6 percent had two modifications, 10.4 percent had three modifications, 10.8 percent had four mod-
ifications, and 5.6 percent had five modifications. That is, as many as 69.6 percent of the municipalities had at least one mod-
ification during this period.
We then estimated separate ordered logistic models (Models 9a and 9b) to test whether H1 holds for multiple Type A
modifications during 2009–2013.
SUMMODIFIED A ¼ AVEINCOMEF þ AVECASH þ AVEDEBT þ AVESIZE þ AVELAG þ AVEAGE þ AVETRANSFERS
þ SWITCH þ AUTHORIZED þ e;
Table 7
Frequencies for multiple Type A modifications over 2009–2013.
No. Freq. Percent Cumulative

0 93 30.4 30.4
1 71 23.2 53.6
2 57 18.6 7.2
3 35 10.4 83.6
4 33 10.8 94.4
5 17 5.6 100.00
Total 306 100
where
SUMMODIFIED_A = sum of Type A modifications over 2009–2013;

AVEINCOMEF = average annual contribution of the parent municipality per municipal citizen over 2009–2013;
AVEDEBT = average loan stock of the group municipality per municipal citizen over 2009–2013;
AVECASH = average cash and cash equivalents of the parent municipality per municipal citizen over 2009–2013;
AVELAG = average natural logarithm of days from 31.12 to the issuance date of the audit report over 2009–2013;
AVESIZE = average of the natural logarithm of number of municipal citizens in a municipality over 2009–2013;
AVETRANSFERS = average government contribution per municipal citizens over 2009–2013;
AVEAGE = average age of the population in a municipality over 2009–2013;
SWITCH = equal to 1 a municipality switched audit firms over 2009 –2013, and 0 otherwise;
SPECIALIZED = equal to 1 if a principal auditor has an additional qualification as either a KHT or HTM auditor (authoriza-
tion to audit business firms and foundations) throughout 2009–2013, and 0 otherwise.
Table 8 discusses the results for this model, presented as Models 9a and 9b. The results for Model 9b indicate H1 was
supported. First, AVEINCOMEF was estimated as negative and significant (coefficient = 1.903, p < 0.01), which indicates that
the lower the average level of income financing, the more modifications a municipality received over the period of interest.
Second, AVEDEBT received a positive and significant coefficient (coefficient = 0.170, p < 0.1), indicating that a high average
level of debt increases the likelihood of audit report modifications. Third, AVECASH also had statistically significant coeffi-
Table 8
Determinants of the sum of audit report modifications over 2009–2013.
Variable (Expected sign) (Hypothesis) Model 9a Model 9b

