External Auditing In the United States

The term external auditing is generally used in accountancy, which means to evaluate the internal financial status of the company. Audits involve the evaluation of the financial capability of the company by checking the validity and reliability of the information. It also involves the assessment of the internal control. Financial auditing involves the assessment of the set of the financial statements prepared by any company which represent their overall performance. Auditors evaluate these financial statements according to the industry standards and determine whether they are fair and true in terms of both qualitative and quantitative factors and whether they are free of any misstatements. Auditing affects the company a lot as it is directly related to the company’s reputation and success. The shareholders also get affected by the result of auditing as they invest in the company with full faith. “It is a unique opportunity of recording, in the way most useful to the greatest number, the fullness of the knowledge which the nineteenth century is about to bequeath“.

Background

External Auditing is not at all a present day procedure. It has been a pillar of the business world and existed since the beginning of the business history. The role of auditors changed according to the demands of the era they passed through. Previously it was used for record keeping purpose. Then it was time for the Industrial Revolution (1750 to 1850). The aim of auditing then changed. It was used for fraud detection and checking accountability of the financial statements. “The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed.”

Auditing in US

The United States started growing and the business world expanded. In the late 1800’s and early 1900’s the large corporations were strengthened by people’s investments greatly. The creation of intermediate management system was a result of this expansion, which used to handle the business when the owner was not present. This in turn resulted in the increasing distance between the owner and the customer. Auditors got new Importance as there was a growing need of keeping track of the finances by the owner. In 1929 there was a big blow to the stock market as it crashed and there were few more scandals in the 20^th century. Because of these incidents the auditors realized that there were some weaknesses in the auditing systems which needed to be addressed. As it is “The accountancy profession in the United States is large and sophisticated and is the world’s leader.” Thus, the emphasis on auditing is a prime concern and its history is of fundamental interest.

The external auditors’ job has changed through times and faced new challenges. However, every time the issues were handled efficiently by them and feasible solutions evolved. The reporting practice of the auditors’ findings was standardized and started to be known as “Independent Auditor’s Report”. The business world was expanding and the demand of auditors was ever increasing. It was not possible for the auditors to examine everything in detail. So they took the help of internal controls which was a testing method, developed to represent the specific prominent cases as the company’s performance representative. This saved them from rigorous effort and could be done in lesser time.

Testing process is today’s standard method of auditing. It is not that detailed external auditing is not done anymore. It is done when there is chances of fraud are revealed through wrong or erroneous information. The business owners generally monitor their finances such that there is lesser requirement of frequent audits. The business world is now so expanded that there arose a lot of complexity in business. That is why a risk based auditing system has come in front to increase the affectivity and efficiency of external audits. It is determined through risk based audits that whether there is a real need of audit is there or not. Any misstatement or ambiguity then calls for an audit.

Auditing sometimes has become easy for the auditor and sometimes it gave tough challenges. Though today there are ways of ensuring efficient auditing in lesser time and with less effort it was not at all like that at the beginning of the history of auditing. At that time internal controls were not there and when they came into field they were not effectively used till the late nineteenth century. Chances of fraud were greater. Then to make auditing stronger in the nineteenth century some land mark measures were taken and The English Companies Act was brought forward in 1862.

The law expresses concern over the need of specialist and trained people in the field of auditing for accurate, independent, reliable and efficient evaluation done. The fraud chances could reduce only through a standardized and reliable system for auditing.

19^th Century audit

In the late nineteenth century audits were tedious, rigorous and time consuming. It involved in depth and detailed examination of all the transactions and after that corrected accounts and financial statements were prepared. This procedure was not efficient, was quite expensive and took away a lot of time. There was a definite need of making auditing a less expensive, less tedious and above all more efficient process felt both in the United States and England. The first step towards that was the emergence of sampling process which came in 1895.

At the beginning external auditing was mainly focused on the detection of fraud and minimizing errors as there was no other purpose of external auditing was determined till that time. The auditing norms of United States were highly influence by Britain. Then in the 1900’s the influence started to reduce and United States started to deviate from that influence and create its own norms. In Britain error or fraud prevention was still the main objective but the United States deviated from it to make presenting the accurate financial statements of an enterprise its first goal. The necessity for preventing fraud was still there, so it was made their second objective.

