As the likelihood of mandatory auditor rotation in the United States fades, the results of a two-year field experiment in India suggest audits are far more effective when auditors are paid by someone other than the party they are auditing.

A group of academics out of MIT and Harvard have published the results of a two-year study on environmental audits for industrial plants in India after regulators there decided to change the way auditors are engaged and compensated to check a plant's compliance with environmental and pollution standards. The India state of Gujarat wanted to end the conflict of interest inherent when a company hires and pays its own external auditor. The study looked at audit results for companies that continued to retain their audit firms and compared them to outcomes where auditors were assigned randomly to plants and paid fixed amounts out of a common pool.

The study found the status quo audit system appeared to be corrupt, with auditors “systematically underreporting the pollution emissions of control plants at levels just below the regulatory standard,” the authors wrote. The more random, fixed-fee audits, on the other hand, led to more truthful audit reports and a reduction in the percentage of plants that were falsely reported as compliant with pollution standards. It also led to reduced pollution emissions, the authors said. “The results suggest reformed incentives for third-party auditors can improve their reporting and make regulation more effective,” they wrote.

Nicholas Ryan, a research fellow at Harvard and a co-author on the study, says the results have implications for all types of auditing, including the audit of financial statements. “We are extremely cautious on that point, but this definitely has applicability in terms of other market structures where reforms are considered,” he says. “There are strong market forces that make auditors or credit rating agencies aggressive so they can pursue new business. So it's always going to be likely that they will understate risks or overstate earnings or creditworthiness.”

In the United States, the Public Company Accounting Oversight Board has toyed with the idea of setting term limits on auditors of public companies as a way of producing a system of mandatory rotation, although the movement has lost steam for lack of support. The PCAOB still has an open project on its agenda to consider reforms that would cause auditors to exercise greater independence and skepticism, but it's not clear what the board plans to pursue. The European Union is considering a mandatory rotation measure, although it would allow for much longer terms for audit firms than originally contemplated. 

“This should raise deeper doubt about whether the reforms that are considered are fundamental enough,” says Ryan.

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