Accounting History and the Rise of Civilization, Volume II

Gary Giroux

• Publisher: Business Expert Press
• Year: 2017
• Print ISBN: 9781631577932
• eBook ISBN: 9781631577949
• Topic: Business
• Subtopic: Financial Accounting
• Index: Business

Accounting history continues in Volume 2 with six chapters, four supplements, plus conclusions. Chapters 1 to 3 of the second volume cover specialty topics, specifically auditing, taxes, and government accounting. Chapters 4 to 6 march along from the New Deal to beyond the mortgage meltdown and Great Recession. Supplements include audit opinions (the audit reports written for the annual financial audits), the scandals and corruption associated with accounting fraud, the formal standard setting process creating generally accepted accounting principles (GAAP), and finally computer technology, a key component of the accounting profession—and civilization. The concept of accounting as a profession developed by the 19th century, as accounting-related services (bankruptcy, taxes, and auditing) became important enough to hire experts and separate businesses to support these functions. Soon, licensing was required. Auditing and tax proved to be major money-makers for accountants. Accounting firms became mammoth and global (especially the Big 4) providing audit, tax and consulting services to giant multinational corporations as well as smaller business, governments, nonprofits organizations, and individuals. The rest of the book covers accounting since the early 20th century, when accounting became increasingly sophisticated and important to the commercial and political worlds. The 1920 reverted to "free markets, " financial market manipulation and speculation, fueled by abundant credit precipitating a boom; then the Great Depression, followed by FDR's New Deal. Chapter 5 covers most of the post-World War II period. Chapter 6 covers the bubbles and busts of the late-20th century and beyond, with particular attention to Enron. Conclusions summarize the last 10, 000 years of accounting, its overall impact on civilization, and predictions for the future.

CHAPTER 1

Auditing: The Rise of a Profession

We have audited the balance sheet and say in our report
That the cash is overstated, the cashier being short;
That the customers’ receivables are very much past due;
That if there are some good ones they are very, very few;
That the inventories are out of date and principally junk;
That the method of their pricing is very largely bunk;
That, according to our figures, the undertakings’ wrecked.
But, subject to these comments, the balance sheet’s correct.

—John Carey¹

A textbook definition of an audit: “A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.”² The U.S. securities acts of the 1930s required an annual audit conducted by a certified public accountant (CPA) for all publicly traded corporations, making the CPA a critically important profession—with something of a government-sanctioned monopoly.

Early auditors reviewed all transactions beginning with the original voucher or receipt through posting to the journal and ledger, recalculating the trial balance because debits must equal credits; a simple, time-consuming process to document all operating and financial activity. The objective of checking for clerical errors and certain types of fraud was met; the auditor emphasized the importance of “profession judgment,” that all entries were recorded correctly. The auditing profession was created in the 19th century and well established by 1900 in both Britain and America. Bankers, capital markets, and investors came to demand reliable information, presumably supplied by the auditor.

Auditing has never been fool-proof and changes in audit procedures and objectives often come from market and audit failures; the failures make the headlines, not the successes. The number one failure was McKesson & Robbins in the 1930s, because of undetected and long-term fraud on a massive scale—uncovered by a whistleblower not the auditor. Auditors were led astray by fast talking executives and lack of stringent techniques to detect the fraud—in part because there were no professional audit standards at the time. The embarrassment to the entire profession led quickly to auditing regulation by the American Institute of Accountants (now the American Institute of Certified Public Accountants or AICPA), the trade association of CPAs. Beginning in the 1950s computers became big business and corporate use continually expanded, including accounting-related activities. Auditors had the complex task of auditing around or through the mysterious “black box” that defined computer systems. Audit failures continued, including the disastrous bankruptcies at Enron, WorldCom, and other tech firms early in the 21st century.