The business owners needed external auditors to submit a balance sheet about their accounts to the banks. The submission of a certified balance sheet earned credit while there was a need of borrowing money from the banks. Because of different fraud cases banks stopped loaning to people depending on their good characters; instead the financial accounts of the client became more and more necessary. That was true for big life insurance companies also. They also started depending on published financial statements of a policy taker certified by an independent public accountant after Hughes Investigation in 1905.

The accounting community wanted to make accounting practices a high standard process from the early 1900’s and took different measures to ensure that. To keep the business community under strict rules The Interstate Commerce Act was formulated in 1906. The act declared clearly what types of accounts are to be kept and based on that a uniform annual report was to be placed before the Commission. Failing the submission or any other deviation was definitely prohibited and punishable.

Need of external audit

The business community felt the heat of World War I in their pockets and in the form of increased income taxes. Before the World War I the income tax payable by the business community was very low and almost had no effects on the finances of the companies. But to meet up the war expenses the United States Government in 1917 and 1918 increased the income tax so heavily that the business community found it tough on their accounts.  It gave rise to the need of maintaining improved account principles by the business community. There was also a need for finding out accountants to make this toughness of tax on the pocket of the business people less harsh by providing some tax planning. Wide spread and large cause of seeking public accountants was now for tax planning and providing some relief. That also gave rise to regular and periodical auditing of the company finances.

Development of external audit After WWI

The next significant stage of auditing was the dominance of internal controls. The 1920’s and the 1930’s were the decades of the significant change. That was the beginning of present day external auditing. The book called “Audit Programmes” emphasized on the possibility of effective use of internal controls. Internal controls could be used for internal checking and making external auditing more efficient. Auditors and business management system of organizations found new energy on finding out a method like the internal controls to evaluate the organizations’ statements. The evaluation involved less detailed examination of the entity and made external auditing time efficient. The stronger the controls were the more efficient, less detailed and less time consuming the auditing was. A lot of reformative actions were taken by Mr. J.M.B Hoxsey when he took entry in the Stock Exchange Committee in the 1920’s. It is in his time it was ensured that the financial statements of a corporation are published on the basis of a set of standard accounting principles and that turned out to be of immense help to the accountants.

Auditors and accountants have been getting guidance from the American Institute of Certified Public Accountants from 1917 about preparing financial accounts and external auditing. The guidelines were presented in the form of a series of pamphlets with the approval of the U.S. Federal Trade Commission and the Federal Reserve Board. But in 1929 the first pamphlet was published which was fully about and dedicated to auditing and was called “Verification of Financial Statements”. It contained the most basic principles in auditing in the very first paragraph. The line said “the responsibility for the extent of the (audit) work required must be assumed by the auditor”.

Effect of 1929

In 1929 the stock market crashed and the Government again felt the necessity of imposing higher standard of trading and external audits on the corporations so that they keep the uniformity and truthfulness of their businesses and financial statements on the topmost priority position. The Government then brought the Securities Act in1933 which made it mandetory to file a balance sheet and the income statement certified by a public accountant with the Securities and Exchange Commission in which all the assets of the entity was declared according to the standards. The New York Stock exchange had placed a demand on the corporations applying for the security listings that they would have to submit an annual financial statement along with the application and that have to be external audited by an independent public accountant.

With that a certificate was also to be submitted stating that the financed were in good standing position. Later it was also mandatory to have the balance sheet, income statement and the surplus statement of the recent fiscal year audited by an independent public auditor. The annual report of the stock holders was to be audited and given a similar certificate also. It is said that, “Nothing is a risk in itself; there is no risk in reality. But on the other hand, anything can be a risk; it all depends on how one analyzes the danger, considers the event”. Thus, auditing is a subject of playing safe and playing with assurance.

However, in 1935, another important step was taken. The Public Utility Act came into action that year which prevented the payment of divident without the approval of the Security and Exchange Commission. This was to draw a clear distinction between the earned and unearned surplus in the statutory law. As the distinction was made clear it became very helpful for the accountant to understand and define it. The Federal Power commission in 1935 was given power through an amendment in the Federal Power Act to classify the depreciable properties into specific classes and fix proper depreciation rates.

In 1936, “Examination of Financial Statements by Independent Public Accountants” was issued by American Institute of Certified Public Accountants to provide revised detailed guidelines to conduct external auditing of small and mid sized companies. They placed emphasis once again on the internal controls and the size and nature of the client. The American Institute of Certified Public Accountants in 1939 formed the Committee on Auditing Procedure which might be consider as an ancestor of the presesnt day ASB (Auditing Standards Board).

