CHAPTER 3

Great Depression and Reforms

Following the complete collapse of the U.S. economy and the discovery of massive manipulation and several large corporate scandals, the 1930s brought in Franklin D. Roosevelt’s (FDR) New Deal and federal regulation of markets and corporations. Of particular importance was the creation of the Securities and Exchange Commission (SEC), which developed rules of corporate accounting and financial disclosure. The SEC was given control over accounting procedures, which were ultimately delegated to the private sector, with the American Institute of Accountants (AIA, now the American Institute of Certified Public Accounting, AICPA) assuming the responsibility. The largest and most successful auditing firms evolved into the “Big Eight.” Beginning with New York in 1897, all states had a formal licensing process for certified public accountants (CPAs). In the process, accounting become more formal and supported by a growing profession. Accounting manipulation and fraud could now be defined with reasonable accuracy. It did not take long for the first major criminal fraud case to materialize, McKesson & Robbins (MR), a large pharmaceutical company.

The Great Depression

Although the U.S economy was already in recession, the market crash of October 1929 is usually considered the start of the Great Depression, a decade-long economic catastrophe. Banks failed by the thousands and millions of investors, large and small, investing heavily on margin lost it all—Groucho Marx being a famous example. Most individuals lost all faith in the market and stayed out of stocks for decades.

President Herbert Hoover continued the Republican pro-business stance of the 1920s and “traditional approaches” for dealing with economic slumps, including raising taxes and bailing out some businesses. Hoover’s Treasury Secretary Andrew Mellon, one of America’s richest men, famously declared: “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate … purge the rottenness out of the system”—not a philosophy to promote government action (or reelection of Hoover). The unemployment rate, 2.9% in 1929, rose to 22.9% by 1932, while gross domestic product plunged 43% (from $104 billion to $59 billion).

Congress got into the act of smashing the economy with the Smoot- Hawley Tariff of 1930, which increased tariffs, bringing retaliation and decimating foreign trade. Because of rising federal deficits, Congress passed the Revenue Act of 1932, raising tax rates (with the top income tax rate rising from 25% to 63%). These blunders were considered responsible fiscal actions at the time.

Initially, the Federal Reserve provided positive action as the New York Federal Reserve under George Harrison lowered interest rates and flooded cash into the banking system. Unfortunately, the Federal Reserve Board in Washington supported Mellon’s call for higher interest rates. Fed action mandated by Washington drove Treasury bill rates from 3.2% to 3.7% to maintain the U.S. gold supply and value of the dollar (mainly by selling Treasury securities to decrease the money supply). Economist Milton Friedman claimed this action was the primary cause of the Great Depression. Banks failed by the thousands.

FDR won the 1932 presidential election, then faced a banking crisis on his first day in office, March 4, 1933. The New York Stock Exchange (NYSE) closed the same day because of the banking crisis. The market opened two weeks later and went up after dynamic actions by FDR. The Dow hit 100 by July 1933 and rose as various New Deal programs appeared reasonably effective. The Dow peaked at 194 in March 1937. After that, the market and the economy headed down on a combination of poor monetary and fiscal policy actions, resulting in a recession in the middle of the depression. At the end of the 1930s, the Dow was back to 150 but economic recovery had to wait until World War II.

Business Scandals and the Pecora Commission

Typical of a bursting economic bubble, the depression of the 1930s resulted in the discovery of widespread corruption, fraud, and scandals. Kreuger and Toll (KT), a Swedish multinational with a major U.S. focus, was a complete fraud. Holding company pyramiding (multiple layers of companies usually in a specific industry based on huge levels of leverage) proved to be common during the 1920s and led to bankruptcy in the 1930s. Samuel Insull ran a utility pyramid, which failed, and he was indicted for fraud. Investment trusts, holding companies selling debt and equity securities to the public, often on large margin, lost vast sums of money for their investors.

