The History of Auditing in the United States


What is Auditing; in short Auditing is an examination of records or financial accounts to check their accuracy. Auditing has been around for centuries and has evolved into one of the most important parts of an entity, assuring that a business information has been recorded accurately. Laws and regulations have evolved into some of the most important events in the history of the United States. Auditing has also been a great part of Americas long history and has had its own share of laws, events, and people among other things in the United States.

A Brief History of Auditing

The definition of auditing is self explanatory even though the beginning of auditing was very different than what it is now. Centuries ago the master (auditor) would require the steward (client) to inform him of what transactions had taken place and report to the master what he had done with the wealth in which he was entrusted by the master. Therefore the master was known as the listener or auditor: "So the word 'Auditor' (derived from the Latin word audire, to hear) acquired a second meaning: 'one who satisfies himself as to the truth of the accounting of another' [1] . Before it was the (AICPA) American Institute of Certified Public Accountants it was the American Association of Public Accountants (AAPA) in late 1800's.

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Auditing was primarily used for governmental accountancy, and record keeping was its main focus. It was this way until the industrial revolution,1750 to 1850, that auditing began rising into its own core of financial accountability and fraud detection. During this period businesses were expanding rapidly because of the prosperity in the U.S. The growth led to an increase in jobs positions among owners and consumers. This led to the hiring of managers by owners in their absence, which in return caused owners to increase the monitoring of their financial actions for two things, accuracy and fraud prevention. In the early 1900's the practice of auditing, which involved reporting of their responsibilities and findings was standardized as the "Independent Auditor Reports".

Increase in requests for auditors lead to the development of the testing process. Auditors developed a way to tactically select key cases as representative of the company's overall performance. This was an affordable option to investigate every case in detail, and it required less time than the standard audit [2] . All auditing work was done by hand in the early 20th century until the computer came along as is described in the passage by Tracey Miller:

"The arrival of the computer on the corporate scene in the late 1950s changed everything. Since accounting was the first application used in the business world, a firm's CPA was the natural shoulder to turn to in understanding this new contraption. IT consulting - which has since boomed into a multi-million dollar industry for accounting firms - was born" [3] 

Events in Auditing

Perhaps the invention of the computer helped companies and small businesses organize their inventories and financial statements, they also made it easier for companies to figure out techniques to deceive the system to their advantage. We have to understand that fraud and misleading statements have been around the business field for centuries and will continue to border the field in the future. The appeal for corporations to raise bottom line numbers in order to make the company seem healthier than what it really is, is one of the hardest temptations to overcome. There have been many events in the history of auditing that have molded the practice of auditing as a whole.

One key event in auditing history was the downfall of WorldCom, one of the largest telecommunications company in North America and was once worth well over 150 billion dollars. The owner of the company Bernard J. Ebbers was responsible for the demise of the once thriving corporations. Ebbers was the main architect in destroying the company by creating an 11 billion dollar accounting scheme that left the company in shambles. This resulted in investors, employees, and others to lose out on health insurance, pensions as well as investments. It was one of America's largest economic failures since its assets were numbered at 107 billion dollars when the company filed for bankruptcy protection in 2002. Ebbers was convicted of securities fraud and falsifying financials reports which lead the company to fall into a pit of false numbers, liability, flaccid stock, and network overfilling. When WorldCom collapsed it also brought down many others small communication companies due to the smaller companies attempting to keep up with the growing WorldCom [4] .

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Another event in the history of auditing and perhaps the most infamous of them all was that of Enron Corporation in Houston, TX. In 1985 Houston Natural Gas merged with InterNorth to create Enron and became the largest natural gas merchant in the United States, headed by Ken Lay and Jeff Skulling. In 2000, Enron stock reached a record high of ninety dollars a share and in 2001 the once thriving stock hit a bottom low of less than $1 a share. By this time Enron's beginning of the end has begun, the company reports $638 million loss in the third quarter and also releases a $1.2 billion decrease in shareholder's equity in the same year. By the end of 2001 the once unstoppable energy trading company files for Chapter eleven bankruptcy protection and lays of over 4,000 employees. Many of the company's employees which include Enron accountants, chief traders, CEO, assistant treasurer, treasurer, COO and many others are arrested and put on trial for various accusations. The accusations stem from conspiracy to the manipulation of California's electricity markets to fraud.

