A History of Auditing

The Changing Audit Process in Britain from the Nineteenth Century to the Present Day

Derek Matthews

• Publisher: Routledge
• Year: 2006
• ISBN:
  9781134177905
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

The rise of the British accountancy profession from the late nineteenth century to the present day, and the world-wide success of its accountancy firms, were to a large extent based on the growth of the audit function.

This book explores the history of the audit process in Britain, demonstrating that the characteristic features of the auditing industry are a diversity in practice based largely on the different types of clients the auditors serve. The book examines the innovation that was brought about by the staggering developments in information technology which have been seen over the last few centuries.

This comprehensive history will be a useful reference tool for accounting, business and economic historians and will also be an enlightening read for all those with an interest in auditing procedures.

1 Introduction

Auditing today is clearly the most controversial aspect of the accountant’s work. The collapse of Enron, and Worldcom, together with their auditors, Arthur Andersen, has put the spotlight in the past few years firmly on the company audit (Economist 30 November 2002). The scandals across the Atlantic were of course presaged by equally dramatic upheavals in the audit world in Britain in the late 1980s and early 1990s, with the performance of Price Waterhouse, the auditors of the Bank of Credit and Commerce International (BCCI), and Coopers & Lybrand, auditors of the Maxwell companies and Barings bank, among many other examples of audit failure (Mitchell et al. 1993).

Audit scandals of course have a long history in Britain going back through the performance of Andersens as auditors of the DeLorean company in the early 1980s, to the London and County affair in the 1970s, and the Royal Mail case in the interwar period. Yet apart from these negative aspects it is also the case that the rise of the British accountancy profession from the late nineteenth century down to the present day, and the world-wide success of its accountancy firms, were to a large extent based on the growth of the audit function (Matthews et al. 1997). In view of this background then it is remarkable how little attention auditing has received from accounting historians, and how relatively little published research there is on the subject. In the introduction to his collected edition of previous writing on the matter Lee (1988: xi) made the point that: ‘As a subject, the history of auditing has received little attention.’ Since then not much has changed.

The lack of interest in audit history can easily be demonstrated by surveying the accounting history literature. First, the various collected editions of essays on accounting history show the paucity of work on auditing. Out of 18 papers, Yamey’s (1978) collection on The Historical Development of Accounting has none on auditing but, for example, five on cost accounting. Garner and Hughes’ (1978), Readings on Accounting Development, contains two papers on auditing out of a total of 29; Lee and Parker’s (1979), The Evolution of Corporate Financial Reporting, contains two papers discussing auditing out of a total of 17; while Parker’s (1984), Papers on Accounting History, has none out of 14 contributions. Parker and Yamey’s (1994), Accounting History: Some British Contributions, has nothing on auditing, but again four contributions in their section on ‘Cost and Management Accounting’. Finally, Lee et al. (1996) for their Accounting History from the Renaissance to the Present: A Remembrance of Luca Pacioli, commissioned seven chapters by leading accounting historians, ranging in subject matter from financial accounting and reporting, professionalisation and management accounting (two chapters), but again there was no mention of auditing.

The general histories of accounting, the few that there are – for example, Brown (1968), Woolf (1912), Littleton (1981) and Stacey (1954) – contain due reference to the auditing function but not in proportion to the extent to which the profession earned its living. Chatfield (1977), for example, in his History of Accounting Thought, has two chapters out of 20 on auditing. Edwards’ (1989: 263–9) history of financial accounting has scattered references to the audit and a section of six and a half pages devoted to the process, but as with most accounting history the focus of the book is on accounting and financial reporting. The histories of accounting firms, for example those of Edgar Jones (1981) and (1995), usually give a fair treatment to the audit function but of necessity this is not the main focus of the story. Auditing also impinges on some events and issues which have been heavily researched, for example the Royal Mail case (Green and Moss 1982), but obviously this in no way adds up to a history of the process.

