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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.
ON-THE-JOB TRAINING. 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.
RAILROAD TEST. 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.
Copyright 2003, Bloomberg L.P.
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