July 1999 Issue

The CPA Journal Millennium Series

The Accounting Profession in the 20th Century

By Wallace E. Olson

The second in a series of articles commemorating the past, present, and future of the CPA profession, from a variety of perspectives, as it approaches the new millennium.

In Brief

Preparing for the 21st Century

The accounting profession in this country was built upon a state-established monopoly for audits of financial statements. The Federal securities statutes of 1933 and 1934 raised the stakes to the national level and caused the rapid growth of firms that audit public companies. They also had the effect of dividing the profession between those firms that audit public companies and those that do not.

In the 1970s, demands for more reliable and comparable financial reporting by Congress and the SEC led to the transfer of accounting principles standards setting to FASB. At about the same time, the plaintiff's bar discovered the profession's deep pockets and started to pursue the large firms, aggressively seeking sizable damage awards. A series of spectacular business failures and the actions of big oil companies led Congress to question the performance of the SEC and the accounting profession. The result was the establishment of the AICPA Division for CPA Firms, which, while responding to perceived structural weaknesses, also served to further separate firms that do SEC audits from those that do not.

On top of this, the repeal of anticompetitive rules against advertising and solicitation of clients, under pressure from the Federal Trade Commission, caused even more turmoil in the '70s.

Increased competition, with its pressures on pricing, led the large firms to seek out other services to offer, which led to the growth in consulting practices. This has provoked the SEC and others to question the effect on auditor independence that the huge fees paid by audit clients for consulting services may have.

The author, president of the AICPA during the decade when many of these events took place, looks to the future and where the profession is headed. He suggests it may be time for a high-level commission to take a hard look at the structure and direction of the profession.

It has long been held a truism that those who ignore history are doomed to repeat the mistakes of the past. With this in mind, it would seem appropriate at the end of the 20th century to retrace the development of the public accounting profession in the United States to see what guidance the past may offer to the future.

The American profession was, for the most part, founded by accountants that migrated from England and Scotland in the 19th century. It emerged over many decades into the organizational structure that is today the American Institute of Certified Public Accountants. Two books authored by John L. Carey, who served as staff head of the AICPA from 1930 to 1967, give a full account of the events and efforts that resulted in firmly establishing public and political recognition of the profession during the first 70 years of the century.

It is noteworthy that most of the founders' early attention was directed toward persuading state legislatures to enact laws providing for the examination and certification of public accountants and restricting the performance of opinion audits to those that successfully passed the examination and became certified. The result was the establishment of a state-based monopoly fundamental to assuring accountancy's status as a recognized profession.

The American state-based approach to regulation of the profession was supplemented in the 1930s with the passage of the Federal securities acts giving birth to the Securities and Exchange Commission. The SEC was established to deal with the problems that caused the 1929 crash and the ensuing economic depression. The SEC was empowered, among other things, to require independent audits of companies, which had to register with the SEC before selling their securities to the public.

The profession successfully persuaded Congress and the newly established SEC to rely on the AICPA to set accounting and auditing standards for the purposes of filing financial reports with the SEC. However, the SEC retained the authority to override those standards when it deemed necessary. In addition, the SEC has the authority to disbar CPAs from SEC practice when, in its judgment, they fail to meet their responsibilities under its rules.

The SEC's Impact

The establishment of this new form of Federal regulation of the securities markets strongly influenced the development of the public accounting profession. Among other things, it gave impetus to the rapid growth of firms auditing SEC registrants, which culminated in the large national and global firms that exist today.

Because virtually all SEC registrants were clients of a small number of CPA firms, the distinctions between public accounting practice on a local and regional basis and that of the SEC practice firms were destined to result in a serious divide within the ranks of the profession. The distinctions were further exacerbated by the rapid growth of the national firms through a large number of acquisitions of local and regional firms from the 1950s through the 1970s.

Demands by the SEC and Congress for more reliable and comparable financial reporting put increasing pressure on the profession to establish more comprehensive and refined accounting and reporting standards. This effort was originally carried out under the AICPA through a series of modified organizational structures largely dominated by representatives of SEC practice firms. Ultimately, as a result of widespread criticism by groups having a stake in the financial reporting process, the standards-setting function was transferred in 1973 to the present Financial Accounting Standards Board under control of the Financial Accounting Foundation. This independent body, however, is subject to pressures from the conflicting interests of its constituent groups as well as the SEC and Congress.