In 1939 the Trust Indentured Act came to function to ensure that the issuer of the securities is verified by accountants and abide by the rules and regulations. That was the first step of the auditor reports towards the mainstrem business world.

The Investment Act in 1940 came to deal with the abuses done by the investment companies and trusts. The stock values of these trusts rose very sharply during the 1920’s which was the peak period of their performance. That rise was not a normal one. The values fell down during the 1929 stock market crash. There arose a necessity to safeguard the money of the public. The The Securities and Exchange Commission instructed through the Investment Act that the stockholders also were to be provided with the financial statement certified by an independent accountant along with the Commission.

A significant incident that took place in 1939 which brought the fraud detection issue to the topmost priority position again was the McKesson and Robbins scandal case. This created a stir in the business world. The chances of loopholes in auditing were prominent and a need of stricter and careful method of auditing came forward. The McKesson and Robbins Company were declared clean by Price Waterhouse where the head of the drug company had shown false inventories in the book and manipulated Millions of dollars. An investigation by the Securities and Exchange Commission revealed that the audit done by Price waterhouse was according to the standards. The American Institute of Certified Public Accountants set the benchmark for the external auditors. The verification of inventories of companies was now included in audit and the auditors were to be selected by the company directors and approved by the stock holders. Because of this scandal case, the responsibility of fraud detection was now of the managements’ and the auditors were to assure the reliability of the statements. Audits were done by testing methods with detailed examination when needed and stronger internal control meant less testing.

In 1941, the Committee on Auditing Procedure declared the necessity for the auditors’ judgements on the audit procedure by issueing a pamphlet with title “Statements on Auditing Procedure”. After that a series of pronouncements were published titled Statements on Auditing Procedures, or SAP. These were issued till the early 1970’s and were total 54 in number. These were regarded as the precursors of Statements on Auditing Standards. The Securities and Exchange Commission asked the public accountants to include a representation that the audit had been done according to the standard norms through a booklet published during this period titled “Generally Accepted Auditing Standards—Their Significance and Scope”.

Post WWII Audit

During the 1950’s the main duty of fraud detection shifted more to the management from the auditors. The auditors’ duty was to inform the management when there was a significant ambiguity in the statement. A lot more reforms took place in the 1950’s afterwards. Auditors during this period had to follow the guidelines of Generally Accepted Auditing Standards (GAAS).

In 1963 the Statement on Auditing Procedure No. 33 was issued through which the pronouncement between 1949 and 1963 were consolidated. Further consolidations came in 1972 under Statements on Auditing Standards (SAS).  The name of the Committee on Auditing Procedure was changed to Auditing Standards Executive Committee. From 1972 to 1978 the Committee issued total 23 SAS to declare the authoritative guidelines of external auditing.

In 1978 all the previous executive committees were replaced and AICPA formed the Auditing Standards Board (ASB) which became the highest authoritative board to establish the GAAS. It was the guidelines of the ASB which the auditors would have to follow and strictly adhere for audit, attestation and quality control. The ASB also defined the responsibility of auditors and the norms of placing reports. Alongside, after the Cold War, the “Interest in quality auditing for business applications really took off in the second half of the 1980s.

Recent trends in US External Audit

The most recent development in the field of external audit was the formulation of The Sarbanes-Oxley Act in 2002. Through this act all the previous hierarchy in the external auditing principles and standards were changed. The final words regarding the auditing rules and regulation and the practicing standards of public auditors regarding the audits of public companies were now to be spoken by the Public Company Acounting Oversight Board (PCAOB) and the Securities Exchange Commission (SEC). The registration with the PCAOB became must for all external auditing companies along with the strict adherence to all its rules regarding audit, attestation and quality control.

More changes took place in 2003 and 2004. In 2004 the AICPA made changes in the designations of the authoritative bodies for the GAAS standards. PCAOB became the authority in GAAS for public companies and ASB became the authority in GAAS for the non public companies.

Conclusion

The history of external auditing in United States shows a lot of changes and a consistent effort for the betterment of the standard of auditing. Auditing has been the backbone of the business world and it will continue to help in maintaining clean truthful environment in the business world.