What do Enron and the corporate-accounting scandals of the early 2000s have in common with the subprime-mortgage crisis and the Great Recession? In both cases, the delivery of accurate information to the broader economy was compromised because auditors were hired and paid by the firms they audited.
Auditors face a conflict of interest between reporting the truth and running their businesses successfully. Our economy and many markets throughout the world remain vulnerable to this conflict. But it does not have to be this way.
There have been efforts to strengthen auditing regulations. In the early 2000s, Congress created a watchdog organization, the Public Company Accounting Oversight Board, to reduce the chances of accounting scandals. But the board’s work to implement even modest reforms has faced strenuous opposition from the auditing profession.
Senator Al Franken’s amendment to the Dodd-Frank financial-reform law of 2010 targeted an obvious conflict of interest — security issuers shopped for their own ratings, which contributed to credit rating agencies’ generous grading of many financial products before the Great Recession. Despite bipartisan support for the amendment, lawmakers instead asked the Securities and Exchange Commission to study the issue. Three years later, they’re still studying.
What would happen if auditors were given better incentives to tell the truth?
In a recent study published in The Quarterly Journal of Economics, my co-authors — Esther Duflo, of M.I.T., and Rohini Pande and Nicholas Ryan, both of Harvard — and I reported on an experiment we conducted in the state of Gujarat, India. We found that altering auditors’ incentives to mitigate the conflict of interest leads auditors to report more truthfully. More important, this means regulations work better and keep people safer…