In the end, nobody would have ever imagined that the founders of the enormous corporation that was Enron would result dead and in jail. Ken Lay died of a heart attack months before his sentencing hearing and Jeff Skilling was sentenced to 24 years in prison which was one of the harshest sentencing's ever handed down for a crime of such magnitude in the United States. Enron's demise consisted of many things from fraudulent accounting to irresponsibility of managers not overseeing their subordinates. Enron was one of the worst scandals in corporation history and an embarrassment to the United States. It could have all been prevented if the correct steps would have been taken in the first place. Enron was used as a stepping stone for lawmakers to introduce the Sarbanes Oxley Act of 2002, which main focus was to protect potential investors, the public and shareholders [5] .

In another similar event, rehabilitation hospital operator Health South was under investigation by the SEC and the Justice Department for overstating earnings by more than two billion dollars in 1999. In the end founder Richard M. Scrushy was put in jail for a short period of time and was ordered to pay 2.87 billion dollars for the fraud of HealthSouth. These situations are just some examples of how corporations took advantage of the trust granted by the SEC to a company's accounting department. Not only that, it also shows that when trust is put into the hands of people with greed and love of money, a situation can turn dreadful one. It will ruin the lives of not only the employees of the business but also the lives of those closest to each of the individuals.

Process of an Audit

When auditing a business or corporation there is a procedure that must be followed to ensure the best results possible from the audit. This procedure has been used for decades in the auditing field, with some adjustments made along the way. If an auditor does not plan an audit properly then the auditor puts himself at risk to provide a unsatisfactory conclusion of the client being audited. Even if the auditor takes all the recommended steps to evaluate a client properly it does not guarantee that the outcome will be flawless. Demonstrated below are the three most important steps of an audit. The three steps are described by authors Rittenberg, Johnstone, and Gramling:

"Understanding Client and Industry: Preliminary Planning and Risk Analysis

Assess Risk of Material Misstatement: Understand and Test Internal Controls and System Processing.

Test Details of Account Balances and Transaction" [6] 

Laws in Auditing

In the aftermath of the Stock Market Crash of 1929 the government decided to implement a new law that would protect potential investors from fraud or information that may be misleading. The Securities Act of 1933 was enacted by Congress; the law required that investors obtain significant figures concerning securities being offered for sale to the public. As stated in the Securities Act of 1933 a Security is:

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"any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral trust certificate . . . . . or, in general, any interest or instrument commonly known as a ''security'', or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing." [7] 

The Act also entitles people who sell and trade securities (brokers, dealers, etc...) need to care for investors truthfully and practical while putting the investors' interest first. Even with the new laws in place to protect investors and buyers, a higher power was needed to oversee that the laws were being implemented and operated properly.

To oversee the new Act, Congress implemented The Securities Exchange Commission in 1934 which was put in place to enforce the federal securities acts and regulate the securities industry, stock and options, and other markets in the United States. The SEC was also given the power to revise any act in order to keep it efficient. SEC has the authority to bring enforcement actions against individuals or companies that have been alleged of committing accounting fraud, providing false information, or having an unfair advantage over the public. Harrison explains how the SEC is made of in his book:

"composed of five commissioners appointed by the President by and with the advice and consent of the Senate. Not more than three of the commissioners may engage in any other vocation or participate in any stock market transaction of a character which is subject to regulation by the Commission. Each commission receives a salary of 10,000 a year, and holds off for five years, except the commissioner first appointed, who will hold office for one, two, three, four and five years respectively, and commissioners appointed to fill a vacancy, who will hold office for the remainder of the term of their respective predecessors." [8] 

The Securities Act of 1933 is not the only act that the SEC oversees, it is also in charge of supervising the Trust Indenture Act of 1939, Investment Company Act of 1940, the Investment Advisers Act of 1940, and perhaps the most important Act of all, the Sarbanes Oxley Act of 2002.

