In its basic form, auditing has been around for most of human civilization. There were people who double-checked public spending in Ancient Egypt and the Roman Empire. But auditing as we think of it today is closely linked to the growth of modern industry, which began during the Industrial Revolution (historians disagree on exact start dates, but it was around the mid-18th century).
During this time companies were being scaled up like never before, and the number of joint-stock companies exploded. A joint-stock company is one owned by multiple investors. It differs from the public limited companies of today in one important aspect: joint-stock investors are liable for the company’s debts. Being financially on the hook if a company went bust made these investors a lot keener on being able to know what state the company accounts were in.
At the same time, governments and society at large were also becoming more invested in what companies were getting up to, because the world had now experienced its first stock market crash: the South Sea Bubble. This happened in England in 1720, when the South Sea Company and a bunch of other businesses started selling masses of shares on the promise of great returns. The problem was that these companies weren’t actually doing anything of value that would allow them to make the money needed to pay back their investors. Eventually people realised this, and the bubble popped. Loads of folk, including lots of poorer ones, lost substantial amounts of money. Some became destitute. The ripple effects of this caused the UK economy to collapse. The British government responded by introducing the Bubble Act, which barred most sales of shares between 1720-1825.
Even once this trade was allowed to start up again the British Parliament remained wary of the potential consequences. So in 1844 it passed the Joint Stock Companies Act, which required companies to give shareholders an audited financial statement. (However, companies weren’t legally required to appoint an independent auditor for this until 1900.) It was also during the second half of the 19th century that professional associations for accountants, which trained people in auditing, began to be set up. In 1923 Britain started requiring wannabe auditors to first pass an exam.
That brings us to 1929 and another huge stock market crash (although this one started in the United States). The economic and social fallout from that pushed the US government to pass laws in the 1930s aimed at regulating the stock market there. These laws then inspired copycat versions in other countries. One important aspect of this new regulation was that all companies listed on a stock exchange had to have audited accounts.
Around the same sort of time there was also a shift in what auditors were asked to focus on. Previously, they’d just done what is called ‘balance-sheet auditing’. That means if a company wrote that they’d earnt x and spent y, the auditor checked to see if x and y were the correct amounts. Post-1930, auditors were also asked to check if companies were presenting these figures in a way that was fair, not misleading, and didn’t obscure important but unfavourable information.
By the ‘70s, auditing had evolved further. This was the era of globalisation and with it the development of huge multinational firms. Indeed, many companies were growing to such a size and complexity that it had become difficult and time consuming for auditors to check everything they were doing. So a set of International Accounting Standards (IAS) were issued for companies to follow, and auditors also started switching their focus from checking a company’s transactions to checking its internal controls i.e. how much the company generally seemed to comply with IAS rules and best practices. Essentially, if an auditor deemed that a business seemed trustworthy, they didn’t waste time doing a deep dive into their accounts.
By the next decade auditors had decided that even this model of determining the overall trustworthiness of a company was unnecessarily expensive. The new norm became analytical procedures. Basically, auditors looked at a bunch of information about the company, compared it to the books, and did a broad sense check to see if it seemed about right. For example, if a company reported that they made no money but their CEO recently gave an interview celebrating bumper profits, then the auditor would determine something was fishy and have a closer look. But when everything seemed a-ok they generally wouldn’t investigate further. Similarly, the ‘80s was the high point of risked-based auditing - where auditors only really looked at the parts of accounts that they thought were most likely to contain errors.
Unfortunately, there’s a reason why ‘the devil’s in the details’ is a saying. The early 2000s were rocked by accounting scandals. The most famous happened at the energy company Enron. In 2001, it came to light that the business had engaged in massive accounting fraud, fraud that had not been reported by its auditing company, Arthur Andersen. (In fact the auditor was charged with deliberately ignoring and even helping to cover up the fraud.) Shareholders lost their money. Tens of thousands of Enron employees, many of whom were also shareholders, lost their jobs and their pensions. Arthur Andersen went bust, putting another 85,000 people out of work and turning ‘the Big 5’ into ‘the Big 4’.
As before, the world responded with new rules and legislation. It was decided that part of the problem was that auditing relied too much on the personal judgement of individual auditors, which introduced space for bias. So firms moved to standardise auditing. Those IAS accounting rules which many companies around the world were obliged to follow were also updated. In 2001 they became the International Financial Reporting Standards, or IFRS. (American firms follow a distinct but very similar set of rules.)
But the accounting scandals still did not stop. Carillion, a construction company, collapsed in 2016. It took with it thousands of jobs, tens of thousands of supplier contracts and £148 million of UK taxpayers money. KPMG, its auditor, is now facing a lawsuit for not warning anyone about what should have been Carillion’s obvious financial problems. In 2018 a similar incident happened with Patisserie Valerie, a cake chain. Its auditor, Grant Thorton, has been fined millions of pounds for missing the financial red flags.
That brings us to now. Three hundred years after the South Sea Bubble and economies are still being rocked because nobody is doing a good enough job of checking what companies are getting up to - including the auditors whose role was invented to do exactly that. Will this situation now change? The calls for audit reform are getting louder and the UK government is promising to revamp the industry. We’ll have to wait and see to what extent auditing is reformed, but certainly such reform is long overdue.