Pecora Commission

In 1932, the Senate Banking and Currency Committee investigated the market crash and depression, which became the Pecora Commission, named for Ferdinand Pecora, the last chief council of the Senate committee. The common view of the crash and depression (shared by President Hubert Hoover and much of Washington) was the deceit of short sellers and Wall Street: “Hoover now shared the average American’s view of Wall Street as a giant casino rigged by professionals.”¹ Richard Whitney, NYSE president and first witness (more on him shortly), proclaimed the virtues of Wall Street, especially the NYSE. The hearings dragged on until Pecora became chief council (the fourth) early in 1933. According to Chernow²:

With Pecora as counsel, the hearings acquired a new, irresistible momentum. They would afford a secret history of the crash, a sobering postmortem of the twenties that would blacken the name of bankers for a generation. From now on, they would be called banksters.

Speculators testified about their manipulations, including Harry Sinclair (jailed for his involvement in Teapot Dome) and Bernard (“Sell ‘Em Ben”) Smith. Techniques included stock pools to manipulate prices, insider trading, and bribing of journalists to influence prices. The income tax records of Wall Street bankers were analyzed, including the tax-avoidance schemes at J.P. Morgan (Morgan partners, for example, paid no income tax in 1931 and 1932) and other banks. Several executives were indicted for tax evasion, including Charles Mitchell, president of National City Bank, the largest bank at the time. Banks repackaged delinquent bank loans from South American countries as bonds, selling them as “low-risk government debt.” Albert Wiggins, president of Chase National Bank, shorted the bank’s stock using money borrowed from the bank.

Pecora investigated the many scandals of the era, including the stock pyramiding schemes in utilities (with Samuel Insull’s empire prominently) and the Van Swearingen brothers and others in railroads; the KT fraud; and leveraged investment trusts. U.S. Attorney General John Sargent indicted over 1,500 firms and individuals, and conducted almost 150 criminal prosecutions. The Internal Revenue Service (IRS) collected about $2 million from tax evasion fines based on Pecora testimony. Pecora became a commissioner of the SEC after it was created.

Kreuger and Toll

KT was a construction and engineering company founded in 1908 by Ivar Kreuger and Paul Toll. It was split in to two with the holding company KT run by Kreuger. KT invested in various industrial companies, using Swedish Match Company as the base. Kreuger became involved in numerous complex international dealings. KT acquired various European match companies, using large-scale production, emphasizing economies of scale and increased efficiency in both production and distribution. KT eventually became the largest match company in the world.

International agreements at the time involved bribery of key officials and KT became increasingly corrupt. Archibald MacLeish³ thought 1923 was the year Kreuger became an outright crook, creating International Match Company (IMCO) when the match industries ceased being profitable. KT used loans to European governments for favorable deals, including France in 1927 for a match monopoly. Early in the 1930s KT controlled over 200 companies and continued to pay large dividends, suggesting that Kreuger was one of the richest and most powerful entrepreneurs in the world. However, his empire was a composite of legitimate businesses and smoke. Bookkeepers relied on numbers supplied by Kreuger to create financial statements and move cash and other assets around the globe—mainly to issue new securities to raise the cash from U.S. and Swedish investors to keep the empire alive. Ultimately, even forging Italian securities was not enough to keep the empire afloat during the depression. Kreuger shot himself to death in 1932, creating what became the “Kreuger Crash,” as KT and related securities collapsed—transforming Kreuger from the “match king” to the “world’s greatest swindler.”

Understanding the fraud and settling accounts took over a decade. Price Waterhouse audited the books and stated that the KT balance sheet “grossly misrepresented the true financial position of the company.”⁴ The American operations of KT failed in 1933. The Pecora Commission investigated KT and the forthcoming securities regulations were based in part on the financial failings of KT. Some of the KT empire survived, including KT Construction (which changed its name to Toll Construction). The final report was issued in 1945, resulting in bond holders receiving 30¢ on the dollar.

Samuel Insull and Stock Pyramiding

Samuel Insull created a utility empire that proved highly successful based on stock pyramiding, but failed in the Great Depression. He started working for Thomas Edison shortly after Edison invented the light bulb and electric generation, becoming a vice president of Edison Electric. A competent manager, he became president of Chicago Edison, transforming it into Commonwealth Edison in 1907. Insull formed Middle West Utilities as his first holding company in 1912, acquiring small, inefficient local utilities—the strategy was reducing costs, increasing efficiency, and growing the customer base.