Early Auditing

Auditing is an ancient concept coming from the Latin term “audire,” to hear. By ancient tradition, reports were presented orally, largely because most people were illiterate. Trade and wealth expanded during the late Middle Ages, with the important assist of double-entry bookkeeping. The concept of reviewing records by skeptical partners, bankers, customers, and tax-collecting governments increased and auditing procedures expanded and became more sophisticated. Italian Merchant partners in, say, the 12th century typically liquidated operations periodically. A formal liquidation needed to pay all outstanding debt, then divide the available cash and other assets between the partners. Reviewing the records supporting the final accounting was critical, made easier by both double entry and review by outside experts. Accountants in Florence and Venice often were paid a percent of the errors and frauds discovered.

The English Experience

Anglo-Saxon England had experience with record-keeping and a developing government-bureaucratic-judiciary structure, which was adapted by and expanded on by the Normans. The Domesday Book of 1086 could be considered an audit census for tax purposes. Woolf described the Pipe Rolls (annual tax records) used by the English Exchequer: “showing the amounts due each year from the Sheriffs to the King … made in triplicate. This system of checking by means of copies obtained throughout the Exchequer. We find that three officials (the Treasurer’s Clerk and two Chamberlains) kept separate accounts of all moneys actually received, and a record of all moneys actually paid out, the accounts of each officer being compared periodically with those of the other two.”³ This interesting internal control process was expanded upon in later reigns, including the “Auditors of Imprest” and later Commissioners of Public Accounts.

The South Sea Co. became the first financial bubble and bust of a joint stock company. Charles Snell, calling himself a “writing master and accountant in Foster Lane, London”—perhaps the first public accountant—reviewed the finances of Sawbridge & Co. in 1720 because of the alleged corruption after the South Sea Bubble burst. Jacob Sawbridge was a director of the South Sea Co. and accused of bribing government officials. Snell’s report, issued in 1721, is the earliest “audit report” in existence. Sawbridge was expelled from the House of Commons and stripped of most of his fortune.

The Industrial Revolution changed everything in the world of economics and business. Factories using steam power replaced the craft system and the interrelated concepts of productivity and economies of scale became meaningful. Industrial corporations, railroads and other mass transportation, new markets (national and possibly global), plus the capital markets to finance big business all required new accounting perspectives—and professional accountants. Accountants had to be innovative to provide the information to meet the needs of complex operations.

Prior to 1800 the term “professional accountant” had little meaning. A directory of London professionals from 1790 listed exactly five accountants; the list would grow to over a thousand by 1900.⁴ Owners and professional managers performed most accounting functions as part of their jobs (and virtually anyone could claim to be an accountant or auditor). A real profession was on the way by mid-century. The British Companies Act of 1844 required audits of joint stock companies (now corporations), although exactly what an auditor did was not explained.⁵ Early professional accountants dealt largely in bankruptcies, liquidations, taxes, kept books, and examined disputed accounts, with the support of government regulations. The Bankruptcy Act of 1831 mentioned accountants (along with merchants and brokers) as potential “Official Assignees.” Railroad legislation in the 1840s called on the use of auditors. The Bankruptcy Act of 1869 included the need for trustees for the estate, which again could be accountants.⁶

British accountants took it upon themselves to create a profession. The earliest British version was the Institute of Accountants in Edinburgh, founded in 1853, followed by the Institute of Accountants and Actuaries in Glasgow two years later. They joined in 1893 to create the Chartered Accountants of Scotland. England proved a laggard, creating the Incorporated Society of Liverpool Accountants in 1870, followed shortly by the Institute of Accountants in London, then the Manchester Institute of Accountants. Finally, a charter was passed in Parliament, resulting in the Institute of Chartered Accountants in England and Wales in 1880. The first members became Chartered Accountants by waiver. Admission by examination started in July 1882. As of 1882, the Institute had 1,193 members.⁷ Accounting societies followed in the various British colonies as well as the United States. Professional training was based on apprenticeship, initially a five-year program, which was reduced as firms began to hire college graduates. Several accounting firms becoming the Big 8 (now reduced to the Big 4) were founded in mid-century London. These were named after their founders, including Deloitte, Whinney, Price, Waterhouse, Cooper, and Peat.