The growing body of complex standards to deal with increasingly sophisticated forms of business transactions and financial instruments has resulted in standards overload. Accounting theorists insist that standards should apply to SEC registrants and nonregistrants alike. In the world of local firm practice, however, this is seen as an unrealistic and unnecessary burden on accountants, their clients, and the users of their financial statements. This difference in viewpoint has aggravated the divide between firms serving non­SEC clients and large firms practicing under the watchful eye of the SEC and Congress.

The visibility of the large CPA firms and the AICPA grew dramatically during the 1970s. The financial press began reporting extensively on their activities, especially in connection with large business failures that raised questions about the performance of auditors. These events also attracted the attention of the plaintiff's bar, which brought huge class-action suits against the large CPA firms. The exposure to this risk had several effects:

* The skyrocketing cost of liability insurance premiums and increase in deductibles posed a serious threat to the survival of individual firms.

* The firms tightened their internal policies and their audit procedures to minimize liability risk.

* The firms lost some of their enthusiasm for the audit side of their practices and began placing more emphasis on consulting services, which were both financially rewarding and less prone to litigation. This trend was made more acute by the loss of large company audits stemming from the rash of mergers and acquisitions during the last three decades of the century.

Who's to Blame?

During the 1970s, scandals involving illegal payments and bribes by companies with foreign operations, a series of spectacular and unheralded business failures, and huge increases in oil prices generated a high level of interest by Congress in the adequacy of the performance of the SEC and the accounting profession. What followed was an intensive look at the profession by two congressional subcommittees that held public hearings and issued reports on their findings and recommendations. It is noteworthy that the congressional concerns were focused almost entirely on the profession's practice under the SEC's jurisdiction and had virtually nothing to do with the performance of local and regional firms.

Each of the large firms testified at the hearings on its own behalf, expressing views that did not present a united front. Indeed, on some matters they directly contradicted each other. The AICPA testified on behalf of the entire profession and formulated a program of changes that responded to the perceived shortcomings expressed during the course of the hearings. It became apparent that AICPA membership structure, by individuals rather than firms, added to difficulty dealing with the problems of the profession. While the individual members of the AICPA seemed to aspire to equal status as CPAs, those practitioners not subject to Federal regulation were generally not too keen about being saddled with the extra burdens and responsibilities imposed on the large SEC practice firms.

In 1978, the AICPA attempted to cope with this less than satisfactory situation by establishing a Division for CPA Firms with two sections, one for firms serving private companies and one for firms serving or aspiring to serve SEC registrants. It was hoped that through this organizational structure the non­SEC practice firms could be spared the more stringent requirements imposed on SEC practice firms.

Key features of the SEC Practice Section are required peer reviews, mandatory continuing education, reporting on liability lawsuits, and monitoring of the section's activities by a Public Oversight Board composed of prominent individuals mostly from outside the accounting profession.

Repeal of Anticompetitive Rules

During the 1970s, the U.S. Department of Justice and the Federal Trade Commission embarked upon a program to force professional organizations to repeal their rules banning advertising, solicitation, and competitive bidding. The AICPA became an early target and, on the advice of its legal counsel, signed a consent decree to repeal its rules of conduct that were deemed anticompetitive.

Before the repeal of the AICPA's rules, the largest firms were at least indirectly soliciting clients and offering to perform services at the same fees others had charged the prior year. However, they refrained from openly advertising in order to acquire business. Generally, the small firms complied with the prohibitions, believing it would be injurious to the profession's reputation if they violated the spirit of the rules.

With the repeal of the rules, the level of competition within the profession increased dramatically, putting heavy pressure on fees charged. This in turn put a premium on performing services as efficiently as possible, which may have had a negative effect on the quality of work performed. In any event, the forced repeal of the rules regarded as anticompetitive under the Sherman Antitrust Act may have temporarily reduced the costs to consumers of the profession's services. If so, lower costs were achieved at the risk of diminishing the quality of opinion audits.

