How can we prevent another Enron, or worse?

July 10, 2012: 10:08 AM ET

If reforming our auditing system could reduce the probability of a financial disaster, even by a little bit, we should be willing to endure costly and disruptive change to do it.

By Don Moore and Max Bazerman

FORTUNE -- Remember the adage that those who forget the past are condemned to repeat it? Unfortunately, history lessons don't seem to appeal much to the corporate world, even the firms tasked with making sure companies' books are on the up and up: the auditors.

Take the case, for example, of Ernst & Young, one of the Big Four audit firms. E&Y also operates a lobbying firm that also works with its audit clients, including companies like Amgen (AMGN), Verizon (VZ), and yes, Groupon (GRPN). Groupon stock is now trading around $8 per share, down from a February high of over $24. In March, the startup revised its profit numbers downward and E&Y voiced concerns about the company's accounting systems. Wasn't E&Y required to voice such concerns before Groupon's November 2011 IPO? No, it turns out that audit regulation applies to public companies, not to companies planning to go public. Nor does the law require Groupon to disclose what other services E&Y has provided the tech company.

Although Ernst & Young has argued that its work complied with the rules, we think the rules may be the problem. Just think back a few years to when Arthur Andersen was auditing Enron's books. While that auditing firm was approving the company's misleading financial statements, it was also collecting some $27 million in consulting fees from Enron. Arthur Andersen also argued that its arrangement didn't violate auditor independence rules.

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The problem is not compliance with the rules. No, the problem is the rules themselves, which permit conflicts of interest and ultimately undermine auditor independence.

Auditor independence is a cornerstone of our capital markets. It means that auditors should be able to objectively assess whether publicly traded companies are telling the truth about their finances. And this independence is threatened by cozy, long-term partnerships that develop between firms and their auditors.

So, then, what can we do to make sure we don't have to face yet another (and another) Enron, or worse?

Enter the Public Companies Accounting Oversight Board (PCAOB), which was created by the Sarbanes-Oxley Act to oversee the auditing profession. Make no mistake, they have a difficult task ahead of them as they consider regulatory reform -- a task made all the more difficult since it's being done without the benefit of the kind of public anger that immediately follows a scandal. Reforms born from that sort of post-mortem pressure, however, typically close the barn door after the horse has been stolen. This time, the PCAOB has anticipated a likely cause of future scandals and is considering closing the door before it's too late.

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Speaking at a meeting of the PCAOB last spring, we identified three core threats to independence, all of which focus on the incentives auditors have to keep their clients happy. First is the desire to retain the audit client. Auditor rotation is a useful response to this threat. We also noted that selling other services like consulting or lobbying undermines independence. Finally, auditors taking jobs in the firms they audit also leads to conflicts. All these should be under careful scrutiny by the PCAOB.

Reform will not come easily. There are entrenched interests lined up to oppose any change that disturbs the convenient and lucrative status quo. That is what happened with Sarbanes-Oxley in 2002. As drafted, the act included audit firm rotation, but thanks to heavy lobbying by accounting firms, it was watered down to require only the rotation of the manager from the audit firm overseeing the audit. When we testified before the PCAOB, one of the corporations speaking against reform had been with its accounting firm for 129 years. Teaching new auditors about their financial systems every 10 years, it argued, would lead to increased costs and reduced flexibility.  We think that's a small price to pay for honest audits.

The benefits of a system that delivers true auditor independence are enormous. Equity markets depend on the truthful and reliable public disclosure of information about public companies. If reforming our system could reduce the probability of another Enron or   WorldCom, even by a little bit, we should be willing to endure costly and disruptive change to do it.

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Trouble is, most of the investors who would benefit from this reform do not show up at PCAOB panels. They do not know about the potential for audit fraud at the companies whose stock they own, and so cannot calculate how much they would benefit from mandatory auditor rotation. And while the discussions drag on far away from the public eye, interested industries work with regulators to figure out how to soften the edges of legal constraints and work around regulations.

Conflicts of interest in auditing are a blight on the integrity of our economic system. It's time for the PCAOB to act.

Don Moore is an associate professor at the Haas School of Business at the University of California at Berkeley. Max Bazerman is the Jesse Isidor Straus Professor of Business Administration at Harvard Business School.

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