On 12 March 1903, US Steel published its consolidated financial statements for the year ended 31 December 1902.

It was the dawn of the era of modern financial accounting, says Thomas King, chair of the Department of Accountancy at the Weatherhead School of Management in the US and author of More Than a Numbers Game: A Brief History of Accounting.

Along with its financial statements, in 1903 US Steel Corporation published an assurance from Price Waterhouse & Co that they were “audited and found correct”, becoming the first major US company to publicly issue an audited financial report.

Back then, audit was voluntary and US Steel published its accounts in order to secure the confidence and support of investors, including famous economist John Maynard Keynes, who promoted US Steel’s annual reports as exemplars in corporate reporting. Indeed, supporting the smooth and efficient functioning of capital markets remains a central aim of financial accounting and auditing.

Information is power

Auditing has been around since the time of the pharaohs in ancient Egypt.

Professor David Gilchrist CA, chair of the University of Western Australia Business School Economic and Business History Research Network, notes that the word ‘audit’ arises from the Latin audire (to hear). It relates to early medieval times when a bailiff (today, this role is more like a business manager) would speak his report to his lord, who was likely illiterate and innumerate, who would then make decisions pertaining to his manor.

“The development of the audit process was relatively slow, but very much always focused on the stakeholder and delivering what you might call appropriate error-free, or omission-free, information,” he says.

Forming a profession

Two developments in the 1800s took auditing a step closer to its modern-day form. The introduction of tertiary degrees in accounting in the late 1800s meant companies or owners could appoint skilled independent auditors.

The second? The creation of the public sector audit. “At this time, audit is not only becoming more professional and more important in terms of its role, it’s also becoming more respected in terms of its need in ensuring the appropriate allocation of resources,” Gilchrist says.

In fact, when the colony of Western Australia was established in 1829, the colony’s Board of Counsel and Audit was established on the ship on the voyage from Britain, before settlement had even taken place.

Assurance developed further when, at the outbreak of WWI, governments imposed price controls. With them came a need to police the prices consumers and governments were being charged. This saw the forming of assurance practices and of management accounting.

“Assurance was critical to allow trained auditors to report back to government, whether or not there was price gouging or other issues that came out of the costing and pricing process, informing government with respect to the prices it was paying for war materiel and prices consumers were paying for their daily living,” Gilchrist says.

Mandated and regulated

Audits of public companies became mandatory in the UK in 1844. The Joint Stock Companies Act enabled companies to be incorporated by registration of a deed of incorporation and required the appointment of auditors – including at least one by the shareholders – and the provision of the auditors’ report to shareholders.

In the US, the Securities Acts of 1933 and 1934 required audited financial statements of certain companies as a condition for them to publicly offer and trade their securities, although by then many companies were already making audited financial statements available.

Another important development came in 1939, when the American Institute of CPAs issued the first authoritative auditing standard, the Statement on Auditing Procedure (SAP) 1, which required auditors to perform tests to substantiate receivable and inventory balances. Until then, the auditor had a lot of discretion as to what was contained in the audit. At just 12 pages, the document is tiny in comparison to publications today, but marked the beginning of standards setting for auditors.

It also encapsulated some changes in the audit requirements since the 1903 US Steel audit, now requiring auditors to determine that the accounts “present fairly” the position of a company. Auditors were required to test a sample of transactions and to examine internal controls of a company.

Addressing the expectation gap

PwC remains US Steel’s audit firm and King points to the audit report of its 2020 accounts as an indication of how audit has changed since 1903.

The report says the financial statements “present fairly, in all material respects” – a major shift from Price Waterhouse’s 1903 assertion that the accounts were “correct”. King says the changes represent an attempt by the profession to address the expectation gap – the belief by many people that audits should uncover all instances of fraud and incorrect accounting.

Instead, auditors now strive to ensure the statements they examine are valid, accurate and complete.

The audit statement points to other developments in accounting and auditing as well. The results are “in conformity with accounting principles generally accepted”, a reference to generally accepted accounting principles and to the rise of agreed accounting and audit standards, as determined by standards setting bodies.

“Also in our opinion, the company maintained, in all material respects, effective internal control over financial reporting,” the auditors state, which brings in the additional role of the modern audit to consider how an organisation carries out its own assurance of its accounts and account preparation.

King notes that the audit process was toughened up in the wake of the Enron and WorldCom accounting scandals. Accounting firm Arthur Andersen earned US$52 million in fees from Enron in 2000 – half of that from auditing and the other US$27 million from consulting fees.

The firm approved Enron’s financial accounts, despite the energy company’s questionable accounting practices, including hiding financial losses and making the company appear profitable by manipulating mark-to-market accounting.

Following Enron’s collapse in 2001, Arthur Andersen was abandoned by clients and subsequently found guilty of obstruction of justice for shredding documents. It lost its licence to engage in public accounting, leading to the demise of the firm.

