A Historical Perspective on Auditing System in the US

Category: Accounting

The financial statement audit is a vital part of the United States modern business environment, where there is more scrutiny and skepticism of a company's financial statements than ever before. To fully appreciate the need for a financial statement audit, it is important to understand the origins of the audit and how events in the United States history have assisted in its evolution.

Auditing can be traced back to the Greek ruler Ptolemy Philadelphus II who lived over 2500 years ago. Internal audits can be traced back to the Middle Ages. External audits are documented as early as 1720 by Charles Snell as a result of the South Sea Bubble scandal in England. Auditing is seen in the United States in its early beginnings with the arrival of the Pilgrims. The Pilgrims sought capital from those called the Adventures to help them in settling in America. The Pilgrims or the Planters drew up an agreement of 10 pounds and 2 shares. At the end of seven years the profits of the enterprise were to be divided between the two based on the number of shares held. After the seven years the Pilgrims reported their debt to the Adventures. The debt held by the Adventures was almost ten times the amount the Pilgrims showed. The Adventures then sent an auditor to the America's to discover the discrepancies. This lesson came with a hefty price for the Pilgrims. A mistake the vowed would not happen again. Puritans began teaching accounting in school. It ranked importance along with reading and writing. The Puritans used auditors from the beginning in Plymouth. Auditors were used to audit the accounts to prevent the same problems that the Pilgrims incurred (Flesher, Dale L., Gary John Previts, and William D. Samson).

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Another glimpse of auditing in the United States occurs with the first United States Congress. In 1789, they passed an act that appointed a secretary of the treasury, a comptroller, and an auditor. The next major milestone in auditing occurs during the industrial revolution in England. The British Companies Act of 1844 provided for mandatory audits in England. At the same time the United States was experiencing the industrial revolution as well. By the late nineteenth century, British auditors were being sent to the United States to audit American companies. Price Waterhouse, a British firm sent auditors to the United States in 1873. Soon afterwards, British firms such as Price Waterhouse, Peat Marwick & Company, and Arthur Young & Company had offices in New York. Thus, with the help of the British, professional auditing had arrived in the United States.(Porter, Brenda, et al.)

The post-Civil War era is the pioneering period for the accounting/auditing profession. In

1882, the Institute of Accountants was formed, bringing public accountants, bookkeepers, and others interested in accounting together (Flesher, Dale L., et al). The American Association of Public Accountants made its appearance in 1887. This organization held closer the ideas of the British accounting profession (Flesher, Dale L., et al). Auditors were seen by most, during the late 1800's and early 1900's, as merely someone who oversaw the accuracy of accounting records. This would change because banks were becoming a larger source of funding for businesses, thus the need for quality balance sheets became much more necessary than just clerical accuracy (Porter, Brenda, et al.).

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As the Industrial Revolution sped along, so did the emergence of the railroad system in the United States. As the railroads grew so did their need for an auditing system. The Baltimore and Ohio railroad bylaws show that in 1827 the railroad required the use of an audit committee. The committee was needed to safeguard the company's assets. The Board of Directors hired John B. Morris and William Stewart to perform the audit and report their findings. Their report is the first noted auditing report in the United States history. As railroad construction progressed so did the need to audit construction engineers and their spending habits. This practice led to the now known as operational auditing (Flesher, Dale L., Gary John Previts, and William D. Samson).

In 1917 a joint publication of the American Institute and the Federal Trade Commission, Uniform Accounting, set forth the first formal declaration of accounting and auditing principles. Within this publication was a standardized audit report and instructions on how to audit specific account balances. This publication and its subsequential revisions would become the leading authority of the auditing profession for the next two decades (Porter, Brenda, et al.).

During this time frame prior to the Great Depression, external auditing had become a more standardized profession, but its size had not grown significantly. This was partially due to the fact that bankers were main users of financial statements. Companies that used banks for capital would utilize the external auditor to satisfy the banks' requirements. At this time in history, companies financed mainly by stockholders did not regularly publish financial

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statements or have external audits(Porter, Brenda, et al.). This would all soon change.