He created Insull Utility Investments in 1928 as his pyramiding base, using high leverage to expand. Stock price exploded, from the initial public offering price of $12 to $150 within six months. Insull Utility created five holding companies under his umbrella and these owned over 100 separate utilities. At the height of the stock bubble in 1929, this empire had a market capitalization of $3 billion, with profits largely generated by writing up the value of property, plant, and equipment, while ignoring various operating expenses. Stock dividends from subsidiaries also were treated as income. Insull Utilities went bankrupt in 1931—one of over 50 failing holding companies. Insull was charged with mail fraud and antitrust violations and fled the country. He was extradited back to the United States, stood trial, but was not convicted. Without specific accounting standards, a jury was not convinced fraud had occurred. The illicit methods did not seem to violate any existing laws.

Goldman Sacks Trading

Investment trusts became a new tool in the 1920s, promoted by investment banks as the new innovation of financial engineering for small investors to reap the rewards of professional management. They resembled later mutual funds but without the regulations. According to a Time article in 1929, basically at the top of the market⁵:

The investor in an Investment Trust, in effect, turns his money over to a group of experts who have the advantage of thorough market knowledge and of handling sums ranging from three to five hundred million dollars. Such an investor is letting men like Simon William Straus, the Seligmans, Arthur Cutten, Fred Fisher, and Walter Chrysler, invest his money for him. Investors in U.S. investment trusts usually do not know exactly where their money is being used (English investment trusts are more considerate); they are simply trusting the Trust. Perhaps the best analogy to an Investment Trust would be a hypothetical bank that had no restrictions on what it could do with the depositors’ money. Funds invested in Investment Trusts may well yield 10% or more, may also yield nothing at all. Prior to 1925 there were only 29 U.S. investment trusts; at present there are some 200.

Goldman Sachs was a latecomer, but Goldman Sachs Trading Corporation (GSTC), not created until 1928, became the biggest and riskiest. GSTC started with little capital, but soon increased to $100,000 (with 10% retained by the Goldman partners, about half the equity of the partnership). GSTC zoomed to $326 a share (three times the initial price) just before the 1929 market crash—in part driven by trading shares to drive up the price. Based on GSTC success, two new investment trusts were formed by Goldman, both using substantial leverage.

When the market collapsed in late 1929, GSTC fell, bottoming out at $1.75 (less than one percent of its high). The holding company barely avoided failure, selling the remnants to Atlas Corporation in 1932. Goldman almost went under, but managed barely to survive the depression and World War II. None of the investment banks did well, nor were they or their services appreciated by the public.

Richard Whitney

Whitney was the NYSE executive who “saved the day” on Black Thursday, buying thousands of shares of several stocks as prices were collapsing. Of course, the market collapsed a few days later anyway. Whitney, as NYSE president, was the first witness of the Pecora hearings, proclaiming the benefits of the exchange. Unfortunately, Whitney had a dark side that would send him to jail.

Whitney and his brokerage firm, Richard Whitney and Company, were ruined by the crash, but hid the fact by borrowing money using his company stock as collateral for loans (because the firm was private, he was able to hide the fact that the stock had no value). He also borrowed money from his successful brother George (a partner at Goldman Sachs) or anyone who would lend to him. That was not enough to maintain his lifestyle, so he resorted to embezzling. As a trustee of the NYSE Gratuity Fund (basically a life insurance fund for members), he sold about $1 million in bonds in the Fund’s name and kept the cash. He was also treasurer of the New York Yacht Club and looted the club. When caught, he confessed to brother George who loaned him $1 million to cover the crime.

Whitney’s total debt was a staggering $27 million when the crime spree came to an end. His brokerage firm was suspended and New York District Attorney Thomas Dewey indicted Whitney for grand larceny. FDR famously exclaimed when he heard the news: “not Dick Whitney!” Whitney pled guilty and served about three years of a five-to-ten year sentence. That was the end of his less-than-illustrious career on Wall Street.