The playing field for engaging in advertising was not level, because the large firms could devote far greater resources to this activity than the smaller firms. This disadvantage may have been somewhat reduced by the institutional advertising program sponsored by the AICPA and state CPA societies. Over time, the profession seems to have adapted to a new world where all-out competition with other CPAs as well as non-CPA groups is accepted as a way of practice.

Consulting Practice

One of the most important developments since the 1970s has been the greater emphasis on providing consulting services in a wide range of business management areas, which requires competence in a variety of established disciplines that lie outside the traditional training and skills of a CPA. Historically, CPAs have acted as consultants to their accounting, auditing, and tax clients, but consulting fees constituted a minor portion of their total practice. The services offered were generally closely related to accounting and taxes. Today, however, consulting is the largest source of income for the largest CPA firms, and the types of services are broader and rendered on a far more formal and sophisticated level than in the past. The larger CPA firms actively compete at the level of the biggest non-CPA consulting firms.

This phenomenon is generally not true of the thousands of small local CPA firms that do not have the resources to provide formal consulting in the same depth and breadth as the large national firms. However, some local and regional firms do specialize and are recognized as experts in a single field such as real estate development, health care, or litigation consulting. The use of professional accreditations and specialty designations provides a way to affirm that a CPA is suited for a particular engagement.

Underlying the concept of auditor independence is the need to retain an outsider status to the maximum extent possible. Clearly, consulting services performed for an audit client work contrary to this objective because they require the auditing firm to become more deeply involved in the affairs of the client.

Consulting and Independence

The term "consultant" lacks a clear focus because it embraces a diversity of specialties from a variety of professional groups. In short, a consulting firm is generally by necessity an amalgam of professions operating under a single identity.

This is important because it poses the question, addressed repeatedly during the past 30 years, of whether an auditing practice can retain its objectivity in appearance and in fact when it is combined with a consulting practice under a single firm or a commonly owned consulting firm. Congressional subcommittee hearings in the 1970s and periodically since then have raised concerns about combining the independent audit function with the practice of consulting. Their concerns resulted in the voluntary ban by the SEC Practice Section firms of certain types of consulting engagements and required disclosures about others.

One firm, Arthur Andersen, decided to transfer its consulting practice to a separate, but commonly owned, entity in response to independence concerns. According to newspaper accounts, this approach has led to internal turmoil and strife between the separate entities. This result was probably inevitable because the mindset and objective of auditors are different from those of consultants.

Based upon the Arthur Andersen experience, it seems clear that practicing auditing and consulting under commonly owned entities is fraught with internal problems. These same problems also exist where the two practices are combined under a single firm entity; however, they may be less acute and less visible under one management.

Regardless of internal friction, the question of whether consulting poses an unacceptable threat to the objectivity of a firm's audits remains unresolved. The AICPA and others have argued that consulting enhances the quality of audits because it provides more insight into a company's operations. In theory, this results in more informed judgments about the validity of management's representations. This may be more theory than fact, because it assumes excellent and unbiased communication between consultants and auditors.

Another argument for consulting is that the glamour it exudes helps firms recruit the upper level of accounting graduates to their audit staffs. Presumably, members of the audit staff will then go on to the more exciting consulting work. In actuality, this has been the exception rather than the rule because the consulting staff has been largely recruited from among those with education and experience in other disciplines. Even if these are valid considerations they must be weighed against the effect on independence when the services are provided to audit clients.

It has been argued that the audit fee itself is a much bigger threat to independence. While this may be true, it does not follow that the added threat posed by consulting is inconsequential. Neither does it help to say that an internal wall between consultants and auditors mitigates the threat. To do so is in direct contradiction to the assertion that consulting enhances the quality of audits by providing a deeper understanding of the client's company.

The SEC's concerns that the credibility of the audit function was eroding in the midst of large consulting practices led to the establishment of the Independence Standards Board to deal with matters relating to the independence of auditors practicing before the SEC. Most of the board members are not members of the CPA profession. This action can be construed as a vote of no confidence in the profession's ability to adequately enforce its own independence rules.

In addition, if control of Congress should shift to the present minority party in 2000, an investigation and public hearings could become a strong possibility. This would almost certainly be triggered if there is a sharp downturn in the securities markets or the economy or both, causing a number of major business failures.