During the 1920's Ivan Kreuger, a Swedish business man, known as the "Match King"

had the most widely held securities in the world. Kreuger was operating a huge pyramid scheme

that involved over 400 subsidiary corporations. His insistence of secrecy and refusal of audits assisted him in pulling off this enormous scheme (Flesher, Dale L., et al ). With the crash of the stock market in 1929, Kreuger found it hard to sell his securities to keep his pyramid scheme alive. Krueger committed suicide in 1932 and within weeks his companies were bankrupt. This led to major changes in financial reporting (Porter, Brenda, et al.).

In 1933 the Congress passed the Securities Act. This was followed by the Securities Exchange Act of 1934. Thus the Securities Exchange Commission was born. The purpose of this commission and the legislative acts was to restore confidence in the stock market by providing investors and businesses with reliable information and clear cut rules to ensure fair and honest practices (U.S. Securities and Exchange Commission). Two main points of these laws were that companies offering securities publicly to investors must be truthful about the risks involved with investing in their company and be forthcoming with business finances. Secondly, anyone who sells or trades securities must put the interest of the investor first and treat them honestly and fairly (U.S. Securities and Exchange Commission). With the passage of these laws, the Office of the Chief Accountant was created. The role of the Chief Accountant is to establish accounting principles and to oversee the private sector and how they set standards (U.S.

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Securities and Exchange Commission).

In 1936 an updated version of the 1917 American Institutes's joint pronouncement with

the Federal Trade Commission, made the suggestion that observing inventory and conforming receivables would be beneficial to the auditor, but no requirement was made. Auditors had rejected this as they argued that they were not skilled appraisers. This decision would prove to be a mistake on the auditors' part. A scandal arose in 1938 when McKesson and Robbins used false documents to hide the fact that their inventory and receivables were lacking nineteen million dollars. Price Waterhouse was the accounting firm that completed the audit. They had received assurances from Mckesson and Robbins' management that the inventory's value was correct and truthful. They proceeded to follow standard procedures and checked the inventory to the purchase orders and found no discrepancies. However,the purchase orders were fabricated. Price Waterhouse was found to have adhered to the generally accepted auditing procedures by the Securities and Exchange Commission. It was then concluded that this procedure was inadequate (Porter, Brenda, et al.). This led to the American Institute issuing its first Statement on Auditing Procedure in 1939. SAP No 1 made a requirement for auditors to observe inventories and then confirm the receivables ( Porter, Brenda, et al.).

In 1957, The American Institute of Accountants changed its name to the American Institute of Certified Public Accountants. The push in the fifties was for the setting of stronger auditing standards. This led to the development of the Accounting Principles Board in 1959

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(Flesher, Dale L., et al). For the last twenty-five years. the profession worked hard and secured its place in the American economy with the financial statement audits. By 1957, the AICPA was

a regular advisor to Congress regarding tax legislation and accounting and auditing standards for the federal government (Doron, M.).

Also during this time, there were mass union corruption scandals. These scandals had the public and politicians demanding stricter financial controls over unions and pension funds. This brought about a new attitude of aggressively promoting the skills of CPA's as a business consultant and a financial expert. Thus, Certified Public Accountants were abandoning previous professional standards of not taking on new clients that had questionable financial practices, in order to preserve their public image as the keepers of financial propriety (Doron, M.).

Eisenhower's administration supported the idea of CPAs auditing unions and pension funds, but in its final version, the pension bill left out the audit requirement. There was some conciliation in the bill with the requirement of pension funds with participants greater than 25 to file an annual report with the Department of Labor. The American Federation of Labor would eventually set up new regulations that included an annual audit by a CPA for all unions that were members of their organization. It would take sixteen more years before Congress would pass the Employee Retirement Income Security Act in 1974. This act required the annual audits of pension plans by an independent accountant (Doron, M.).