Auditing became an increasing part of the accountants’ time, probably half the professional work by the turn of the 20th century. At that time auditing centered on the “detailed” or complete audit, which proved reasonably effective for discovering errors and certain types of fraud. Journals were checked to vouchers or other documentation of transactions, then traced to ledger entries. Normally, this was important to the owners and usually bankers and creditors. In addition, auditors would check legal records such as the articles of incorporation of the client and minutes of board meetings.

The typical focus of the balance sheet audit, an extension of the detailed audit, was well established by the late 19th century. Included was checking all securities and cash, receivables (including aging the accounts and estimating value and the need to write off bad debts), determine inventory (including possible obsolete items), fixed assets including reasonableness of depreciation and other wear and tear techniques, all liabilities and other obligations, and finally capital. A major purpose was to determine the capacity of the firm to repay outstanding loans to bankers and other creditors. Stockholders became more interested users of the balance sheet audit, which provided information on the capacity of the firm to earn income and pay dividends. Over time, the purpose of the audit shifted to ascertain actual financial conditions and earnings. All transactions did not need to be audited if small frauds were not important, eventually allowing the auditor to use audit sampling on balance sheet accounts. However, the use of sampling implied that internal controls⁸ worked to limit the potential for fraud.

Auditing Moves to America

Wealthy English investors found investment opportunities in America—everything from railroads and heavy industry to cattle ranching in the West. British accountants followed the British wealth to protect investor interests in the relatively corrupt former colonies. The first accounting firms to establish a New York office was Barrow, Wade, and Guthrie in 1883, followed by Price Waterhouse in 1890.

America had gigantic industries and big domestic investors by then; consequently, American accountants borrowed from their more professional British counterparts. American high tech included electric utilities, typewriters, and mechanical adding machines. The Tabulating Machine Co. produced the Hollerith tabulating machine; the company later changed its name to the more grandiose sounding International Business Machines (IBM).

Accounting was a service that required massive manpower. Before the tabulating machine and, later, computers, office productivity was close to zero—roughly comparable to manufacturing before the Industrial Revolution. Six of the Big 8 (see Table 1.1) had been founded in 19th century Britain⁹ (American firms Arthur Young and Arthur Andersen were started later—in 1906 and 1913, respectively). State licensing for the CPA started late in the 19th century. Many CPAs joined professional groups, including the American Association of Public Accountants (AAPA) and later the American Institute of Accountants (AIA), both predecessors to the AICPA.

The profession established procedures (later incorporated in a code of ethics) that protected their turf as much as provided ethical standards (with practices akin to the guilds of the Middle Ages). Thus, accountants performed “audit engagements” (the terms of which were generally determined by the client), did not advertise or solicit clients, or blatantly seek clients. The firms preferred long-term relationships with clients where audit fees were expected to rise year after year. This perspective did not change much until the 1970s.

Employment at the bigger firms took a pyramid perspective, with the partners (they were the owners of the business) at the top, down the line through managers, supervisors, and staff auditors. The climb up the ladder was based on seniority and merit (the so-called “unsuccessful” often were placed as accountants of client firms). The term “leverage” was defined as the staff-to-partner ratio. A high ratio, perhaps 20 to 1, meant greater billable hours and higher expected partner earnings.

Except for licensing requirements in a few states, audits were effectively unregulated around the turn of the 20th century. Short of outright fraud (or other illegal acts under common law), it was difficult for CPAs to break the law—without specific regulations what laws could be broken? There were few if any rules, no mandated duties or responsibilities beyond engagement contracts with clients, no code of ethics (until the AIA passed a code of ethics in 1917). The auditor worked for the client, the purpose of which was determined by the client, seldom involving the public interest. As the separation of ownership and management expanded and financial needs provided by Wall Street, corporations wanted the credibility that an audit report provided. Wall Street demanded corporate prospectuses and annual reports to market their securities as did bankers for commercial loans. But how effective were these early audits? There were no uniform standards. Price Waterhouse (PW) was an audit firm known for high quality audits. However, not all firms had PW’s high standards, and later events proved even these standards could be deficient.

