The evolution of auditing is a complicated history that has always been changing through historical events. Auditing always changed to meet the needs of the business environment of that day. Auditing has been around since the beginning of human civilization, focusing mainly, at first, on finding fraud. As the United States grew, the business world grew, and auditing began to play more important roles. In the late 1800’s and early 1900’s, people began to invest money into large corporations. The Stock Market crash of 1929 and various scandals made auditors realize that their roles in society were very important. Scandals and stock market crashes made auditors aware of deficiencies in auditing, and the auditing community was always quick to fix those deficiencies. The auditors’ job became more difficult as the accounting principles changed, and became easier with the use of internal controls. These controls introduced the need for testing; not an in-depth detailed audit. Auditing jobs would have to change to meet the changing business world. The invention of computers impacted the auditors’ world by making their job at times easier and at times making their job more difficult. Finally, the auditors’ job of certifying and testing companies’ financial statements is the backbone of the business world.
Auditing has been the backbone of the complicated business world and has always changed with the times. As the business world grew strong, auditors’ roles grew more important. The auditors’ job became more difficult as the accounting principles changed. It also became easier with the use of internal controls, which introduced the need for testing, not a complete audit. Scandals and stock market crashes made auditors aware of deficiencies in auditing, and the auditing community was always quick to fix those deficiencies. Computers played an important role of changing the way audits were performed and also brought along some difficulties.
A Brief History of Early Auditing
Auditing has existed since the beginning of human society. Auditing was used mostly for the detection of fraud and was done through extensive detailed examination from ancient times until the late nineteenth century (Lee, 1988). Fraud was a great concern during the early history of auditing, because internal controls were not used or not used effectively until the twentieth century. The late nineteenth century was a turning point in auditing history, when laws like the English Companies Act of 1862 were enacted. “The English Companies Act of 1862 was a general acceptance of the need for an independent review of accounts for both large and small enterprises (Lee, 1988).” This Act of 1862 showed that there was a great demand for specialized-trained professionals to perform these reviews reliably and independently. The text by William Jackson, In the True Form of Debtor and Creditor, written in 1823 discussed the need for an orderly and standardized system of accounting. Accurate reporting and the prevention of fraud would result through the use of an orderly and standardized system of accounting.
Early U.S. Auditing in the Late 1800’s to Early 1900’s
Auditing of the late nineteenth century involved a complete review of transactions and the preparation of the corrected accounts and financial statements (Lee, 1988). This was obviously an inefficient and expensive way to perform an audit. England and the United States saw the need to make an audit more efficient and less expensive. Around 1895, the technique of sampling emerged.
“With the rapid growth of American business following the Spanish-American war, the increase in size of many enterprises and the auditing of larger concerns, there developed the necessity for making the audit one of selected tests of the accounts rather than an endeavor to examine all of the transactions of that period (Staub, 1942).”
Fraud was still the main concern of auditing in the late 1890’s, therefore the main objectives of auditing were the detection/prevention of fraud and the detection/prevention of errors. Auditing in the United States began to branch from the heavy influences of Britain in the 1900’s. The main objectives of auditing in the United States were to obtain accurate financial conditions and earnings of an enterprise and secondly to detect fraud and errors. Auditors in the early 1900’s were primarily used to submit a certified balance sheet to banks to obtain credit. Bankers were no longer loaning money based on good character, but now focused on the definite knowledge of the financial affairs of the borrowers. Large life insurance companies also began using independent public accountants to certify published statements since the Hughes investigation of 1905(Staub, 1942).
The improvement of accounting practices and standards were the main concerns of the accounting community in the early 1900’s. The Interstate Commerce Act of 1906 prescribed a uniform annual report should be submitted to the Commission and what accounts should be kept. Any deviation from the Interstate Commerce Act was forbidden and punishable. The business world also began to feel the need for improvement of accounting principles when the businessmen’s pocketbooks were being squeezed during the World War I era. Income taxes before World War I were at such a low rate that they had no or little effect on the accounting practices of the business world. In 1917 and 1918, the U.S. Government significantly increased income taxes and a new tax was enacted that was a heavy graduated excess profits tax. These taxes made the business world see the need for improvement of accounting principles and the need for accountants to mitigate the increase in taxes (Staub, 1942). Public accountants were now commonly called on for financial advice and tax planning guidance. This led to periodical auditing of the companies’ accounts. Reform laws and internal controls will be some of the main issues during the next two decades.