FDR and the New Deal Reforms

Roosevelt was New York Governor when Hoover was president. As governor he experimented with a number of welfare and work programs similar to those he later used as president. FDR easily beat Hoover for the presidency in 1932 promising a New Deal of reform of the banking system, unemployment relief, and economic recovery. New federal securities statutes were a major New Deal promise. On inauguration day, March 4, 1933, facing a complete collapse of the banking system and NYSE, which had closed, FDR declared a national “bank holiday,” shutting down all banks until they could be inspected to determine which were still solvent. Solvent banks were reopened under the supervision of the Treasury Department and loans became available from the Reconstruction Finance Corporation (RFC)—over the next six months the RFC loaned out about a billion dollars. Despite this effort, 4,000 poorly capitalized and mainly rural banks failed. This was the beginning of the “first hundred days” of landmark legislation, part of FDR’s first New Deal when 15 major bills were passed. The strategy was economic stimulation and massive financial and economic reform.

The primary bank reform bill was the Glass-Steagall Act of 1933. The act created the Federal Deposit Insurance Corporation, which insured holders of commercial bank deposits. Although insurance was not favored by FDR (who thought it propped up weak banks to the detriment of strong banks—a moral hazard according to economists), it was popular with constituents and remains a major regulatory agency. Based on a number of banking scandals, Glass-Steagall required the separation of commercial banks from investment banks. Scandals considered included the reissuance of failed bank loans to Latin American countries as government bonds sold to individual investors, the failure of investment trusts, and the multitude of Wall Street abusive practices. J.P. Morgan, for example, became a commercial bank, while Morgan Stanley was split off as an investment bank.

Stabilizing farm prices was an early New Deal focus. The Agricultural Adjustment Act (May 1933) was designed to raise agricultural prices by subsidizing farmers to reduce output, later declared unconstitutional by the Supreme Court. The program was modified and agricultural subsidies and related farm programs have been around ever since. The net result was to increase prices, good for farmers but bad for consumers and taxpayers.

One of Roosevelt’s pet projects was the National Industrial Recovery Act (NIRA), passed in June 1933, which created the National Recovery Administration to eliminate “cutthroat competition” by establishing a cartel system of businesses and labor. Somehow, this collusion was supposed to result in “fair competition.” In practice, the critics contended that it was particularly unfair to small businesses and promoted monopoly practices of large corporations. The Supreme Court ruled the law unconstitutional as a violation of antitrust laws. In its place, Congress passed the Wagner Act, greatly increasing the power of labor unions.

Many programs were launched as relief efforts, beginning with the creations of the Federal Emergency Relief Administration (actually a modification of an act passed during the Hoover Administration), which gave some $3 billion in grants to state and local governments to employ millions of unskilled workers. It was replaced by the Public Works Administration, which spent over $13 billion on public works between 1935 and 1943, with highway spending being the largest category. The Civilian Conservation Corps was another public works program (1933–1943), specifically hiring unemployed, unmarried men from relief families at $30 a month ($25 of which went to the parents).

A “Second New Deal” represented reform legislation to solve more long-term problems. The largest and most well-known was the Social Security Act of 1935, providing annuity retirement payments, disability, and other programs. The concept was a self-funding program paid from payroll taxes. Although payroll tax collections started in 1937, the first payments were not made until 1940. Problems did not develop for decades, until life expectancy substantially increased. The Federal Housing Act (FHA) provided housing-related loans. The FHA created the Federal National Mortgage Association (Fannie Mae) in 1938, another program that worked well for decades, until corruption and “housing euphoria” essentially bankrupted the company during the housing crisis of 2008. The Communications Act of 1934 established the Federal Communication Commission to regulate electronic communications, initially radio and telephone services. The Wagner Act (National Labor Relations Act) also was a Second New Deal program.

Roosevelt’s programs were only partially successful. Some worked well, such as Social Security; others, such as the NIRA, were ruled unconstitutional. Many programs, especially the relief programs were often underfunded and later cut or eliminated. The federal government ran a deficit every year of the 1930s decade, increasing the political pressure to raise taxes and cut spending. The individual income tax was increased, with the top rate rising to 79% in 1936, as was the corporate tax rate, to 39%. Also, in 1937, the Federal Reserve reduced the money supply, causing a recession within the depression. Ultimately, the Great Depression ended only with World War II.

The SEC and Accounting Standards

The untold corruption and scandals associated with the market crash and unregulated business practices of the 1920s led to substantial reform including federal regulations and formal accounting and auditing standards. This proved to be a slow and evolving process, with major deficiencies often discovered after scandals and new issues created by a changing business environment. Central to the process was the SEC, which was given federal responsibility for accounting and disclosure practices.