Table 1.1 The founding and changes of the Big 8

The largest, most prestigious accounting firms audit the major public corporations; mainly British firms established in the 19th century and American firms established early in the 20th century. After several mergers, these were identified as the Big 8 in the 1960s. After the failure of Arthur Andersen, they were down to the Big 4: Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers. These firms on average earn about $30 billion in revenues a year.
Arthur Andersen	Arthur Anderson and Clarence Delaney formed Andersen, Delaney & Co. in 1913, which became Arthur Andersen in 1918. Arthur Andersen Consulting separated in 1989 and is now Accenture. After the failure of Enron, Andersen was indicted for destroying evidence and went out of business early in the 21st century.
Coopers & Lybrand	William Cooper opened a London office in 1854; William Lybrand, Adam and Edward Ross, and Robert Montgomery created Lybrand, Ross Brother and Montgomery in 1898 in Philadelphia; the two firms merged (along with MacDonald Currie & Co.) to form Coopers & Lybrand in 1956. Merged with Price Waterhouse in 1998 to form PricewaterhouseCoopers.
Deloitte, Haskins & Sells	William Deloitte had one of the earliest London offices, founding his firm in 1845. Charles Haskins and Elijah Sells formed a New York City partnership in 1895. Haskins & Sells began collaborating with Deloitte in 1905 and the two merged in 1978. Deloitte merged with Touche Ross in 1989.
Ernst & Whinney	Frederick Whinney joined Harding & Pullein, a London firm, in 1867, later becoming Whinney, Smith & Whinney. Alwin and Theodore Ernst started a Cleveland partnership in 1902. Ernst & Ernst and Whinney began collaborating in 1924 and the firms merged in 1979. Ernst & Whinney joined Arthur Young in 1989.
KPMG	William Peat started his London firm in 1867. James Marwick started in Glasgow in 1887 and moved to New York City in 1896. He partnered with Roger Mitchell in 1897. Peat and Marwick & Mitchell agreed to merge in 1911. Barrow, Wade, Guthrie was a London firm, merging with Peat Marwick in 1950. Peat Marwick merged with KMG (Klynveld Main Goerdeler) Main Hurdman in 1986 to form KPMG.
Price Waterhouse	Samuel Price, Edwin Waterhouse, and William Holyland partnered in London in 1849, opening a New York office in 1890. PW was considered the most prestigious auditor, but also suffered the most embarrassing failure with McKesson & Robbins in 1938. PW merged with Coopers & Lybrand in 1998.
Touche Ross	George Touche formed a London partnership with John Niven in 1900, expanded to Touche, Niven, Bailey & Smart in 1947. Merged with Canadian firm Ross Touche in 1960. Finally, merged with Deloitte in 1989.
Arthur Young	Scottish barrister Arthur Young opened a Chicago firm in 1894 to deal with British investments in America, becoming Arthur Young & Co. in 1906. Merged with Ernst & Whinney in 1989.

Substantial abuse existed with the audit. The typical prospectus mentioned the audit, but did not publish the auditor’s report. Stockholders would know an audit was conducted, but not the results or even if it was a standard balance sheet audit or procedures much less inclusive. Because generally accepted accounting principles (GAAP) were decades away, financial statements could easily be manipulated or misrepresented. Accounting procedures and reports were based on the accountants’ judgment, whatever that might mean. Auditors had the choice of accommodating clients or, if not, withdraw from the engagement—giving up lucrative clients made staying in business difficult. Sh...

Table of contents

• Cover
• Title
• Copyright
• Introduction
• Chapter 1. Auditing: The Rise of a Profession
• Supplement A: Audit Opinions
• Supplement B: Scandals and Corruption
• Supplement C: What’s So Difficult About Setting Financial Accounting Standards?
• Supplement D: Information Technology
• Notes
• Bibliography
• Index