| | |The History of Auditing | |A detailed overview | | | | | | | | Auditing has a rich history within the United States. There have always been various rudimentary forms of auditing when the first businesses were started; however the focus of this paper will be on auditing standards within the twentieth century. To look beyond that departs from what would typically be termed as “modern accountancy” and its relevant roots.
Author Bruce Marshall helps describes why this historic perspective is so important of our field: “Accountancy is a recognized profession like those of law and medicine. ... In fact it might not be too much to say that it is regarded as the most important of all the professions. Indeed it is the cornerstone upon which the whole industry of our Empire is built. ” Establishing a Need for Auditing In one of the earliest forms of organized auditing, the American Institute of Certified Public Accountants issued a series of pamphlets to the accounting profession in 1917.
The pamphlets were designed to guide financial statement analysis and auditing in general, offering more transparency to the emerging corporations that were springing up around the country. Strong motivation for this release came from the Federal Trade Commission and the Federal Reserve Board, stemming from a panic in the previous decade that had sent chills through the investment community. Both entities wanted to offer a stabilizing force to help guide the United States’ corporate growth.
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An early accounting journal discusses the pamphlets: “The memorandum is of such importance that it has been reprinted in full in this issue of The Journal of Accountancy and we are confident it will appeal to all readers. To the members of the institute it will serve as a guide in all their audits for credit purposes, and they will understand that the burden of proof will be upon them if they omit any of the procedure laid down in the memorandum.  The pamphlets were an adequate start, yet lacked the authority to be the final solution for stability. Federal Trade Commission Chairman W. E. Humphrey delivered a well timed statement on the progress the FTC had made, but also addressed some of the limitations: “I am constrained to believe that the business of this country, and particularly big business, is more and more forced to the conclusion that honesty is not only the best policy, but that it pays the highest dividends.
I feel that there has been a tremendous improvement in the conduct of the business of the country over the last few years, but the time has not come, and I regret to say that it seems far off, when the strong arm of the government will not be needed to protect the public from greed, monopoly, fraud, and unfair practices. ” Humphrey however, could not foresee how right he actually was. After an especially lucrative decade for investors in the roaring twenties, one of the most devastating financial crises struck the United States in 1929 as the NY stock exchange came tumbling down.
Corruption and greed were rampant among most major companies, whom often distorted how risky their operations actually were. Margin borrowing by investors allowed huge amounts of debt to be taken on without proper risk mitigation. Investors, knowing no better, had dumped small fortunes into the market. The fragile infrastructure of the system couldn’t handle the load and eventually caved in. Those companies that would survive the crash needed standardization and change in order for the investors’ faith to be restored.
The Federal Trade Commission stepped in to fill this need. The first official document: “Verification of Financial Statements,” which was solely dedicated to provide guidance for audit, was released the same year as the crash. This document dove further than the previous decades’ pamphlets did, focusing in on small and medium sized companies, as well as the general need for the customized auditing tailored to each different companies, based on need. In response to the extreme amounts of personal wealth destroyed during the tock market crash in 1929 and the ensuing depression, Congress was forced to take even more action. The suggested guidelines outlined by the FTC were just not enough to ensure a stable economy. The regulation of business and the accounting firms is commonly recognized to have been born just after the Securities and Exchange Commission (SEC) was established in the mid 1930s. Despite public investment being in an advanced stage at the time, corporate regulation was practically unheard of. The SEC was a product of both the Securities Act and the Securities Exchange Act.
William Raymond offers insight on the initial operations of the SEC and how the investor took advantage: “There are probably thousands of investors throughout the country who are at a loss to understand what value is all the data gathered by the Securities and Exchange Commission, which is headquartered in Washington and no convenient way for the investor to visit and secure the valuable data themselves. To these investors, the commission offers a very adequate mailing service, through which various actions by the commission, decisions and other matters may be obtained simply by requesting the placing of their names on the mailing list.  Even from the beginning, serious debates raged in Washington about whether it was constitutional for the government to be involved in public corporations, much less private ones. Without regulation, there was fear another collapse was unavoidable. Establishing standards for preparing and auditing financial statements was decided to be the bare minimum that was essential to steer clear of any future turmoil. The authority to set the rules and oversight for what would become “auditors” was given to the SEC. Auditors themselves were allowed to set their own standards, but final say was still in the hands of the SEC.