At the end of the century, the Big Five firms, which audit the bulk of SEC registrants, have become huge global businesses. If their emphasis on consulting continues, as their advertising suggests, then their image as independent auditors will no doubt become increasingly diluted. Congress might conclude that mixing consulting with auditing is no longer an acceptable practice. Less extreme and more likely, each firm would be prohibited from providing consulting services to its audit clients. This course of action would likely cause a reshuffling of consulting clients among the firms without an overall reduction in business.

Standards Setting

If, as discussed above, Congress is stimulated by future events to take another close look at the profession it will almost certainly examine the present arrangement of financial accounting and reporting standards setting utilized by FASB. While FASB and the profession might find such scrutiny uncomfortable, it seems unlikely that changes would result. But there is no guarantee that Congress would not direct the SEC to rescind its delegation to the present structure and either set the standards itself or, less likely, delegate standards setting to some other governmental body such as the Governmental Accounting Office.

Given the unpredictability of the political process, almost anything could happen if the profession were to fall into serious disfavor with the SEC or Congress. But one thing seems certain: The issue of standards setting and the effects of consulting on the independence of auditors would head the list of matters to be reexamined.

The Non­SEC Client Firms

More than 40,000 CPA practice firms do not fall under the requirements of the SEC because they do not audit SEC registrants. But some of what the profession does to meet the requirements of the SEC affects them in the form of peer reviews and complex accounting and financial reporting standards. Efforts have been made to provide a degree of relief, but some firms have resisted being granted exemptions. They fear being viewed as second-class and subsequently losing their larger clients to the big firms.

The problem of standards overload in smaller firms has festered for many years and ought to be resolved. A solution may lie in the fact that the SEC has size criteria, which, if not met, exempt companies from its purview. Presumably, below a certain company size Congress and the SEC are content to let minority shareholders and credit grantors fend for themselves. Perhaps a similar de minimus theory ought to be applied to privately owned companies where credit grantors have ample leverage to obtain the information needed for their decision-making.

Consolidators and Alternative Practice Structures

A recent development is the arrival of consolidators and alternative practice structures. Large commercial organizations have concluded that providing CPA-type services to middle-market businesses can be profitable as an end to itself and as a cross-seller to other business segments. Because of state regulatory restraints, the large consolidators have had to develop a rather convoluted way of providing audit and other attest services: A shell partnership provides the audit report using employees leased from the consolidator. Independence questions have been raised by the SEC for the handful of SEC clients that acquired CPA firms continue to serve. With the talk of HRB Business Services, a subsidiary of H&R Block, acquiring McGladrey & Pullen, however, this could become more of a problem.

Many Problems Remain Unsolved

This thumbnail account of the history of the profession in the 20th century is by no means comprehensive. However, it is sufficient to draw the conclusion that many problems remain unsolved and that circumstances are not likely to be static for any great length of time in the 21st century. It is difficult to predict what new challenges may arise in the next 20 years, but a look at recent history may provide clues. For this reason, and because solutions are needed to problems already identified, the profession through the auspices of the AICPA ought to appoint a high-level commission to take a hard look at whether the present structures and direction of the profession are appropriate for the new century. Such a commission ought to seek the views of representatives from all groups that have a stake in the work product of the profession in its current structure and scope of services.

The goal should not be how things can be kept the same or how the capacity for services can be increased. Rather, the goal should be reaching an objective conclusion about how the profession can best meet the needs of society in the days ahead and what structural changes may be needed to achieve this result. The profession will survive and flourish if it is driven by a desire to serve society to the best of its ability and not simply to make money for its own benefit. In the final analysis, this is the hallmark of any great profession. *

Wallace E. Olson, CPA, served as chief staff officer of the AICPA from 1972 to 1980. He had been associated with Alexander Grant & Company (now Grant Thornton) for more than 25 years and became its executive partner in 1967. He served on the Wheat Committee from 1970 to 1972, which ultimately led to the formation of the Financial Accounting Standards Board. His book, The Accounting Profession: Years of Trial 1969­1980, was published by the AICPA in 1982.

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