Week 12: Accountants and Auditors

Chapter 51: The Accounting Profession



"The process of identifying, recording, classifying and reporting information on economic events in a logical manner for the purpose of providing financial information for decision making."

What difference from "bookkeeping" or "auditing"? Accounting is about finding meaningful patterns in bookkeeping data, while auditing involves evaluating validity, compliance with standards and performance. An auditor's declaration as to the reliability of a statement by the party being audited is an "attest".


The classic "liberal" or "free" professions are occupations involving special study and knowledge, independent employment by and for clients, and recognition of public duty. Law, medicine and architecture are classic examples

"The free occupations cover generally on the basis of special vocational qualification or creative gift the personal, solely responsible, and technically independent contribution of services of higher kind in the interest of the clients and the public." §1 (2) of the German Partnership Law (machine translation of the Partnerschaftsgesellschaftsgesetz)


Bookkeeping records are as old as government (@ 4000 BC), and the double-entry system, dating from 14th century Italy, was systematized by Fra. Pacioli in 1494 AD. More history here.

Auditing traditionally was an internal governmental activity, aimed at keeping finance and tax officials honest. As early as 440 BC the Roman Republic elected treasury officials known as "quaestors" (= "those who ask questions", just as "auditors" originally meant "those who listen"). In China, the Taizong Emperor (626-649 AD), who perfected the examination system, appointed inspectors to examine local administration at regular intervals -- an institution that later became the "Censorate" or yùshitái

Railroads, Securities, Bankruptcy and Auditors

Outside of government, auditing as a specialized occupation is much more recent. Until the early 1800's, the scale of private business activity was limited to the proprietorship or partnership, such that the business owners themselves monitored financial recording and made their own decisions. Railroads changed this -- they promised extraordinary profits, but required large accumulations of patient capital as well as managerial expertise. These requirements were met by the corporate form of organizing business activity, with the accompanying growth in markets for publicly traded securities, and the new need to monitor the activities of agents because ownership had been separated from management. The first corporate auditors were not accountants, but shareholders (UK Companies Act of 1845) or even members of the Board of Directors (Charter of US Baltimore & Ohio RR, 1828)

The development of securities markets was accompanied by periodic manias, panics and crashes, resulting in waves of bankruptcies and the need for specialists to sort out the finances of failed firms:

"The (U.K.) Bankruptcy Act of 1831 allowed accountants to be appointed 'Official Assignees', the first government recognition of the new profession. A primary role became the preparation of accounts and the balance sheet of public companies. Bankrupt firms were especially likely to use their services, which increasingly served an audit function." Giroux, Accounting History, Ch 2

The English "Railway Mania" of the mid-1840's culminated in the 1849 collapse of George Hudson's railway empire, amid investigations that revealed:

"(The company's) accounts had been systematically falsified by its officers from the very commencement of operations.... "

"Hudson had written in the amended figures he wanted to see in the accounts...."

"The Account Books of the Company were entrusted to a person utterly incompetent for the task [so that] the books were a mass of confusion'. The Accountant arrived at the published accounts for 1845 'from entries put down on loose sheets of paper, with a view of being afterwards posted into books', which was not done 'and the sheets of paper, it is said, are now lost'."

The methods by which these frauds were accomplished are timeless: operating expenses were capitalised "or simply omitted from the published accounts", while "Income was overstated either by simply entering false figures in the accounts or by [using fictitious accounts] to provide corresponding debit entries to fictitious credits."

Shortly thereafter, in 1855 the accountants' associations in Scotland received professional recognition in the form of Royal Charters of Incorporation, which their English colleagues also obtained in the 1870's. Meanwhile, in London, William Deloitte opened a firm in 1845. Samuel Price and Edwin Waterhouse formed their partnership in 1849. William Cooper started his firm in 1854 and William Peat began one in 1867.