It is important to distinguish between accounting standards and auditing standards. Although related, auditing is but a piece of accounting. Nevertheless, to truly understand the history of auditing, one must note the progression of accountancy as well. Regulating Auditing Procedures In recognition of the expertise and resources of the accounting profession, the SEC has traditionally looked to the standard setting bodies from the private sector to provide a foundation for improving accounting principles and reporting standards.
The private sector offered a baseline set of guidelines, which the SEC built off of. From 1938 and 1959, the Committee on Accounting Procedure (CAP) issued 51 Accounting Research Bulletins. The ARBs formed the basis of what is probably the single biggest resource to accountants today. GAAP, or the generally accepted accounting principles, is the foundation of all modern accounting. By 1959, CAP had been replaced by another entity, the Accounting Principles Board (APB). The APB was responsible for 31 new general accounting standards from 1959-1973.
This transition would mark the beginning of a plethora of different organizations over the years which would guide the practice. To improve the quality of audits in the 1960’s, the bigger companies added a new technique. Peer review, as it was called, required firms to confirm the accuracy of one another. It was so effective; the AICPA eventually added it as a requirement in 1977 for any member of the CPA division (within the AICPA). Firms were not required to join this division, but those who did agreed to a peer review as part of the guidelines.
Eventually the peer review was deemed mandatory for all firms, membership or not, as part of the complete overhaul to the self control systems in 1989. The restructuring enacted change in the AICPA’s bylaws that required all members who practice must belong to a special group within the parent organization called the SEC Practice Section. The Practice Section had numerous guidelines for membership. The most notable included provisions that each member must engage in a peer review with another firm of comparable size.
The point of the provision was to offer further reassurance to investors that operating accountants had adequate control mechanisms, regarding the integrity of GAAP and GAAS. While peer review is not a complete test, the idea is that a sampling of a firm’s work represents an adequate representation of the entire operation. Auditing every piece of work in a firm would be a completely unreasonable request, thus sampling method would have to suffice. Any findings from the peer reviews were available for viewing by the general public.
Each firm is issued a report that contains the audit results and sometimes even comments on how the firm might improve its reporting procedures. Occasionally, a reader might even find the resulting changes made and any comments the audited firm has made regarding the issue. This open communication was a significant step forward towards complete transparency. William Kinney comments on what is important to the users: “Internal controls are also important to investors, the government, and ociety as a whole since they may affect long-term confidence in corporate accountability, and in the corporate form of organization. ” Despite this transparency, the increasingly complex business environment was proving to be too much to handle for one part time regulating committee, even with peer reviews. In order to solve this issue, an independent organization was necessary to help cater to the interests of investors, accountants and creditors. A full time committee eventually ended up relieving the AICPA of its duties.
FASB, or Financial Accounting Standards Board, was officially created in 1972. FASB’s primary responsibility surrounds setting ground rules in all non governmental entities. These ground rules covered anything from revenue recognition and all other broad topics, to specific topics such as dividends. Marshall Armstrong writes in detail about its purpose: “The objective of the qualitative standards is to provide guidance in determining the substance of a transaction or event, regardless of its form, and a moral and ethical basis for its fair presentation in financial reports.  These standards are officially recognized by the SEC as the authoritative standard. Even with the establishment of FASB, the AICPA still existed to a limited extent. Through the means of the Accounting Standards Executive Committee, the AICPA works to collaborate with FASB on common objectives. Membership practices in FASB are intended to keep a level of independence but still effectively operate with the private sector in mind. It operates under the auspices of the Financial Accounting Foundation (FAF), which consists of sixteen trustees, twelve of whom are elected by representatives of FAF’s sponsoring organizations -- the AICPA, the American Accounting Association; the Financial Executive Institute; the Securities Industry Association; the National Association of State Auditors, Controllers and Treasurers; the Institute of Management Accountants; and the Government Finance Officers Association. The other four at-large members are appointed by the FAF itself.
