By Mike Brewster
On Apr. 25, a new era will begin for corporate auditors. That's the day the Public Company Accounting Oversight Board (PCAOB), the watchdog group created by last year's Sarbanes-Oxley Act, will adopt an initial series of auditing guidelines. The absolute power held by this five-person regulatory body -- only two of whom can be CPAs, neither practicing -- means that for the first time since 1933, when federal law gave auditors the franchise to independently audit company financial statements, the rules for the profession will be set by outsiders instead of by auditors themselves.
The big accounting firms and the American Institute of Certified Public Accountants (AICPA) are especially concerned that, sooner or later, the PCAOB will require that auditors aggressively seek out management fraud -- such as that uncovered recently at HealthSouth (HLSH ), and last year at Enron (ENRNQ ), WorldCom (WCOEQ ), and Tyco (TYC ) -- instead of just certify that a company's financial statements adhere to Generally Accepted Accounting Principles (GAAP). Broader, fraud-fighting responsibility is something the auditing profession has said for decades that it doesn't want. But that was before the 2002 demise of accountants Arthur Andersen, which presided over auditing failures at Sunbeam, the Baptist Foundation of Arizona, Global Crossing (GBLXQ ), and of course, Enron, and WorldCom.
In a sense, the PCAOB will be following in the footsteps of a British accountant named George Oliver May, who at age 22 brought the seeds of American audit standards across the Atlantic in 1897. May, who led Price Waterhouse from 1911 to 1940, is known in the profession as the "father of American accounting." He took the basic tenets of British auditing and transformed them into the standards that would be used to audit American businesses throughout the 20th century.
May had the finest accounting education, one that would have been impossible to get in the U.S. in his time because of the American profession's inferiority. His respected father, barrister George England May, apprenticed his teenage son in 1892 to a renowned Exeter accountant for five years. Thus, May learned the fundamentals of his trade during the pinnacle of British accounting, when bustling commerce in Victorian England created the need for understandable financial statements for investors and lenders, which were expressed in annual reports that resulted from independent, third-party audits.
While American auditors simply counted inventory and looked at canceled bank checks, British accountants set up tests and procedures to measure profitability and helped companies refinance debt. By 1896, the big London accounting firms were so much more advanced than U.S. auditors that British investors demanded that English firms such as Price Waterhouse and Peat Marwick send auditors to the States to watch over their holdings.
May was part of this "British Invasion." As he boarded his steamer for America, he was told by his Price Waterhouse colleagues to be "as aggressively British as possible" at his new job with Jones & Caesar in St. Louis, Price Waterhouse's American sister firm.
One of May's first tests would lead to some of the groundbreaking standards he would later propose. His assignment was to audit the Central Pacific railroad, a subsidiary of the Southern Pacific Railroad. Since audits weren't required by law in those days and were quite rare until 1910 or so, they typically occurred only when a big Eastern bank wanted to check under the hood of one of its customers. In this case, J.P. Morgan, then a major investor in the Central Pacific, ordered the audit.
May and one of his colleagues insisted on a "qualified" (unsatisfactory) opinion because the company wasn't factoring into its income statement the rate of depreciation of its train cars -- and was counting some of Southern Pacific's income as its own. By Mike Brewster
Morgan himself -- who knew that a qualified audit would hurt his chances of finding other investors for the railroad -- took his objections to May's superiors. But they backed May and wouldn't change the opinion. Morgan grudgingly acknowledged his respect for the Central Pacific's outside audit team and backed off.
A few years later, May would pen auditing standards on how to treat both depreciation and income for a company with many subsidiaries. Perhaps more important, he deduced from his run-in with Morgan -- and those he had with other august clients -- that auditors would best earn the respect of their clients and the investing public by being completely independent from their clients, both in fact and appearance. Thus the modern notion that auditors shouldn't be performing consulting projects for their audit clients can be traced to May.
By the 1920s, May and his peers at other firms were aggressively developing audit standards for railroads, steel companies, and the other major engines of the U.S. economy. It was the auditors themselves -- not company managements or any outside regulator -- who decided the format of the audits, what information the audit certificates contained, and how far the audit opinion went in saying what was "true" or not. Soon, proliferating securities scandals helped May and several of his contemporaries persuade the stock exchanges -- including the New York Stock Exchange -- to require independent audits. By 1930, more than 70% of public companies were being audited by outside accountants.
The creation of the Securities & Exchange Commission in 1934 was the first major incursion into the field that auditors by then controlled. The SEC had full power from day one of its inception to set auditing standards. May saw the commission as an alien bureaucracy, full of accounting dilettantes who wanted to radically alter the auditing rules that CPAs had been drawing up on their own since the late 1800s. In fact, one of the few things that May and his bitter rival, Arthur Andersen, agreed on over the years was that only working auditors -- who were in the trenches at companies every day, seeing the new, creative ways corporate managers were devising to beat the system -- could successfully design auditing standards.
Joseph P. Kennedy, the SEC's first commissioner, locked horns over auditing rules with the leading accountants of the day -- May included. President Franklin Roosevelt wanted to shore up investor confidence with strong, binding auditing standards that reached across all industries, and it was up to Kennedy to deliver them. Following May's lead, however, the auditing profession persuaded the SEC that mandating a single format for audits across all companies would result in chaos that would bring financial reporting to a standstill.
Their blue-chip clients, who didn't want to be restricted by ironclad standards issued by the SEC, supported the auditors. So in 1939, the SEC, under Chairman William Douglas, abandoned its five-year effort to set auditing standards, voting by a 3-2 margin to leave auditing -- and its standards -- up to the professionals. In a sense, the creation of the PCAOB means that after 70 years, the SEC will finally get the power Roosevelt intended it to have to set auditing standards.
After the SEC's abdication in 1939, auditors continued to oppose the creation of any regulatory agency that could fill the vacuum. The profession fought the creation of the Financial Accounting Standards Board (FASB) in 1973, because it knew that the independent organization, formed not to make audit rules but to define general corporate accounting principles, would inevitably try to influence the way audits are performed.
And despite the audit disasters of the past few years, which have proven that not all accounting firms live by the profession's standards, the AICPA still clings doggedly to the idea that the accounting industry should set auditing standards. In a Mar. 18 press release, the association informed its 360,000 members that the AICPA's Auditing Standards Board "will continue to work closely with the SEC and the PCAOB to finalize these new auditing standards."
SEC Chairman William Donaldson, who on Apr. 15 nominated retiring New York Federal Reserve Bank President William McDonough to lead the PCAOB, didn't let the press release pass unchallenged. He sent a terse letter to the AICPA reminding the organization that the new oversight board has the power to set auditing standards, and that the AICPA leadership shouldn't be misleading its constituency.
The AICPA is only trying to maintain a tradition established by George May, who maintained an office at Price Waterhouse and remained active in various accounting associations until his death in 1961. But the truth is that today's auditing profession doesn't have a leader with May's political and diplomatic skills -- not to mention his moral leadership -- to effectively make its case. If it did, accountants might have avoided ending up in a situation where they, too, need to be regulated.
Brewster is author of the upcoming Unaccountable: How the Accounting Profession Forfeited A Public Trust (April, 2003) and is co-author of King of Capital: Sandy Weill and the Making of Citigroup (June, 2002)