According to Mark Cheffers, a former Price Waterhouse senior manager, “There is this huge expectations gap between what auditors believe accounting standards tell them they are supposed to do and that which the SEC and the public expects them to do.”
Accounting began to satisfy the need to account for a business exchange. For instance, a communal granary stores various staples for the town. A generally accepted methodology for being able to deposit and redeem goods was necessary for town people to feel comfortable in using the granary. The ownership of goods was tracked by clay tokens or even knotted string.
Luca Pacioli may be referred to as the “father of accounting” since he established the principles of double-entry bookkeeping (also known as the Italian System) in his book Summa de Arithmetica, Geometria, Proportioni et Proportionalita, published in the fourteenth century.
Sometime around the late seventeenth century, the joint stock company emerged in England, and accounting was used for the first time to ensure that the interests of investors were fairly represented.34 Common use for these establishments at the time were the raising of capital for voyages and the determination of payment upon completion. Voyages were viewed as independent, so books did not roll over.
By the seventeenth and eighteenth century bookkeepers and clerks began establishing associations and standards to professionalize their occupation and begin charging a premium price.
A short verse to remind people of debits and credits:
The owner of the owing thing
Or whatsoever comes to thee
Upon the left hand see thou bring
For there the same must place be
But they unto whom thou dost owe
Upon ye right let them be set
Or what so ere doth from ye go
To place them there do not forget.38
By the 1850s, railroads had developed the concept of the internal auditor. The advancement of accounting was promoted by data-intensive industries, such as shipping, as an operational necessity.
In 1897, New York State legislature created the first CPA designation. At the time there was a pay scale in that the head of the New York Society of CPAs stated, “you can’t be a CPA unless you charge at least $20 a day”.64 Also in the late nineteenth century, the court ruled in the Kingston Cotton Mills case that an auditor, with no reason to suspect dishonesty, was not required to verify inventory figures provided by a company official.
The first major accounting conference in the United States, the World Congress of Accountants, was held in St. Louis in 1904.
A major scandal of the early twentieth century was the International Match Company, which was audited by Ernst & Ernst. The auditors ignored the obvious pyramid scheme and allowed the reporting of phony financial statements for the sales of matches. There were no matches. General view was that this kind of fraud could not occur unless there was some careless auditing.
The first blue-sky law passed in 1911 by Kansas. The term “blue-sky” is reference from a judge’s comment during a lawsuit regarding certain investments as “speculative schemes that have no more basis than so many feet of blue sky.”72
By the first quarter of the twentieth century, the accounting profession was pushing to define auditing not as validation the truth of financial statements but issuing an opinion of the statements based on honest judgment and reasonable accounting principles.
Auditors began to lose some power to management when, in the boom of the late 1920s, companies needed to borrow less and banks were less likely to scrutinize the borrower.
In 1927, George May became the head of the American Institute of Accountants (AIA), which worked in worked in cooperation with the stock exchanges and produced the concept of generally accepted accounting principles. Additionally, this special committee recommended that companies could pick and choose the principles they would use, as long as they disclosed their methods and used them consistently, and the auditor’s certificate would read “fairly presented, in accordance with the accepted principles of accounting” to clarify to the user that it was not an absolute or verification of the truth.75
The Securities Act of 1933, passed in April of that year, and granted independent CPAs the right to audit public companies, rather than the use of governmental auditors, which was a strong recommendation by Congress. The Federal Trade Commission would oversee the requirements of the Act and auditors. Oddly enough, the Act of 1933 did not clarify who, the company or the auditor, was responsible for compiling the financial statements. Additionally, there was not a uniform financial statement template to follow; however, most immediately adopted the proposed NYSE layout. An additional complication for auditors was that the Act called for the auditor’s report to verify the truthfulness of the financial statements. The Federal Trade Commission was overwhelmed and the general consensus was that the Act needed modification.
