A radical solution to improve the effectiveness of audits

Guest blog from Bob Dohrer, RSM’s Global Leader for Quality and Risk

A fascinating and rather contentious article that I read this summer in the Wall Street Journal described an experiment in India that changed how auditors are paid, with the result that audits became more effective. Auditors, as we all know, are paid by the businesses they audit. This, the article suggests, means that auditors can be too cosy with their clients and possibly gives them an incentive to not challenge management when management might be misleading stakeholders. Now, while I believe that the vast majority of auditors demonstrate enormous professional integrity, the major accounting debacles of the early 2000s and the subprime mortgage and financial crises of the late 2000s indicate that the effectiveness of audits need to be improved.

The solution? According to researchers at the Massachusetts Institute of Technology it could be to pay auditors out of a central fund, randomly double check their work (who audits the auditors?) and link pay to effectiveness. I suspect it is the notion of a central fund, with all its statist associations, as much as their work being subject to random regulatory checks that will irk many auditors. Nevertheless, the results are illuminating, and should at least be considered.

The experiment in India took place in the industrial state of Gujarat and involves measuring and reporting factory pollution. Half the plants hired and paid auditors at the market rate; the other half were assigned auditors randomly, who were paid from a central fund and warned that there was a one-in-five chance that an independent inspector would check their work. The experiment was adjusted in the second year to include a bonus for auditors whose work corresponded closest with inspectors. The results are interesting. Overall, auditors in the experimental group were 80% less likely to report falsely that a plant was in compliance with air- and water-pollution rules than auditors in the business-as-usual group. What’s more, auditors who worked in both groups exhibited very different behaviours. Further, the plants audited by the experimental group significantly reduced their pollution. The full article can be found here.

This is a radical idea, and although many auditors will reflexively object to this kind of interference in the market, as a profession can we really say that the current arrangement is satisfactory? The profession needs to regain and enhance credibility, and we need to look at all the options on the table. Having auditors appointed to audits and paid from a central fund is one possibility and others, like efforts to enhance the autonomy and independence of company audit committees who hire auditors, should be explored.  My fear is that unless we come up with proposals ourselves, we could have a much less palatable solution imposed upon us.