Internal Controls: The Roaring 1920’s and the 1930’s
Auditors were slow to change, but the book published in 1910 called, Audit Programs, shed light on the subject of internal controls. E. V. Spicer and E. C. Pegler talked about the concept to “ascertain the system of internal check” (Carmichael, Willingham, 1979). This was the beginning of the modern day auditor. When auditors and business managers learned about internal controls, they were able to evaluate an entity’s controls. Through this evaluation, they can do less detailed testing if the controls are strong, strong controls will save time and money. Mr. J. M. B. Hoxsey became the executive assistant to the Stock List Committee of the Stock Exchange Commission during the 1920’s. He did a lot of reforms during this reign (Staub, 1942). The Exchange was encouraging the preparation of financial statements published by listed corporation on the basis of sound accounting principle. The support of the Stock Exchange Commission was very helpful to accountants, who were in pursuit of improvements in corporate accounting practices.
After the Stock Market Crash of 1929, the government saw the need for more standards and audits. They were needed to keep businesses and publicly traded securities to stay uniform and truthful with respect to their financial condition. The U.S. Government responded with the Securities Act of 1933, the Federal Trade Commission, and the Securities and Exchange Commission. These Federal laws focused on the balance sheet and the income (loss) statement that had to be filed with the Commission, and be certified by an independent accountant. Also the balance sheet had to contain all of the assets of the entity that conforms to the prescribed standards of the time.
The New York Stock Exchange also had a strong influence in making standards for listed securities on the stock market in the early 1930’s. The new standard demanded that all corporations applying for a security listing had to include a financial statement report issued yearly. In addition, the annual report must be audited by an independent public accountant and accompanied by certification that the accounts that are in good standing order. In July of 1933, additional requirements were established that an independent public accountant would audit and certify the balance sheet, income statement, and surplus statement for the most recent year fiscal year. Also, the agreement stated that an annual report to stockholders would be audited and accompanied by a similar certificate (Staub, 1942). In contrast, the railroads were not required to follow the new practices. This was based on the false belief that the Interstate Commerce Commission was responsible to periodically audit the railroads financial statements.
In 1930’s, the Securities and Exchange Commission had rigorous control of public utility holding companies and this would result in a very important accounting provision. The Public Utility Act of 1935 specified the prevention of the payment of dividends out of capital or unearned surplus without the approval of the Commission. This was a very significant movement that made the distinction of earned and unearned surplus in statutory law, which was previously only mentioned, in accounting practice and few corporate laws. Having this in statuary law would establish a clear definition and understanding of the subject that would be very helpful to the accountant. Further amendments to the Federal Power Act in 1935 gave more power to the Federal Power Commission to determine and fix the proper rates of depreciation and classify depreciable property into specific classes. The Trust Indentured Act of 1939 specified that the issuer of securities must show compliance with the rules and regulations and be subject to verification by accountants.
The Act prescribes that, “ Each certificate or opinion with respect to compliance with a condition or covenant for the indentured shall include (1) a statement that the person making such a certificate or opinion had read such condition or covenant; (2) a brief statement as to the nature and scope of the examination or investigation upon which the statements or opinions contained in such certificate or opinion are based; (3) a statement that, in the opinions of such person, he has made such examinations or investigations as is necessary to enable him to express an informed opinion as to whether or not such covenant or condition has been complied with; and (4) a statement as to whether or not, in the opinion of such person, such condition or covenant has been complied with (Staub, 1942).”
This provision placed the foundation of the modern independent auditor report into the mainstream business world. The issues of fraud and the Investment Company act will be the big issues of the 1940’s and 1950’s.