The Securities Exchange Act of 1934 established the Securities and Exchange Commision (SEC), which was granted the power under Section 19(a) to make accounting rules and regulations, to mandate a uniform financial statement layout, and define the periods for which companies must divide their earnings periods. The 1934 Act removed the requirement for auditors to verify the truthfulness of financial statements. The Securities Acts essentially confirmed George May’s premise that auditing was not about whether basic economic data was factual or fraudulent, but whether the principles used to arrive at the data were sound.86 Neither the 1933 Act nor the 1934 Act sets out exactly what the independent auditor was supposed to verify; the Acts just said that companies’ financial statements must be certified by an independent auditor and that the SEC was to enforce this practice.87
Did accountants love the SEC? The accounting establishment took every opportunity to criticize the Acts and the SEC. Part of this resentment was rooted in the fact that prior to the Acts, accountants and auditors had recognized their public watchdog role and handed down this special responsibility to succeeding generations of auditors. After the Acts, the auditor had become part of the mechanism of government bureaucracy.92
McKesson-Robins was a drug company with supposed operations in the U.S. and Canada, however, in 1938 it was discovered that the international operations were a fraud. In response, the American Institute of Accountants recommended in January of 1939 that auditors randomly test inventory and accounts receivable and, if they cannot, they should explain why in the auditor’s certification; this rule became mandatory.95
By the mid-twentieth century, little advancement had been made since the Security Acts of the 1930s. There were still arguments among accounting experts concerning accounting principles, the accounting lexicon was becoming increasingly complex, and the flexibility and content of financial statements were excessive. Additionally, the view of investing began to change from solvency to earnings potential. It was around this time that auditing firms began to realize their value not only to the investors as an auditor, but to management as a consultant. An auditor’s knowledge of the entire company and how the finances flowed through the enterprise put them in an optimal position to assist management from decision making to installing computer systems.
Also at this time, a battle began to brew between principle-based accounting, represented by George May at Price Waterhouse and rule-based accounting, represented by Leonard Spacek at Arthur Andersen. May believed that business leaders had real, fundamental incentives to report fair and accurate financial statements to investors. Spacek told May that accounting without hard-and-fast rules wasn’t accounting at all, but was worthless.109 Spacek was also a strong advocate of systems consulting, recruiting and marketing, which powered Arthur Andersen ahead of the competition.
Accounting firms began to grow, acquire, and consolidate. Peat, Marwick & Mitchell aggressively pursued and acquired small accounting firms. Price Waterhouse was the largest and most prestigious and was more selective in acquisitions. The battleground was Florida, which along with several other states, had passed laws designed to keep out the national firms and to protect local practitioners. To serve clients in Florida, the national firms would have to operate from a nearby state -- for example, Price Waterhouse served clients out of its Atlanta, Georgia, office – and apply for a permit for each engagement.113
In1959 the Accounting Procedures Committee of the American Institute of CPAs (AICPA) was shutdown and the Accounting Principles Board (APB) with 18, part-time, unsalaried members was founded with the hope that they could provide some guidance on GAAP as there were just too many alternative accounting standards. The APB was indulged by the SEC as sort of an ill-fated experiment of the profession, and a slightly condescending approach by the commission was the result. The SEC frequently overruled the new board in the early 1960s and did so even more as the APB failed to cut down on what was then a confusing array of accounting methods that companies could employ.114
By the 1960s the Big Eight (a term coined by Fortune in 1932, but was a changing eight) were firmly established as Arthur Andersen; Lybrand, Ross Bros. & Montgomery; Dloitte, Haskins & Sells; Ernst & Ernst; KMG Main Hurdman; Peat Marwick; Price Waterhouse; and Touche Ross.
Accounting and auditing only became larger as, in 1964, federal laws expanded the definition of “publicly traded company” to include companies whose stock traded over-the-counter.
In October 1966, Harold Roth, former president of Continental Vending Machines was indicated along with three Lybrand, Ross Bros. & Montgomery auditors: two partners and a senior managers. They were indicated on federal charges of mail fraud and conspiring to file false financial statements with the SEC in the 1962 annual report. This was the first major case in which criminal charges were brought against auditors for alleged failure to disclose facts they uncovered during the audit of a company. Roth had been diverting profits from the company to himself through a shell company. According to testimony, two of the auditors knew of $3.5 million having been transferred to Roth for personal use. The first trial resulted in a hung jury, and the second resulted in the three Lybrand auditors being convicted, fined, and paroled with no jail time served. Roth was convicted and sentenced a short jail time. This was a landmark case because it convinced auditors that even if they discover fraud, they might get blamed for not finding it even earlier.
After the conviction of the Lybrand auditors was upheld on appeal, auditor’s responsibilities had officially changed. In its decision to uphold the convictions, the court said that once an accountant suspects fraud, he or she can’t simply be guided by generally accepted standards, as one would in a normal audit. The auditor must investigate further and report any fraud that is found.120
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