More significantly, the fallout from Enron and the collapse of WorldCom the following year led to the introduction of the , which prohibited audit firms from undertaking any concurrent consulting work for the same clients. Ethical standards required of auditors were also toughened up.

Additionally, executives were required to attest to the validity of the financial statements.

Audit beyond the numbers

While the purpose of the modern audit remains the same, technology is changing the way audits are carried out and an increased focus on non-financial metrics is broadening the remit.

UWA’s Gilchrist says that while the financial reports remain important, research by the university reveals that the performance commentary is more important to users of financial reports, particularly as stakeholders pay more attention to non-financial metrics, such as environment, social and governance.

This presents new challenges. How can accountants efficiently and effectively communicate the performance of the entity beyond the numbers? And how can auditors make sure they feel confident in passing an opinion that supports (or otherwise) the commentary and gives comfort to stakeholders?

“It is much harder than just simply saying, well, the bank says your building is worth a million dollars, therefore we’re happy to sign off on it being worth a million dollars,” he says.

The shift in focus, and the broadening of the auditor’s role into activities such as carbon emissions reporting assurance, is prompting audit firms to hire people without a traditional background. At the same time, these other professionals will continue to apply the existing framework of audit standards to these new areas.

Standards setters such as the International Ethics Standards Board for Accountants (IESBA) are already working on standards for audits of carbon emissions and other environmental measures, based on the existing audit standards.

“That will mean that auditors, accounting auditors, will continue to be important in this space because of their sheer experience being able to understand information and also understand how people operate in the context of the incentives that they’re operating under,” says Gilchrist.

The rise of continuous audit

Amir Ghandar FCA, CA ANZ’s assurance reporting leader, says the central role of the audit remains to provide confidence in financial statements, but how they achieve this has evolved since the advent of risk-based auditing three or four decades ago.

“The auditor is not simply looking at the numbers in the financial statements and then trying to gather evidence in regard to that,” he says.

Even before they start looking at the financial accounts, the auditors examine an organisation’s controls and systems and how they might serve to mitigate risk.

“They’re really starting with a holistic understanding of the business and the context of the business whose financial statements they’re auditing, and then from that they analyse what could go wrong, what are the risks?”

Ghandar says increased computing capability has the potential to allow auditors to move away from testing a small sample of transactions to checking 100% of transactions for some balances.

Financial reports that are currently presented as PDFs are not that different in terms of communicative value than the papyrus reports by the ancient Egyptians, Ghandar says. But this is changing. CA ANZ and other accounting bodies are advocating for the universal adoption of XBRL reporting, which is machine-readable. This would open the way for continuous financial reporting and the possibility of continuous audit.

In theory, continuous audit could bring to light issues with financial reporting and internal controls as they happen, but Ghandar warns that continuous reporting could also come with the downside of increasing management’s and investors’ focus on the short term, rather than the long term.

What’s clear is this dynamic specialty will continue to challenge audit professionals, and adapt to provide shareholders and stakeholders the information they need to make informed decisions.

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The history of audit – a timeline

• 4000–3100 BC: In ancient Egypt, granary records are kept by scribes, and temple income is recorded in Lower Mesopotamia.
• 1400 AD: Double-entry bookkeeping emerges in Italian merchant cities.
• 1780: Englishman Josiah Wade founds Tribe Clarke & Co in the UK, which specialises in auditing merchant accounts.
• 1831: The UK Bankruptcy Act lists merchants, bankers and accountants as the professions skilled to perform audits.
• 1903: US Steel publishes its consolidated financial statements and an assurance from Price Waterhouse & Co that they are “a fair and correct statement”.
• 1909: In the UK, the Companies (Consolidation) Act requires all companies to have properly audited accounts. The auditor is responsible for reporting to shareholders.
• 1931: Royal Mail Steam Packet Company chairman Lord Kylsant and auditor HJ Morland are tried for fraud, for failing to state true profit and loss accounts.
• 1933: The New Zealand Companies Act 1933 restricts the appointment of company auditors to members of the New Zealand Society of Accountants.
• 1989: In the UK, the Companies Act 1989 introduces the requirement that a company auditor must be a member of a recognised supervisory body and hold a recognised professional qualification.
• 2002: Enron auditor Arthur Andersen in the US reveals that staff have shredded documents and deleted emails relating to the Enron audit. The firm is indicted by the Department of Justice and subsequently collapses.
• 2002: The Sarbanes-Oxley Act is passed in the US, bringing in new financial and audit regulations for public companies.
• 2018: UK construction and services firm Carillion collapses, with £1.3 billion of debt. The Kingman Review follows and leads to a new audit regulator, the Audit, Reporting and Governance Authority (ARGA), replacing the Financial Reporting Council (FRC).

UK fact source: Institute of Chartered Accountants in England and Wales