Financial History: The Rise of Modern Accounting

In 1913, the 16th Amendment was ratified. It stipulated that, in addition to the corporate taxes that had been passed a few years earlier, there was now a federal income tax to be paid by all individuals working in the United States. Income tax and corporate tax were little understood and heavily resisted in their formative years. As a result, most corporations and individuals were simply not filing or were filing incorrectly. Accountants themselves were not entirely sure of items like depreciation and other tax deductions. The workload and demand for accountants, however, increased in conjunction with tax rates. (See also: Income Tax Guide.)

In 1917, the Federal Reserve published "Uniform Accounting," a document that attempted to set industry standards for how financials should be organized both for reporting tax and for financial statements. There were no laws to back the standards, so they had little effect. The stock market crash of 1929 that launched the Great Depression exposed massive accounting frauds by companies listed on the New York Stock Exchange. This prompted stricter measures in 1933, including the independent audit of a company's financial statements by public accountants before being listed on the exchange. (See also: How The Wild West Markets Were Tamed and The Greatest Market Crashes.)

The years 1933 and 1934 also saw the Securities Act and the Securities Exchange Act pass in rapid succession. These acts became the basis for the Securities and Exchange Commission. The SEC instituted the regular review of financial statements and began a long trend of government regulation over both the practice of accounting and that of investing.

The SEC, in true government fashion, turned around and delegated the responsibility of establishing accounting standards to a succession of committees and boards with an ever-changing array of acronyms: AIA, CAP, AICPA and APB. Finally, the current Financial Accounting Standards Board (FASB) came along in 1973. Although these boards issued pages and pages of accounting standards over the years, the final approval has always been left up to the SEC. The SEC rarely interferes, but it has struck down a rule or substituted in another every now and then, just to remind the accountants who's boss. (See also: Policing the Securities Market: An Overview of the SEC.)

As reporting regulations tightened and corporations were required to use different firms for audit and non-audit accounting services, the same handful of large accounting firms kept getting more and more of the business. This is mostly because they had the people and experience to get the job done, and there was a sense of prestige that went with using them as they grew larger.

As part of their growth, these firms merged with smaller firms in order to keep up with the increasing workload as more companies went public and regulations (and management) demanded increasingly frequent and stringent reports. By the 1970s, there were eight firms—The Big Eight—that handled most of the accounting for publicly traded companies. These were Arthur Andersen, Arthur Young & Co., Coopers and Lybrand, Ernst & Whinney, Haskins & Sells, Peat Marwick Mitchell, Price Waterhouse, and Touche Ross.

Because every corporation had to deal with two accounting firms, one for audit and another for non-audit services, the competition between the Big Eight accounting firms increased, leading to more consolidation. By 1989, the Big Eight had become the Big Six. In 1998, the Big Six was reduced to five. This countdown was advanced by one when, in 2002, the Enron scandal dragged down Arthur Andersen. The remaining four firms -- Deloitte & Touche, Ernst & Young, KPMG International, and PricewaterhouseCoopers -- bought up what was left of Arthur Andersen. These four firms now have a type of oligopoly because the competition has been significantly reduced while the regulations and reporting needs of corporations have increased. This has resulted in listed companies having to pay more for both their audit and non-audit accounting services.

Despite the fact that these four firms rule the world of corporate accounting, some of the largest employers of CPAs are now H&R Block and American Express. Income tax and credit directly affect millions of people who don't even know the FASB exists. Financial reporting may be the limelight of accounting, but the bulk of the accounting industry is built on helping people file their taxes.

Accounting, as a practice, has several guiding principles that will likely survive any changes in the future. Corporate accountants have to abide by these rules, including:

• Provide information that helps management make informed business decisions.
• Provide similar information to others with a stake in the corporation (creditors, investors, employees).
• Ensure that the law is being followed.
• Verify that the records and reports of a company are accurate.
• Indicate areas where efficiency can be improved (investing cash reserves, cutting costs, etc.).
• Protect against fraud, embezzlement and other activities that cost a company money.

One of the biggest changes on the horizon of accounting is the addition of a seventh service: current-value information. Proponents of this type of accounting argue that historical cost financial statements are flawed because they do not provide information on current value, which would be more relevant for investors. As such, this type of accounting may produce balance sheets that are more representative of a company's value, although it is considered by many to be less reliable.

Another change in corporate accounting is the introduction of advertising into the industry. Actively competing with other firms through advertisement was taboo in an industry that used to depend on word-of-mouth recommendations to build clientele. As this competition between only a few firms begins to heat up, the regulations on the industry will also increase to keep firms from offering dishonest services (think Arthur Andersen) to entice clients from their competition. All in all, the future of accounting will be in getting accurate information to managers and investors as soon as possible. In turn, this will ratchet up market efficiency and keep the financial world ticking along happily. (See also: The Rise of the Modern-Day Bean Counter.)