The downfall of Enron and WorldCom was due to misleading financial information and fraud among other things. This led Congress to the creation of the Sarbanes Oxley Act of 2002. The new law received its name from Senator of Maryland and U.S. representative, Paul Sarbanes and Michael Oxley respectively. Not all the blame should fall on these two companies, since there had already been other instances of the same nature in the corporate world. The Sarbanes Oxley Act of 2002, better known as SOX, was put in place to mainly protect the investing public. As stated by Rittenberg:

"In these companies and, unfortunately in many others, significant operational failures were covered up with clever accounting frauds that were not detected by the public accounting firms. The press, Congress, and the general public continued to ask why such failures could have occurred when the public accounting profession had been given the sole license to protect the public from financial fraud and misleading financial statements." [9] 

The main goal of the Sarbanes Oxley Act was to investigate deeper into a company's records so that no doubt would be left in the mind of potential investors and the public. One of the requirements of SOX is that both the CEO and CFO certify the financial statements and the disclosures in those statements. In the past, certain individuals would verify the work being done by the accountant staff, whereas now two of the main personnel in charge must review and accept what is presented to them. Another requirement is that a company establishes an effective "whistle blowing program" whereby important violations of the company's ethical code (including those related to accounting transparency) are reported to the appropriate levels of the organization and the audit committee. This requirement is very self explanatory; it means that an entity will have a confidential go to service, being a phone number, manager or email where an employee can go if he/she is aware of fraud or unethical actions in the workplace. Another requirement empowered the audit committee to be the formal

audit client, with responsibilities to hire and fire its external auditors and preapprove any non audit service provided by its external auditors; audit committees must also publicly report their charter and issue and annual report on their activities. This requirement means that an auditor is not allowed to perform any other services that are not a part of the audit.

Congress has definitely played a role in the accounting and auditing field and has done so for a good reason. If laws and regulations, like the Sarbanes Oxley Act, had not been put in to protect everyday investors and the public, who know how many other businesses and corporation would have failed to date. The laws that Congress has placed have come a long way from the Securities Act of 1933 to the Sarbanes Oxley Act of 2002. The government has tried its best to protect the United States and its citizens from unlawful and greedy individuals.

People and Organizations in Auditing

In auditing history there have been important characters, as well as different individuals that make up committees and organizations that have affected the auditing world as whole. For example, the Public Company Accounting Oversight Board (PCAOB) is not made up of a single individual rather it is made of five members, which only two of the members can be CPAs. The PCAOB has the power to set standards for audits of public companies. The Board is just an example of different people coming together to make it a whole organization.

One of the most famous auditing firms in U.S. history is Arthur Anderson's audit firm. The firm is most famously known for the Enron scandal, which led to the demise of the onetime respected auditing firm. The company made irrational decisions which led it to where it is now. The original founder of the company perhaps foreshadowed the future for his company, Squires describes Arthur Andersen in her book: "The firm would soon evolve into a dynamic, sprawling, more aggressive multiservice organization with clients willing to skate ever so closer to the edge or risk." [10] Although Andersen was not alive to see the collapse of his once wealthy company, his name will go down in history books and will forever be mentioned as an example of what not to do in auditing.

Since the foundation of auditing was laid down, there have been Certified Public Accountants watching company's records. A CPA is as important to the auditing field as a catcher is to a pitcher in baseball. Without one or the other a service cannot be performed at its fullest potential. CPAs are overseen by audit committees to keep auditors honest and on track. The audit committee should receive regulatory audit reports and periodically meet with the regulatory auditors to discuss their findings and their concerns [11] 

Audit committees have been around since the early twentieth century, and were endorsed by the New York Stock Exchange (NYSE) and the SEC to oversee public companies. The committees would be another form of examining companies and non management personnel would be in charge. This way there is no bias toward any company and all are treated as equal.

Both internal and external auditing services have been around for some time now. External auditing has been around somewhat longer, they are both equally important to a company or corporation. External auditors have been used for hundreds of years, though the type of work is more complex now than it was before. Internal auditors are mainly used to keep track of the company on the inside, so to speak. Internal auditor audit the company's compliance with policies and laws, audits the evaluation of efficiency of operations among other things.

Auditing has collected its share of events, people, laws, and organizations throughout its history; although I also believe that much of its history still has to be written. CPAs, the PCAOB, Audit Committees, Arthur Andersen, Enron, WorldCom are just a hint of the long history that auditing has in the United States. There are many other events that have occurred and helped create auditing into what it is today. There are still proceedings that need to be played out, new laws, and regulations that need to be written for auditing. As an accounting major I only hope to be blessed enough to be a part of the rich future that is Auditing.