It is clear, therefore, that there has been very limited primary research into the history of the audit on either side of the Atlantic. There have been some notable articles on audit history, for example, Chandler et al. (1993), who set out to establish the changing purpose of the audit in the nineteenth and twentieth centuries, and Power (1992), who looked at the history of audit sampling. Yet these works are the exceptions that prove the proposition. Anderson’s (2000: 385–93) list of the 154 accounting history publications for 1999, for example, contains only 15 on auditing topics and only 5 of those were British in focus. Moreover, this lack of work on auditing by historians is in sharp contrast to the huge amount of interest shown by writers on contemporary audit issues in recent decades. Despite both concluding that not enough was being done, Gwilliam’s (1987) and Higson’s (1987: chap. 3) surveys of auditing research give remarkable evidence of this: and since then there has been no let-up in the research and publications on present day audit themes. Equally significantly, of the little historical research there has been on auditing, almost none of it pays attention to what auditors actually did, again in contrast with, for example, the extensive treatment of the history of cost accounting techniques (e.g. Boyns and Edwards 1997).

One can only speculate on the reasons for this lack of interest in the audit process among historians but perhaps a major consideration is that, as one commentator has noted, ‘there was very little information about how auditors actually conduct their work’ (Higson 1997: 199). Power (1992: 39) writes of: ‘The impoverishment of historical sources about audit practice’, and as a result ‘field studies of what auditors actually do, as opposed to studies of what auditors claim they do or would do, scarcely exist’. Myers (1985: 70) also concluded of the American scene that ‘there remains very little evidence of what auditors do’. One reason given for this absence of information was that audit firms have not kept their old working papers and manuals, and moreover until the 1980s many accounting firms considered their audit methods to be strictly confidential (ibid.: 70; Higson 1987: 5, 1997: 199). Clearly, the audit is a relatively private activity, and from the historian’s viewpoint it would seem that, apart from sporadic law reports and scattered information in the trade press (e.g. Chandler and Edwards 1994), there is a lack of solid data on the process of the audit as it was practised, rather than as the textbooks said it should be.

Another factor in the situation is that traditionally accounting historians have tended to use only documentary evidence, which, if this is as thin on the ground as seems to be the case with auditing, would itself account for the lack of published work. It is unfortunate that accounting historians have been somewhat reluctant to use oral history (although see: Loft 1990; Mumford 1991; Matthews and Pirie 2001) and accounting historians have been urged to use oral evidence more (Collins and Bloom 1991; Hammond and Sikka 1996). Also, accounting historians (or any other stripe of historian for that matter) have not exploited another technique widely used in the social sciences, namely the postal questionnaire. Academics researching present day trends and issues in accounting use questionnaires relatively frequently; there are, for example, the well known investigations of the shareholders’ reading of the corporate report by Lee and Tweedie (1977) and Bartlett and Chandler (1997), Drury et al.’s (1993) work on cost accounting, and Beattie et al. (2001) on the auditor/client relationship. It is somewhat surprising then that accounting historians have not used the questionnaire technique.

In view, therefore, of the lack of published work and apparent shortage of documentary evidence it was decided to set up a project on the history of the audit which exploited both oral history and the questionnaire, made possible by the generous provision of funds by the Institute of Chartered Accountants in England and Wales (ICAEW). The oral history side of the research entailed a programme of interviews with retired and still active chartered accountants, and the evidence provided has been extensively drawn on here (and is discussed in detail in the Appendix at the back of the book). The other half of the ICAEW project was a postal questionnaire (again dealt with more fully in the Appendix) in which among other matters the respondents were questioned on the process of the audit which generated the crucial historical trends in responses reported in the tables here.

A third source of primary data used in this book is a survey of company reports, a project funded by the Leverhulme Trust, which involved the collection of a sample of quoted company reports. These yielded evidence on audit fees, while an analysis of the wording of the audit reports gives insights into the audit process itself (again the source is more fully discussed and the data used is given in the Appendix).

Finally, in addition to the new material generated by our programme of interviews, questionnaires and the survey of company reports, this book utilises the more traditional documentary sources, principally the trade press and the contemporary textbooks. In addition an analysis of the final audit examinations of the ICAEW revealed when questions on specific audit techniques were first asked, giving another indication of when they came into common use.