The FAF, in turn, appoints the members of the FASB and its advisory council. It is also responsible for funding the FASB. ” The first specific auditing standards were issued way back in 1939. The American Institute of Accountants authorized the appointment of a standing committee to advise on auditing procedure. By 1941, the AIA had released a several statements with the purpose to guide the individual auditor. Most notably was the “Statements on Auditing Procedure”, which offered a baseline for how auditors should responsibly approach individual audits, while using proper judgment.
These “SAP” s would be the first of 54 future statements issued up until 1970. The SEC required all auditors to swear upon their work, that it followed these generally accepted auditing standards. To help with compliance of this requirement, the SEC released the “Generally Accepted Auditing Standards—Their Significance and Scope. ” Within ten years, the committee combined twenty-four of the pronouncements into one single body which would be referenced often during the process of internal control.
Other notable consolidation efforts included the 1962 release of the “Statement of Auditing Procedure No. 33” which combined many of the standards trickled out between 1949 and 1963. This baseline document was turned into a single presentation, being coded in the process by 1972. The 1972 revision was held under the title: “Statement on Auditing Standards” or SAS. With the combination and official first uniform document, the committee officially changed its name to the Auditing Standard Executive Committee (AudSEC).
In the next six years, AudSEC released 23 total SASes as a guideline for auditors. The AICPA continued to conduct numerous studies through committees on how to operate most effectively as a tool to the accounting profession. By 1978, the Auditing Standards Board (ASB) was the newest incarnation of an organized body charged with setting standards for the profession. An AudSEC’s successor, the ASB operated as 15 members with the responsibility to make relevant public statements, without having to obtain clearance first from the AICPA.
Furthermore the ASB would set ground rules for how an auditor performs his assessment in regards to whether financial statement presentation conforms to the generally accepted accounting principles. Before setting new standards, the ASB will carefully gather all relevant opinions, including those of the Chief Accountant of the SEC as well as various other well known and respected individuals in the profession. The ASB replaced all previous senior technical committees in regards to the GAAS. The Public Oversight Board (POB) was created in 1977, which further helped to push transparency in the industry.
The POB is a watch group entity responsible for oversight of the processes of the SECPS. The POB is an independent organization, which despite being funded by the SECPS, controls its own membership. If a firm has more than thirty SEC audit clients, then the POB will engage in reviews of the firm. The reviews can also take place in firms with less than thirty SEC audit clients, but the frequency of them is far fewer. Furthermore, the SEC will periodically inspect a sample of the peer reviews and even compile an annual public report that details its operations for the year. Auditing in Modern Times
Over seventy years after the stock market crash of 1929, again the Unites States would be struck by the uncertainty of the public corporation. The collapse of Enron revealed fraudulent accounting practices by the energy company itself and its accounting firm Arthur Anderson. By creating special purpose entities, Enron and Arthur Andersen effectively hid massive amounts of Enron debt, making the company appear much more profitable than it actually was. The house of cards built by Enron eventually collapsed leaving the SEC to sift through the rubble to discover what had actually happened. Also complicit were Arthur Andersen and lead Partner David Duncan. Duncan earned $700,000 annually to manage this account, plus part of Andersen's partnership profit pool. To appease Enron, he apparently did not require many large audit adjustments for several years, and often signed off on financial statements that were, by any reasonable standards, unclear and misleading. This shoddy work and attempts to eliminate key evidence led to Andersen's felony conviction and demise - apparently ignoring its founder's key slogan of thinking straight and talking straight.  In response to the Enron collapse as well as the other companies which went down in its wake, the SEC was forced to up the ante, so to speak, with public transparency and accountability. In 2002, the Sarbanes-Oxley Act was put into place, which drastically altered the structure of GAAP. Through the Sarbanes-Oxley Act, the Public Company Accounting Oversight Board (PCAOB) and the Securities Exchange Commission (SEC) were given the final say over all auditing standards. Registration was required with the PCAOB for CPAs and CPA firms who worked with public companies.