Securities and Exchange Commission

After the market crash, the collapse of the banking system, and the findings of the Pecora Commission, most Americans lost all faith in the financial system. The answer, according to Washington, was the federal regulation of financial securities, including initial issues and the stock exchanges, replacing the ineffective state (“Blue Sky”) laws. The original legislation was the Securities Act of 1933, also called the Truth in Securities Act. The banking industry lobbied to stall or reduce the effectiveness of the act, but to no avail. It was “the rare time when money talked and nobody listened.”⁶ A major focus was the need for full disclosure of relevant financial information. The Federal Trade Commission (FTC) was responsible for regulation under this act.

The 1934 bill attempted to improve securities regulation relative to the 1933 Act. It created the SEC specifically to regulate securities markets.

The mission of the SEC was (and still is) “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” (www.sec.gov). Five Commissioners, each serving five-year terms, head the agency. Joseph P. Kennedy, a market manipulator during the 1920s and father of President John F. Kennedy, was the first Chairman of the SEC (1934–1935). The rationale was it took a speculator to understand and prevent illicit practices (“takes one to catch one,” according to FDR).

Certain abuses identified by Pecora including margin trading and short selling; floor traders were banned from buying and selling exclusively for their own accounts. Legislation required the SEC to study each of these issues, which ultimately led to new regulations. Margin trading, for example, was not eliminated but the percent of leverage was limited. Other perceived abuses were studied by the SEC but not eliminated, including the use of preferred lists for initial public offerings.

The Securities Acts mandated “full and fair disclosure” of financial data in registration statements before a public offering, including the information needs of a “prudent investor.” Legal requirements and antifraud provisions increased legal risks to corporations and bankers. Section 10b set the antifraud provisions of the 1934 Act. The SEC’s Rule 10b-5 prohibits any “device, scheme, or artifice to defraud.” The rule specifically restricts earnings manipulation, price fixing, and insider trading. In addition, the corporate is liable for any misstatement or omission of material facts.

The SEC required public corporations with over $5 million in assets and 500 stockholders to register with the regulator and file periodic reports before new securities could be issued to the public; exchange- listed companies had to file annual financial statements and other reports with the SEC. An annual audit was required for all trading corporations, making the auditors legally accountable to the SEC (also called “the public”) in addition to the corporation audited.

The SEC’s Regulation S-X lays out the format and required content of the various financial reports, available on the SEC’s website at www.sec.gov/about/forms/forms-x.pdf. Accounting Series Releases (ASRs) issued by the SEC are official accounting pronouncements on accounting and auditing procedures required for reports issued to the SEC, such as the 10-K. These are codified as Financial Reporting Releases. Staff accounting bulletins (SABs) are interpretations and policies used by the SEC staff (of the Corporate Finance Division) on disclosure requirements. Well over 100 SABs have been issued, which are codified by topic at www.sec.gov/accounts/sabcode.htm. Other SEC documents related to accounting issues include accounting and auditing enforcement releases to detail misconduct of companies and/or auditors after SEC investigations.

In the pre–World War II period, the SEC was well-funded, with a staff of over 1,700. During much of the post–World War II period, budget cuts reduced agency effectiveness. Examination and inspections were often postponed. The relative aggressiveness (and budget level) depended on the specific administration in power, with Democratic administration often more assertive than Republicans. Lax enforcement typically meant increased probability of corruption and fraud undetected for long periods. One reason that major scandals such as Enron went undetected until the tech collapse of the early 21st century, was because of lax SEC enforcement—funding was increased with the Sarbanes-Oxley Act of 2002.

Accounting Standards

Prior to the creation of the SEC there were no formal accounting standards and not much interest in standardizing accounting and financial reporting. Many corporations considered finances a private matter and did not disclose any financial information. Until 1910, the NYSE had an “unlisted department” of securities from corporations refusing to disclose any information. Accountants typically emphasized the importance of judgment in determining how balance sheet accounts were valued, when and how much to recognize in revenues, and how to match expenses with revenues recognized.