The aim of this book then is to give a reasonably comprehensive narrative history of the audit process in Britain. It should be emphasised that we focus relatively narrowly on the techniques used in the audit. The related and equally interesting matters of the purpose of the audit, its quality and cost and many other issues are only touched on where relevant to the audit process. Chapter 2 describes the traditional so-called bookkeeping audit as it was practised from the nineteenth century down to about the 1960s. New evidence is offered which emphasises that the characteristic feature of the audit in this period was the extent to which the auditors were also doing their client’s accounting. The chapter also describes the labour intensive audit process known in the trade as ‘ticking and bashing’, but demonstrates that although mechanical this was usually not the cursory job that previous writers have assumed. The succeeding chapters describe the ways in which the bookkeeping audit has changed over time, although noting that the apparent innovations all had their precursors in early audit procedures.

Chapter 3 looks at the changes in the documentation involved in the audit, and traces the evolution of the early audit notebooks and brief sets of instructions into comprehensive audit programmes, working papers and voluminous manuals. The development of testing and sampling is discussed in Chapter 4, which finds that sampling was of necessity an aspect of the audit of large companies from the first, and, although it became increasingly used, probably did not increase in sophistication until the 1970s, when computers made statistical sampling a realistic possibility. Chapter 5 relates and quantifies the rise of the so called systems approach based on testing the client’s controls rather than the underlying bookkeeping; and Chapter 6, after wrestling with the shifting meanings of the term ‘balance sheet audit’, gives evidence of the increased emphasis on procedures such as the attendance at stock-taking and the circularisation of debtors. Chapter 7 looks at the biggest single change in the audit in the period – the coming of computers – and how the auditors attempted to come to terms with the new technology, which took away their traditional source of evidence – the audit trail. Chapter 8 rounds off the narrative survey with a description of the most recent of the changes in audit technique – the coming to prominence of concepts such as risk, materiality and analytical review.

The book concludes with Chapter 9 which summarises the changes in audit procedures and offers explanations for these developments. The characteristic features of the history of the British audit are a diversity in practice based largely on the different types of clients the auditors served. Although all the changes in technique and their nomenclature seemed to emanate from America, the British adopted them in their own time. Leaving aside the upheaval caused by computers, the most important factor driving change, which distinctly accelerated in the 1960s, was the growth in the size of British companies. The most recent changes, coming into widespread use around 1980, were however driven by the commercial pressures bearing on the audit firms.

2 The bookkeeping audit

Nineteenth-century accounting and the rise of the professional audit

As is well known, the audit dates in Britain from at least medieval times, when the auditor on landed estates literally heard the accounts read out and checked on the lord’s behalf that his steward had not been negligent or fraudulent (Edwards 1989: 37; for a summary of the early history of auditing see Higson 1987: 14–30). Then, as trading and manufacturing companies multiplied in the eighteenth century, accountants were commonly employed as auditors to check that all was in order with the investments of partners or shareholders. An audit certificate: ‘Examined and found right, Bristol, December 20, 1797’ forms part of the records of the accountancy firm of Josiah Wade (Howitt 1966: 245). But, as Lee (1988: xvii) has argued, the biggest fillip to the audit process was given by changes in the economic environment in the nineteenth century: ‘developments in the economic structure of civilizations caused audit needs. Industrialization created the need for financing. This created, in turn, the need for incorporation. And this created the need for financial reporting of audited information’.

A major step forward for professional accountants in Britain was the coming of the railways, particularly resulting from the speculative mania of the 1840s (Kitchen 1988: 26). Railways were by a long way the largest companies spawned by industrialisation and they presented a major accounting challenge. The literature gives a mixed picture of railway accounting. Reed (1997: 5), for example, writes regarding the 1840s of ‘the sophisticated accountancy required to integrate even a relatively small number of railways into a cohesive system . . . and it was clearly essential to have a secure system to record takings and allow effective audit . . . Most railways accordingly had well developed financial control mechanisms’. Even in the 1840s and 1850s railway companies usually had, as in the case of the Lancashire and Yorkshire, an accountant’s office with teams of bookkeepers, and a treasurer or secretary capable of drawing up some form of accounts (Broadbridge 1970: 41). These, of course, were not the trained public accountants of the sort that were well established in the City of London and elsewhere by this time mainly involved in bankruptcy work, but they were often highly competent bookkeepers, a skill which helped them get to the top of the management ladder (Matthews et al. 1998: chap. 2). For example, Henry Tennant was, in the 1840s, the accountant of two smaller railways before moving to the giant North Eastern Railway in 1854, and in 1871 he became their general manager (Irving 1976: 15–16). Between 1846 and 1858, the general manager of the London & North Western Railway (LNWR) was the outstanding Mark Huish, whose knowledge of bookkeeping, learnt with the East India Company, had apparently helped gain him his first railway job (Gourvish 1972: 49).

