Auditing the Auditors

October 9, 2013
By Doug Gavel, HKS Communications

Reliance upon third-party auditors to help regulate markets can be a problematic exercise – especially when the auditors are being paid by the very entities they are monitoring. However, a set of relatively simple structural changes can reduce such conflicts and incentivize more accurate reporting. That is the conclusion of a new research paper (pdf) co-authored by Rohini Pande, the Mohammed Kamal Professor of Public Policy at Harvard Kennedy School (HKS).

Pande and her fellow researchers undertook a two-year field experiment in the Indian state of Gujarat to examine the veracity of information attained via environmental auditing of industrial plants, and to analyze how altering the market structure may increase truth-telling.

"Although the Gujarat High Court put in place several safeguards to limit conflicts of interest, the basic financial arrangement underlying these audits is typical of the practice the world over—plants hire and pay auditors directly, and the work of those auditors is subject to very little oversight," the authors remark. In fact, "the reported market price for an audit was often lower than the cost of collecting pollution readings, suggesting that at least some readings were not even taken."

During the course of the field experiment a random subset of the 473 audit-eligible plants in the region were selected for a treatment in which: the plants were randomly assigned auditors; auditors were paid from a central pool rather than by the plant owners; follow-up audits of auditors were conducted to increase monitoring; and auditors were informed that their pay would be linked to accurate reporting.

The research uncovered several key findings:

  • Under status quo audit reporting auditors systematically report plant pollution readings just below the regulatory standard;
  • In treatment plants, the auditors reported more truthfully such that the fraction of plants that were falsely reported as compliant with pollution standards was reduced; and
  • Pollution outcomes for treatment plants were reduced, likely because they recognized that the regulatory authority would receive more reliable audit reports.

The article, titled "Truth-telling by Third-party Auditors and the Response of Polluting Firms: Experimental Evidence from India,(pdf)" is co-authored by Esther Duflo, MIT; Michael Greenstone, MIT; Rohini Pande, HKS; and Nicholas Ryan, Harvard University.

Rohini Pande is an economist, the Mohammed Kamal Professor of Public Policy, Area Chair for Political and Economic Development, Co- Director of Evidence for Policy Design (EPoD) and Director of Governance Innovations for Sustainable Development Group at Harvard Kennedy School, Harvard University. Her research examines how the design of democratic institutions and government regulation affects policy outcomes and citizen well-being, especially in South Asia.

Print print | Email email
Rohini Pande, the Mohammed Kamal Professor of Public Policy

Rohini Pande, the Mohammed Kamal Professor of Public Policy

"The basic financial arrangement underlying these audits is typical of the practice the world over—plants hire and pay auditors directly, and the work of those auditors is subject to very little oversight."