The Interstate Commerce Commission, the federal agency regulating railroads since 1887, developed a uniform system of accounts for railroads (various states had earlier uniform accounting standards for railroads and other industries). Consequently, the concept of accounting standards for business was not out of the question. Accounting failures were noted after the Panics of 1893 and 1907. The Bureau of Corporations was established in 1903 to investigate business affairs. The Pujo Hearings of 1912–1913 uncovered many abuses of the “Money Trust” and big business. The FTC was created in 1914 to protect consumers and prevent anticompetitive business practices—the Bureau of Corporations was collapsed into the FTC. In 1917 the Federal Reserve, FTC, and AIA published “Uniform Accounting” in the Federal Reserve Bulletin to increase standardization of accounting disclosure and auditing methods. Because compliance was voluntary, this attempt had little impact on either financial reporting or auditing. According to Hawkins,⁷ “In the area of prospectus financial disclosure the impact of ‘Uniform Accounting’ was almost nil.”

In 1933 the NYSE required all listed firms to disclose audited financial statements and partnered with the AIA on accounting and audit issues. This private sector action was beneficial, but comprehensive reform had to come from the federal government. The SEC had Congressional authority to regulate accounting and disclosure with: “Authority … to prescribe the form or forms in which the required information shall be set forth, the items or details to be shown in the balance sheet and the earnings statement, and the methods to be followed in the preparation of accounts.”⁸ The Chief Accountant of the SEC from 1935 to 1938, Carman Blough, did not believe the agency had the resources to establish accounting standards. The SEC implicitly transferred the authority to the AIA based on ASR No. 4 (1938), which gave the organization with “substantial authoritative support” the responsibility.

The AIA created the Committee on Accounting Procedure (CAP) in 1938 to issue what became generally accepted accounting principles. The process was ad hoc, created by this part-time committee of accountants; however, the results proved reasonably effective and the CAP issued some 51 Accounting Research Bulletins (ARBs) over the next 20 years. Most of the basic accounting procedures came in large part from these ARBs—first codified in ARB No. 43 in 1953. Deficiencies of the CAP would lead to new committees, but the fundamental process of establishing accounting standards in the private sector was established. After the accounting abuses associated with fair value techniques of the 1920s and 1930s, both the CAP and IRS favored historical cost accounting rather than fair value measures.

MR and Audit Reform

Before the Great Depression, financial auditing practices were not standardized and substantial abuses could be hidden based on the limited scope of some audits or the deficiencies in audit techniques used. Both Insull Utilities and various subsidiaries of KT were audited, but were inadequate and helped camouflage the widespread corruption. Abuses were uncovered before the Pecora Hearings (in part by additional audits), which analyzed both fraud cases. The NYSE called for annual audits and SEC rules later required audits conducted by CPAs. This was a boon to the accounting profession, but before the 1930s decade was over a major fraud was discovered, perpetrated at a company audited for years by the premier accounting firm, Price Waterhouse.

McKesson & Robbins

MR was an old, established pharmaceutical company originally founded in 1833. MR was acquired by Frank Coster in 1927. Unfortunately, Coster (his real name was Philip Musica) was a crook and con artist who also happened to be a good business person—if he had been honest, MR could have been increasingly successful even during the depression. Before acquiring MR, Musica ran Girard and Co. as a pharmaceutical, with a “customer” called W.W. Smith, actually a dummy company to expand profits for himself and confederates. Price Waterhouse (now PricewaterhouseCoopers) was Girard’s auditor and, using only documents provided by Musica, never discovered the fraud.

With Girard reporting large profits and growth, Musica was able to acquire MR. Fraud expanded, while Price continued as auditor and continued to give unqualified (clean) opinions. With excellent audited financial statements, MR was a blue chip borrower and issued more stock and debt. MR developed a national distribution chain for pharmaceuticals, which did not exist before Musica, considerably expanding growth, profits, and debt. Simultaneously, dummy companies and fraud expanded as well. Most American subsidiaries were legitimate but a Canadian subsidiary was a dummy corporation. Bogus documents showed fraudulent sales, inventory, and receivables, claiming substantial profits and assets of $20 million—about 23% of MR’s total assets.