The 1940’s and 1950’s: Issues of Fraud and More Acts
The Investment Act of 1940 was a new branch that extended from the Securities and Exchange Commission. This Act of 1940 was concerned with the function and activities of investment companies’ and trusts’ policies. Studies found abuses in these companies when they were popular during the 1920’s. The investment trust stocks values would rise rapidly, well beyond inflation and normal appreciation, during the 1920’s and fall just as hard during the 1929 Stock Market Crash. The Securities and Exchange Commission saw the need for more protective measure for the public. Now not only financial statements were to be filed with the Commission, but also they would be required to be given to the stockholders (Staub, 1942). These reports were also to be certified by an independent accountant. The accountant was required to audit the statements to a high degree in scope and procedures that would be ordinarily used to prove the financial statements as dependable and comprehensive. Also this act had the requirement for an in-depth statement regarding the verification of securities owned by the investment trust or company to be full disclosed.
The McKesson & Robbins scandal case of 1939 brought fraud issues to the center stage in the accounting and business world. This case made accountants aware that there was a need for much more careful auditing practices and more stringent mandatory standards. The McKesson & Robbins scandal case of 1939 involved the head of the Drug Company who had stolen millions of dollars by carrying fictitious inventories on the books. The McKessons & Robbins Company was given a clean audit by Price Waterhouse. In review, the Securities and Exchange Commission did an investigation that revealed that the audit Price Waterhouse conformed to the mandatory standards of that time. The American Institute of Certified Public Accountants made a review committee to set higher standards for auditors. An example of these new standards was direct verification of inventories when deemed necessary and selection of auditors by the companies’ directors with approval of stockholders. Stockholders should also be entitled to a description of the scope of the auditor’s work, and to read the auditor’s opinion in a separate section of the annual report (Carmichael, Willingham, 1979).
The responsibility to of fraud detection was a question that was unanswered for many years until the McKesson & Robbins scandal case of 1939, which put this question in the spotlight. Before 1940, the uniform agreement as to the audit responsibility for the detection of fraud did not exist (Lee, 1988). By 1940, with heavy influence of the McKesson & Robbins scandal case, the responsibility for fraud detection now began to shift to management. Auditors’ main concern was to determine the fairness of the reported financial statements. By this time, a uniform agreement was made that testing was the auditors’ technique, and detailed examination was only done when deemed necessary. Of course, the strength of the internal controls was the deciding factor on how much testing should be done.
The 1950’s continued to reduce the importance of fraud detection on auditors. The belief that fraud detection was the responsibility of the management of the company was generally held. If auditors found any irregularities as they performed their audit, it was their obligation to bring this to the attention of the management. Ironically, many audit techniques of the period were specifically designed to assist in the detection of fraud (Lee, 1988). Emphasis of the audit was placed on the determination of the truthfulness of the financial statements. The late 1950’s and 1960’s brought more reform and brought up the concept of reasonable assurance of financial statements. Also, materiality of misstatements was brought to attention of the accounting profession. The auditor was required to perform tests in line with G.A.A.S. to detect material misstatements that would influence the confidence of investors in a company. The general concept to start an audit with an examination of the companies’ internal controls and the extent of testing required was decided from the test results. The computer had a great impact on how businesses and accounting would be performed from the 1960’s to the present.
The Computer Would Shock the Auditing World
The evolution of computers would change auditing forever. The first electronic computers were analog devices that began in the 1920’s and developed through World War II. These computers were used to perform complex mathematical computations such as integration. The 1940’s brought the development of digital computers that used binary logic. With binary logic, it was now possible to express exact numerical values instead of using approximate analog quantities to approximate numerical values. Binary logic was more advanced then just a fancy-adding machine, it had internal ability to express a logical decision, yes or no answer (Needleman, 1983). The first type of digital computer used glass vacuum tubes that took up a lot of space, used high amounts of power and produced high amounts of heat so special air conditioned rooms were needed. These tube units required a full time crew to keep them running smoothly and were unreliable.