England leads and the US follows

The United States industrialized rapidly in the post-Civil War era; GDP in constant dollars almost quadrupled from $9.1 billion in 1865 to $34.6 billion in 1900 and the US took the world lead in manufacturing by 1894. Much of the industrialization was financed by British capital, so accountants like Price, Waterhouse (1890), Arthur Young (1894) and James Marwick (1896) crossed the Atlantic to watch over these investments. The predecessor of the AICPA was formed in 1887, and in 1896, New York became the first state to regulate accounting practice.

The Structure of the Accounting Profession

“[D]uring most of the twentieth century, accounting has been an important avenue of upward mobility for talented and ambitious people from relatively humble class origins.” Jacobs, K. “Reproduction in Professional Recruiting: Examining the Accounting Profession Class” Critical Perspectives on Accounting 14: 569-596

Special study and knowledge

Public Accountants are certified by state-level licensing boards (often mostly themselves CPA's). California, for example, has had a State Board of Accountancy since 1901. It is currently made up of 7 CPAs and 8 "public representative" non-CPA's appointed by the Governor and legislative leaders. See Bus & Profs Code Sec. 5000 et seq. The Board regulates admission to practice through a licensing examination combined with education and experience requirements. Here's the Handbook for Applicants.

The Board also regulates CPA practice. It requires continuing education, sets standards, and disciplines rule-breakers with fines, suspensions or even license revocation.

Practicing public accountancy without a Board license can be enjoined by court order, and may also be a criminal misdemeanor (B&P Code Secs. 5050 and 5120). The California Supreme Court has held (in a 4 to 3 decision) that it is against the law for unlicensed persons to call themselves "accountants". Bonnie Moore v. California State Board of Accountancy

Independent employment by clients

The demand for accounting services has come from:

  • Audits (the 1934 Securities Exchange Act requires all publicly traded companies to file annual audited financial statements)
  • Securities analysis (reverse-engineering meaning from financial statements)
  • Taxes (Since the 1913 US income tax) incl. payroll
  • Design and implementation of [accounting] information systems and security systems for money and data
  • Production costing and pricing
  • Compilations and write-up services
  • Forensic fraud detection
  • Government regulations (price controls, eg ICC for transportation in 1889, and utility rate regulation)
  • Business valuation
  • Litigation support

Recognition of Public Duty

Traditionally, the AICPA -- the nationwide professional organization that CPAs may join voluntarily -- took the lead in setting ethical rules and promulgating audit standards (GAAS). Since 1973 a nonprofit entity, the FASB, has set financial accounting standards.

It has been said that every profession is a conspiracy against outsiders. The AICPA traditionally frowned on CPA's who advertised, competed on price, or generally acted as though accounting were a business, rather than a learned profession. These barriers have been eroded over the last 30 years, as a result of Supreme Court cases and Federal Trade Commission proceedings against practices in restraint of trade. In a 1990 settlement with the FTC, the AICPA agreed, within limits, not to restrict its members' ability to advertise or compete on price.

CPAs as Auditors & the Rise of the "Big 4"

Government regulation creates a captive market

The 1933 and 1934 Securities Acts and implementing SEC regulations require companies with publicly issued or traded securities to file annual financial reports, "examined and reported upon with an opinion expressed by an independent public or certified public accountant." [Rule 12b-2, 1934 Act] The SEC can decide which accountants it will accept as auditors, and control over the format for annual report presentation gives SEC *lots* of potential power over accounting standards. Until recently, SEC tended to allow professional self-regulation by the AICPA, but that changed about five years ago.

Consolidation and oligopoly

By @ 1970 a series of mergers had resulted in eight firms becoming dominant in auditing. Further mergers among the major firms during the 1990's took the number down to 5, and after Arthur Andersen & Co. collapsed in the Enron scandal in 2002, only 4 -- the "Big 4" -- now survive. The smallest of the Big-4 firms, KPMG, is roughly eight times as large as the next biggest audit firm (Grant Thornton). These four firms have worldwide practice networks, and their clients represent @ 96% of all US publicly traded companies, based on sales. The economics of audit practice favored consolidation: multinational corporations need multinational auditors, while standard procedures, checklists and best practice databases have a high fixed cost of development but a low marginal cost to use once developed.