But there was another side to early railway accounting. According to Gourvish (ibid.: 30) ‘the early railways produced only the most rudimentary of accounts’. Often the speculative railway companies were fraudulently run and the payment of dividends and day to day expenditure out of the shareholders’ capital was common (Jones 1995: 52). These rail companies’ accounting systems were, perhaps as a result of the frauds, frequently in a mess, with no uniformity in a company’s accounts from one year to the next, let alone comparability between companies. The Times in 1850 described the accounts of the Caledonian Railway Company as ‘just such a tangle as one might dream of after supping on lobster salad and champagne’ (Robb 1992: 43). Leading City public accountants, like William Quilter and William Deloitte, were frequently brought in to sort out railway company frauds and other financial problems, and were often largely responsible for putting their accounting systems on a sound footing (Jones 1984: 58; Bywater 1985: 792; Edwards 1985: 38). For example, professional accountants introduced a general balance sheet into the accounts of the Midland and the South Eastern railway companies for the first time in 1850 (Edwards 1989: 265).

The initial employment of public accountants to sort out a railway’s accounting led on very often to an auditing role, while they also continued to take responsibility for the accounting. Although Quilter and Deloitte probably did not originate the double account system, which separated out capital from revenue expenditure, they certainly refined and promoted its adoption by the railways (Jones 1984: 58; Bywater 1985: 792; Edwards 1985: 30; Kitchen 1988: 28). The double account system devised by Edwin Waterhouse, as auditor of the LNWR and other railways, probably acted as a model for the uniform accounts required of all rail companies by the 1868, Regulation of the Railways Act, which according to Pollins (1969: 138–9): ‘after many years of chaos. . . marked a turning point in the history of railway accounting’.

After the 1868 Act, the published accounts of the railways were by far the most detailed, and probably the most accurate, of any public companies. The rail companies had for the most part settled down into stable bureaucracies with no need for outside public accountants to help them with their basic accounting, as had often been the case in the 1840s and 1850s. Gourvish has detailed the management changes wrought on the railways which ‘led the way in developing relatively advanced techniques in business management, making progress in the fields of accounting, costing, pricing, marketing and statistics’ (Gourvish 1972: 290). Huish, at the LNWR, for example, had introduced relatively sophisticated ‘internal controls on costing and pricing’ (ibid.: 267). By 1870, the Great Western also had a sizeable management team, indicated by the item in their accounts: ‘Salaries of Secretary, General Manager, Accountant and Clerks, £20,170’; and by 1880 the company employed a chief accountant (Great Western Railway, Minutes of the Half-yearly General Meeting, 31 August 1870 and 9 February 1880).

Most of the other public utilities, like the gas companies, and also insurance companies, and the larger banks, had by the last quarter of the nineteenth century probably installed adequate accounting systems, and were also successfully handling their own accounting. According to Wilson (1991: 121–41, 158) gas engineers were responsible for drawing up their company’s accounts, and they also had relatively large accounts departments producing their own balance sheets by the 1870s. In banking, Edward Holden, for example, joined the Midland as an accountant in 1881, and soon became secretary and later chairman, making his reputation on an ability to analyse the balance sheets of take-over targets (Holmes and Green 1986: 83).

In most of British business, however, where even in 1914 ‘introverted family groupings still dominated most British firms’, it was a different story (Wilson 1995: 120, 132). Chandler has described in detail the amateurishn...