Once registered, members must adhere to all standards, principles, rules, and interpretations set forth by the PCAOB. Further restructuring surfaced in 2004 as the PCAOB was set as the authority on public companies (as it pertains to GAAS), while the ASP oversaw private companies. Chuck Landes, a VP with the AICPA, speaks to the changes in an interview with the Ohio Society of CPAs: “Auditing standards have changed and now call for more attention to the audit itself. Auditing is a serious business and it needs to be taken seriously. You can't be a part-time auditor.
I see firms making intelligent decisions about being in the audit business and committing the necessary resources around the audit function. In our new risk assessment standards, having an understanding of the industry is essential. ” The unfortunate trend with auditing standards is that a tragic event usually occurs for the foundation to adjust. It is a great system to catch and fix problems, but as the time passes, the scale of the instigating event becomes larger and larger. As long as there are men and women with greed, there will be a need for auditing.
Armstrong, Marshall. 1973. FASB will develop broad qualitative standards. The CPA Journal (pre-1986) 43, no. 000010, (October 1): 844 Bateman & Co. A History of Accounting & Auditing Standards. February 2002. http://www. batemanhouston. com/newsStds. htm Humphrey W E. 1928. A Friend of Honest Business. Nation's Business (pre-1986), June 5, 31. Kinney, William R. , Jr. , Maher, Michael W. , and Wright, David W. 1990. Assertions-Based Standards for Integrated Internal Control. Accounting Horizons 4, no. 4, (December 1) Lasch, Erin. 2002. Chuck Landes is Rewriting Audit History.
Catalyst 48-50 Marshall, Bruce. 1958. The Bank Audit. Edinburgh: Houghton Mifflin. Alan Reinstein, Stephen R. Moehrle, and Jennifer Reynolds-Moehrle. "Crime and punishment in the marketplace :Accountants and business executives repeating history. " Managerial Auditing Journal 21, no. 4 (May 1, 2006): 420-435. Raymond, William T. (1935, July 29). SEC Keeps Investors Informed. Barron's (1921-1942), pg. 8 Richardson, AP. "The Federal Reserve Board and audits. " Journal of Accountancy (pre-1986) 23, no. 000006 (June 1, 1917): 452. ----------------------- 1] Marshall, Bruce. 1958. The Bank Audit. Edinburgh: Houghton Mifflin.  Richardson, AP. "The Federal Reserve Board and audits. " Journal of Accountancy (pre-1986) 23, no. 000006 (June 1, 1917): 452.  Humphrey W E. 1928. A Friend of Honest Business. Nation's Business (pre-1986), June 5, 31.  Raymond, William T. (1935, July 29). SEC Keeps Investors Informed. Barron's (1921-1942), pg. 8  Kinney, William R. , Jr. , Maher, Michael W. , and Wright, David W. 1990. Assertions-Based Standards for Integrated Internal Control. Accounting Horizons 4, no. , (December 1)  Armstrong, Marshall. 1973. FASB will develop broad qualitative standards. The CPA Journal (pre-1986) 43, no. 000010, (October 1): 844  Bateman & Co. A History of Accounting & Auditing Standards. February 2002. http://www. batemanhouston. com/newsStds. htm  Alan Reinstein, Stephen R. Moehrle, and Jennifer Reynolds-Moehrle. "Crime and punishment in the marketplace :Accountants and business executives repeating history. " Managerial Auditing Journal 21, no. 4 (May 1, 2006): 420-435.  Lasch, Erin. 2002. Chuck Landes is Rewriting Audit History. Catalyst 48-50
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