The audit industry is now an oligopoly [a market dominated by a few sellers], with significant barriers to entry. This creates concerns about potential price-fixing and other anti-competitive behavior, and about the economic consequences if one of the remaining Big 4 firms were to fail as Andersen did.

The Sarbanes-Oxley Act of 2002 in context

The political background

The SEC and FASB got rolled by the big firms' political lobbying over the proposal @ 1994 to show options as an expense (it's finally in the rules now, years later)

The large firms were moving into multidisciplinary practice, into law, into consulting, into being "cogitors" rather than auditors. When the SEC proposed new standards for independence in @ 2001, the firms resisted and brought political pressure to bear

Enron Collapses and Arthur Andersen disintegrates

The dot-com bubble bursts in 2000-2002, and the general market declined by about 50%. As usual, the crash exposed unsound financial practices, and resulted in a political chorus of "never again".

Governance problems [ironically, owing to success in adding systems consulting to an audit practice] led to a string of audit failures at Arthur Andersen & Co.: Waste Mgmt, Sunbeam, Enron, Worldcom. The SEC moved to discipline the firm and the Dept. of Justice brought a criminal prosecution shredding Enron documents. Partnerships aren't all that stable -- the result was a chain-reaction of client defections and partner departures. Congress felt pressured to "do something!", and "Sarbox" was the result.

The new Regulatory Structure for Auditors

Public company auditors must register with the PCAOB, an oversight entity (which acts like a spinoff from the SEC.) It has inspection, investigation, discipline and licensing powers. PCAOB has also been given the AICPA's former role in developing auditing standards (GAAS).

The SEC and PCAOB mandated a split between auditing and law/consulting, on grounds of "independence". The surviving big firms have had to shed their law and consulting practices, because legal advocacy and systems implementation are seen inconsistent with Sarbox independence. In 2005, the PCAOB limited contingent fees, aggressive tax shelter work by auditors, and tax work for key individuals at corporate clients, after KPMG paid a huge file to settle IRS claims involving fraudulent tax shelters.

Sarbox created a lot more work (like Sec. 404 for stronger internal controls), and it has made audits much more time-consuming and expensive -- and much more profitable. But the dreams of multidisciplinary practice have evaporated.

Professional liability of auditors

Private enforcement by classic contract/tort law is limited

Investor or creditor users of financial statements generally have no contract with the auditors and are not identified third party beneficiaries, while courts have limited negligence liability. The leading case in California is Bily v. Arthur Young, 3 Cal. 4th 370 (1992).

But liability for 10b-5/fraud on the market/class actions is still a "bet the firm" issue

See the Report by the Committee on Capital Markets Regulation, calling for an end to criminal prosecution of entire firms and limits on auditors' liability exposure. But what are the Big-4 willing to relinquish in exchange?

The Future of the Audit Profession: Research Links

Government Reports: The Current Situation

The Regulators and The Regulated

The Center for Audit Quality

Academic Research: How Things Got This Way

"As accounting becomes progressively more regulated, transactions become increasingly structured in anticipation of their subsequent accounting treatment. In addition, profitable transactions may be delayed or not undertaken if there is sufficient uncertainty about their current or future accounting treatment. The causality from transaction to accounting can thus reverse so that the relation now runs from accounting to transaction. This reversal of causality can be further magnified by rigid accounting standards that seek a uniform “correct” accounting for transactions that are themselves endogenous responses to current and anticipated accounting standards." Accounting as an Evolved Economic Institution

Academic Research: The Political Economy of Audits

GAO Report on Audit Concentration (Jan. 2008)
Auditors as Oligopolistic Gatekeepers
The World's Weakest Oligopoly?
Audit Reports: "Have symbolic value, but little communicative value"
Governance Flaws in Audit Firm Partnerships
Human Capital Challenges in Accounting Education

Blogging the Auditors

The System Isn't Working
The Big-4 Are In Critical Condition
The Auditors' Role in the Current Financial Crisis

The Public Sector

The Role of Auditing in Public Sector Governance
The US Government Accountability Office

notes and format (c) 2001-08 Robert H. Daniels