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In the 1980's there were a rash of bankruptcies. Many of these bankruptcies occurred within days after a clean opinion had been rendered by an auditor. CPAs expressed that they too

were victims of fraud. This led to the Creation of the Treadway Commission in 1987. One main suggestion of the Treadway Commission was that internal auditing needed to be more effective as well as corporate audit committees. Another important event in the 1980's that changed the field of auditing was the introduction of the personal computer. This would change the way audits were conducted and the information that would be audited (Flesher, Dale L., et al).

The next big change in the auditing profession would follow the Enron - Arthur Andersen scandal of 2001. In the early 2000's Enron was on top of its game or so it was believed. Little did anyone know the mass fraud that was taking place behind the scenes. When Enron filed for a 50 million dollar bankruptcy they not only left investors holding the bag but the employee retirement fund were drained of over 1 billion dollars. Also left in the lurch were their auditors, Arthur Andersen. The internal audit committee of Enron was riddled with former partners of Arthur Andersen. Arthur Andersen not only performed external audits for Enron but also did financial consulting. In the end, it appeared that Andersen was playing both sides of the street and knee deep in the mess. With the fall of Enron and Andersen arose the need for reform once again. This reform would come from the Sarbanes - Oxley Act (Byrnes, Nanette, et al.).

The Sarbanes - Oxley Act made drastic changes in accounting practices and principles.

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Section 201 specifically made changes to services that could be provided to a company that an accounting firm has as an auditing client. In other words it made it illegal to continue the

practice of working both sides of the street as Arthur Andersen had done. This would help with

the ethical dilemmas that could arise from such a scenario again. Section 203 put in place the need to rotate the lead and review partners every five years from the audit (Byrnes, Nanette, et al.).

Another outcome of the Sarbanes - Oxley Act was the establishment of the Public Company Accounting Oversight Board. The board is a private sector, nonprofit corporation designed to oversee the auditors of public companies. Their goal is to protect the public interest and investors by promoting audit reports that are informative, fair and independent. A further requirement is that for the first time in history, auditors of public companies are subject to external and independent oversight. Prior to this auditors self regulated themselves (PCAOB).

In the current spotlight of auditing is Chuck Landes. He is currently working on the Clarity Project for the AICPA. The Clarity project has a two fold purpose. The first part is to bring about change to the current auditing standard that would make it easier for auditors to read and understand. The theory behind this move is that by making the standards easier to understand then it would result in a more effective implementation by the members. This would hopefully lead to a higher level audit (Lasch, E).

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The second part of this plan is to better align the standards and the standards of the International Auditing and Assurance Standards Board. The current push of many nations is for

a united accounting standard and this initiative is one way to bring that one step closer to a

reality (Lasch, E).

The financial audit can be traced back over the centuries to as early as the ancient Greeks. The need to maintain honesty and accuracy of ones financial situation has evolved over the years due to necessity and unfortunately due to corruption. As companies expanded the need to internally audit their finances became a necessity. An internal audit was needed to maintain the honesty among of the multitude of employees involved in day to day transactions as well as maintaining an accurate look at the company's overall financial health. Out of the unfortunate circumstances of corruption can come the ability to adapt and change for the betterment of society. This is what has happened over the years to improve auditing practices. External auditing is a necessary function in the financial accounting world to help to protect the investor as well as the integrity of the exchange market. Due to hard lessons learned from notorious fraud cases such as "the Match King" Kreuger, the teamsters and union fraud, and from the present day scandals of Enron and Arthur Andersen, the auditing society of the United States has made needed and necessary adjustments to strengthen the principals and procedures by which they adhere themselves to.

As the United States looks to the future of auditing and accounting we continue to hold

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ourselves to a high standard of ethics and integrity. The principals and standards by which our public and private governing bodies adhere our profession to will in no doubt help us to maintain

this desire of excellence and will assist us in ever striving to continue to evolve to serve the best interest of society.

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