The second version of these computers had transistors during the late 1950’s, which made the computer units more compact and proved to be better in every aspect compared to the first type. The development of mass storage units likes magnetic tapes showed the usefulness of computers in the business world. This advanced storage capabilities let information be stored and accessed at a later time. The late 1950’s and early 1960’s computers saw a new use in the business world (Needleman, 1983).
The business world realized that the E.P.D., electronic data processing, computer systems could do a lot of good in the business/accounting world. The UNIVAC 1 by International Business Machines was the first real successful computer. UNIVAC 1 was used to process insurance accounting data. Other IBM computers were sold in the late 1950’s, as many companies took advantage of this new magnetic storage devise. The new range of computers, the second type, produced in 1959-1960 was designed from the start with the commercial market in mind with more improvements (McRae, 1964).
Business, rather than scientific use, became the most popular use for computing equipment for the first time in the late 1950’s. In 1958, the Institute of Chartered Accountants issued a statement entitled Accounting by Electronic Methods. This statement referred to E.P.D. as
“…the method of analyzing, marshaling, recording and reporting business information by means of equipment, the central feature of which is an electronic digital computer (Pinkney, 1966).
Bookkeeping for accountant has been time consuming and in the 1950’s accountants have looked around for new ways of processing this data. Punch card machines was the first move but they were not fast enough for their needs, the digital computer was the next choice for providing a faster and more detailed cost analysis. Accountants didn’t change their ways overnight; changing over from manual system to computers took many years.
Computers in general were still complicated to most of its users. In the late 1970’s the microprocessor with integrated circuits changed the computer world age with all around improvements from memory to the size of the computers. The mainframe and minicomputer was in most places of business in the late 1960’s. The need for less computer language (binary code) and the ease of use were the main concerns of the late 1970’s. Auditing in general was changed forever, as data once on paper was now on magnetic tape reels and later floppy disks. The detection of fraud was more difficult to discover when data could be easily erased or changed. Auditing changed with the times as it always had. The discovery for new internal controls was needed, as these controls were important to make an audit successful and efficient. A computer system within a business with strong internal controls made an audit easier and resulted in more dependable financial statements. The computer of the 1970’s could handle large amounts of data and process the information in a very short time. Computers made accounting jobs in general easier, with the computer handling the bookkeeping work. This freed up time so accountants could focus on more important jobs. The history of auditing and auditing with computers ends here in the 1970’s. I, like most historians, feel that there should be at least 20 years to have passed by to really view and understand a decade.
The evolution of auditing is a complicated history that always changed through historical events. Auditing always changed to meet the needs of the business environment of that day. Auditing has been around since the beginning of human civilization, focusing mainly, at first, on finding fraud. As the United States grew and the business world grew, auditing began to play more important roles. In the late 1800’s and early 1900’s, people began to invest money into large corporations. The Stock Market crash of 1929 and various scandals made auditors realize that their roles in society were of great importance. Their jobs would have to change and meet the changing business world’s needs as they always did. Computers impacted the auditors’ world by making their job at times easier and at times making their job more difficult. The auditors’ job of certifying and testing companies’ financial statements is the backbone of the business world. In the end, the auditor enables the public to invest confidently in a company. The auditor is an indispensable member of the business world.
Lee, T. A., The Evolution of Audit Thought and Practice(New York: Garland
Publishing, Inc., 1988), p. 3, 5, 6
Staub, Walter A., Auditing Developments During the Present Century(Massachusetts:
Harvard University Press, 1942), p.15, 17, 26, 29
Carmichael, D.R. & Willingham, John J., Perspectives in Auditing(New York: McGraw-
Hill Book Company, 1979), p.8, 10, 55
Pinkney, A., An Audit Approach to Computers(London: The Institute of Chartered
Accountants Press, 1966), p.11
McRae, T. W., The Impact of Computers on Accounting(New York: John Wiley & Sons,
1964), p.38, 50, 182
Needleman, T., Micro-Computers for Accountants(New Jersey: Prentice-Hall, Inc.,
1983), p.3, 7