Auditing

Auditors are accountants from outside a firm who review the financial statements and a firm's procedure for producing them. Their job is to attest that the statements are fair and that they materially represent the condition of a firm. While banks and other creditors have always wanted independent verification of a firm's financial health, the role of monitoring the firm was cemented by the Securities Act of 1933 and the Securities Exchange Act of 1934. In the Great Depression, after the excess of the late 1920s, the country was reeling from business scandals. The U.S. Congress reacted with stronger oversight, regulation, and punishment . Does this reaction seem familiar?

This legislation required annual independent audits of all public companies. Therefore, in the late 1930s and the 1940s, accounting firms flourished with the increased demand for auditing services. Initially, the high demand for auditing was due to the new laws that required independent verification of a firm's books. Later, the demand for auditing services continued to grow because the economy eventually picked up, increasing the number of public firms. This environment was such that auditing firms could play an effective role of independent monitor ”even becoming adversarial with a firm if necessary. For example, Al Bows was one of the first partners at Arthur Andersen and recalls the days when auditors were very credible and influential. At that time, while auditing a fruit juice company, Bows discovered that the CEO was starting another juice company on the side for his own benefit. Bows was concerned about the conflict of interest and told the CEO to dissolve the other company. The CEO did. ^[2] In another audit of a real estate firm, the CEO complained that Bows was imposing tougher standards on his company than on other companies in the industry. Bows responded that Arthur Andersen didn't care what other firms did ”it was going to do what is right. Being confrontational with firms was not very risky at that time. Firms rarely switched auditors and auditing firms were too busy with existing clients and new companies to poach the clients of other auditing firms. Indeed, competitive marketing of auditing services was originally banned by the code of ethics.

In the 1970s and 1980s, the auditing business began to change. The number of new companies that needed auditing services was no longer expanding. If auditing firms wanted to grow, they would have to steal the clients from other auditing firms. The code of ethics was changed to permit advertising and other competitive practices. Auditing firms began to advertise and cut auditing prices to lure new clients. The relationship between the auditing firm and the audited company also began to change. With other audit firms courting them, corporate managers no longer tolerated adversarial auditors. Auditors became friendlier in order to keep their clients, especially the larger companies. It is prestigious to have Fortune 500 companies as clients, so auditing firms changed from Doberman watchdogs to poodle lapdogs in order to keep them as clients. During this period, auditing firms also developed consulting services to advise companies on how to improve their accounting methods and business activities. This provided both another source of income for auditing firms and solidified their relationship with company management.