The fraud was discovered by an inside whistleblower, not Price Waterhouse. Julian Thompson, MR Treasurer, discovered both the bogus Canadian subsidiary and fake customer W.W. Smith. Thompson confronted Musica. Musica panicked and put MR into bankruptcy. The SEC and the New York Attorney General investigated. Musica was arrested and after receiving bail, killed himself. Most confederates pled guilty, became government witnesses, and avoided jail. Only Controller John McGloon was actually sent to prison. MR was reorganized and emerged from bankruptcy in 1941. The SEC report claimed: “the financial statements [audited] by Price Waterhouse & Co. [were] materially false and misleading.”

An embarrassed accounting profession conducted an AIA investigation uncovering major audit deficiencies. This led to a new AIA committee to establish formal auditing standards, later called generally accepted auditing standards (GAAS).⁹ McKesson Corporation still exists and is part of the S&P 500. Ironically, McKesson was involved in another accounting scandal 60 years later, when it acquired medical information system firm HBO & Company (HBOC) and accounting irregularities were later discovered.

Auditing and Audit Reform

The concept of auditing started in the Middle Ages, reviewing reports orally (from the Latin audire). The relationship of auditors and business started in the 18th century, but the development of “professional accountants” performing audits by reviewing the books of business and relevant documents really started in 19th-century Great Britain (11 people were listed as accountants in 1799, growing to 1,000 by 1900). Professional organization began in Britain in that century: the Institute of Accountants in Edinburgh (1853) and the Institute of Chartered Accountants of England and Wales (1880). A number of what became the Big Eight accounting firms were established in mid-19th-century Britain, including Price, Waterhouse, Coopers, Peat, Deloitte, and Whinney.

Several British accountants, often sponsored by their firms, immigrated and practiced in America. The predecessor body to the AIA was founded in 1887 (the name was changed to AIA in 1917 and AICPA in 1957). New York became the first state to license CPAs, followed by Pennsylvania and Maryland. All states licensed CPAs by the early 1920s. In the United States, little regulation beyond licensing existed. Few rules were written and the scope of the audit (what was actually covered by the audit) was determined by the client. The AIA created the first code of ethics in 1917; many provisions protected the firms from competition such as bans on advertising and client solicitation.

Despite the lack of standardization, the “balance sheet” audit developed to check all transactions and balance sheet accounts and trace all vouchers, receipts, and other documents through the accounting records. Banks first used audits as a method to ensure the accuracy of financial statements and the ability to pay back loans, followed by investors evaluating earnings and dividend potential. Bankers and the public typically believed audits would uncover fraud, although auditors seldom made that claim.

In this era before regulation, considerable abuse was common. A corporate prospectus or annual report might list an audit but not include the report. The user would have no idea of the scope or outcome of the audit. The auditor might withdraw from an audit due to discovered (and uncorrected) abuses, but the outside user would not find out. The Federal Reserve and FTC published “Uniform Accounts” in the Federal Reserve Bulletin (which included audit methods used by Price Waterhouse), to be used as a standard audit practice, but compliance was voluntary (and not widespread). On the other hand, 90% of NYSE firms were audited by 1926.

The AIA established the Committee on Auditing Procedure (CAuP) in 1939 to consider audit deficiencies in light of MR. The first pronouncement, called Statement on Auditing Procedure (SAP) No. 1, specifically mandated observing inventory and confirming receivables, the practices missing in the MR audit. It also included other requirements, such as selecting the auditor either by the stockholders or the board of directors and an auditor’s report that included an evaluation of internal controls. The SEC (ASR 21) mandated the auditors to state in the report whether the audit followed “GAAS,” that is, those prescribed by the CAuP. The CAuP continued issuing SAPs (54) until replaced by another committee, called the Auditing Standards Executive Committee. This process of the profession-mandated audit standards continued until the Sarbanes- Oxley Act of 2002 created the semi-public Public Companies Accounting Oversight Board (PCAOB—it is technically a nonprofit organization rather than a government agency) to establish audit standards and regulate the audits of public companies.

Lessons to be Learned

The early 20th century saw substantial federal regulatory responses to economic catastrophes, especially FDR’s New Deal after the Great Depression. This period established the basic mechanisms of financial reporting, as well as accounting and audit standard setting. This level of regulation, along with strict enforcement and rule changes as needed (such as audit standard requirements after the discovery of fraud at MR), worked reasonably well, especially over the next quarter century. Thus, the potential for effective regulation was demonstrated.