Coeff. Coeff.
AVEINCOMEF 2009–2013 () (H1) 1.373** 1.903***
AVEDEBT 2009–2013 (+) (H1) 0.091 0.170 *
AVECASH 2009–2013 () (H1) 0.266 0.293*
AVELAG 2009–2013 (+) 2.551*** 3.747***
AVESIZE 2009–2013 (+) 0.231 0.213*
AVETRANSFERS 2009–2013 (?) 0.000 0.000
AVEAGE 2009–2013 (?) 0.003 0.011
SWITCH (?) 0.136
SPECIALIZED (?) 0.467*
Obs 306 279
Pseudo R2 0.028 0.050
LR chi-square 31.10*** 47.16***
a
SUMMODIFIED_A is the sum of Type A modifications over 2009–2013 (dependent variable);
AVEINCOMEF is the average annual contribution of the parent municipality per municipal citizen
over 2009–2013; AVEDEBT is the average loan stock of the group municipality per municipal
citizen over 2009–2013; AVECASH is the average cash and cash equivalents of the parent
municipality per municipal citizen over 2009–2013; AVELAG is the average of the natural loga-
rithm of days from 31.12 to the issuance date of the audit report over 2009–2013; AVESIZE is the
average of the natural logarithm of number of municipal citizens in a municipality over 2009–
2013; AVETRANSFERS is the average of the government contribution per municipal citizens over
2009–2013; AVEAGE is the average age of the population in municipality over 2009–2013;
SWITCH is a dummy variable equal to 1 if a municipality switched audit firm over 2009–2013, and
0 otherwise; SPECIALIZED is a dummy variable equal to 1 if a principal auditor has an additional
qualification as either a KHT or HTM auditor (authorization to audit business firms and founda-
tions) throughout 2009–2013, and 0 otherwise.
b
⁄⁄⁄, ⁄⁄, and ⁄ denote statistical significance at the 1, 5, and 10 percent levels, respectively. This
table presents one- and two-tailed results depending on the variable. If a variable has an expected
sign, the one-tail result is reported. If a variable has no expected sign, the two-tail result is
reported. One-tailed results are in bold.
cients (coefficient = 0.293, p < 0.1), meaning that the liquidity of a municipality tends to increase the likelihood of modifi-
cations as well. In terms of the control variables, AVELAG and SPECIALIZED were estimated as positive and significant.
7. Discussions, conclusions, and limitations
While little is known about the audit report modifications of municipalities, a recent exception is the study Paananen
(2016), who studied the modifications to joint municipal authorities’ audits. Therefore, this study adds to the nascent
municipal-based literature on audit report modifications and extends prior research (Paananen, 2016) in four important
ways. First, contrary to previous empirical-based studies, we draw on agency theory, which has been historically applied
in auditing research, highlighting the municipality-specific aspects related to conflicts of interest between the different
municipal actors. Second, our units of analysis are the actual municipalities themselves, which deviates from the previous
investigations of joint municipal authorities as organizations, as shown in Table 1. Third, we re-examined prior hypotheses
on economic performance in the context of municipalities (Paananen, 2016), testing them using new measures better suited
to municipalities. That is, this study contributes to the literature by introducing two new, previously untested, hypotheses on
modifications related to the political competition between parties in local councils and on the decentralization of decision
making, which are relevant for municipal administration. Finally, in contrast to prior cross-sectional based data, we extended
the research in the municipal context by empirical analyses on multiyear panel data that include a number of novel inde-
pendent and control variables.
The main contributions of the study and their implications can be summarized as follows. First, it reaches a significant
new finding related to the prevalence of audit report modifications in municipalities. Our data showed that as many as
one third of the audit reports over the period of interest included modifications. This rate is very high compared to the mod-
ified audit reports found in firms, for example, and raises serious concerns about the state of management culture, gover-
nance, administration, internal control systems (including risk management), and preparation of financial statements in
municipalities. Additionally, the prevalence of modifications decreases the trustworthiness of the financial statements pre-
pared by municipalities. Since the responsibility for steering municipal administration and legislation lies with the state, as a
practical implication of the finding, the state should evaluate how the management of finances, administration, governance,
management, internal control, and risk management across municipalities should be further developed to decrease the
alarming frequency of audit report modifications. As another practical implication of the results, decision makers should
assess potential new measures (e.g., new regulations) to improve the governance of municipalities and reduce the material
errors found in municipal audits.
Second, this study is, to the best of our knowledge, a first in the international research on the audit report modifications of
municipalities and a new opening in the field of audit research. Since municipalities are major social actors and users of pub-
lic funds, their audit report modifications need to be understood. As such, a separate body of research from traditional firm-
based auditing research is needed for two reasons: i) municipalities differ significantly from business firms as organizations
(e.g., they do not have a profit motive and cannot be declared bankrupt) and ii) they have auditing systems that differ sig-
nificantly from the auditing systems of firms (e.g., the content of audits). Given these considerable differences between
municipalities and firms, firm-based research does not allow for reliable conclusions to be drawn on municipal auditing
issues. For this reason, separate research on municipal auditing systems is needed. One key implication of our study is stim-
ulating the currently modest debate among researchers about municipal auditing in general and audit report modifications
in particular.
The third key contribution of this study is that it identifies municipality-specific determinants of audit report modifica-
tions in the context of municipal administration that could not be identified in firm-based studies. Specifically, we developed
and empirically tested three hypotheses and the following conclusions can be made based on their results. First, we can con-
clude that economic performance has effects on the results of auditing in municipalities (H1). Our results showed that a low
level of income financing increases the likelihood of modifications, as does a high level of debt. Second, high relative political
competition in local councils increases the likelihood of audit report modifications (H2). Third, a high level of decentraliza-
tion in decision making also increases the probability of audit report modifications (H3). As a practical implication, these
findings can help in identify the potential risk factors derived from auditing municipalities.
As with any archival study, the current research has certain limitations. First, a general limitation of municipal auditing
studies are country-specific auditing systems and municipal regulations, which hamper the generalization of the results (e.g.,
the contents of audits vary across countries). To have a more comprehensive understanding of the determinants of audit
report modifications in municipalities, similar studies based on data from other countries should be conducted. Second, this
study tested three types of determinants of audit report modifications, but there are potentially more determinants that
require exploration. Therefore, future research should explore other potential determinants such as the distribution of deci-
sion making between different political parties, the internal control environment of a municipality, the information system
relevant to the financial reporting of a municipality, and auditor-specific characteristics (e.g., experience in municipal audits
and educational background). Examining a broader group of potential determinants could lead to a more comprehensive
understanding of municipal auditing and, specifically, the reasons behind audit report modifications in municipalities. Addi-
tionally, municipality-specific auditing research brings valuable new information for auditing researchers pursuing the dif-
ferences between municipal and firm audits.
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Contents lists available at ScienceDirect

J. Account. Public Policy

Full length article

Determinants of audit report modifications in Finnish

2. Municipal auditing in Finland

Topic Municipality Joint municipal authority

(continued on next page)

Topic Municipality Joint municipal authority

Municipality's auditor (mitigates

3.1. Economic performance

3.2. Relative political competition between parties in the local council

3.3. Decentralized decision making

4. Empirical model and variables

5. Data and descriptive statistics

Panel: Sample selection criteria for municipalities Total

5.2. Descriptive statistics

6.1. Results for Models 1–7

Variable Mean Std. dev. Min Max

M. Paananen et al. / J. Account. Public Policy xxx (xxxx) xxx

6.2. Results for Type B modifications

Variable (Expected sign) (Hypothesis) Model 8a Model 8b

6.3. Additional empirical model

No. Freq. Percent Cumulative

SUMMODIFIED_A = sum of Type A modifications over 2009–2013;

Variable (Expected sign) (Hypothesis) Model 9a Model 9b

7. Discussions, conclusions, and limitations

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