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The History of Auditing

Abstract
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 efraud. As the
United States grew, the business world grew, and auditingbegan to play more important roles. In the late
1800s and early 1900s, 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.
Introduction
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 1800s to Early 1900s
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 1890s, 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 1900s. 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 1900s 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 1900s. 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 businessmens 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 1920s and the 1930s
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 entitys 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 1920s. 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 1930s. 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 1930s, 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 1940s
and 1950s.
The 1940s and 1950s: 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 1920s.
The investment trust stocks values would rise rapidly, well beyond inflation and normal appreciation,
during the 1920s 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 auditors work, and to read the auditors 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.