Centre for Economic Policy Research

3.2
The evolution of auditing, standards and regulation
From the earliest days of separation between managers of resources and their 
owners, there has been a role for an auditor to provide some credibility, certifica-
tion or validation of the financial information being conveyed (O’Connor, 2002).
Each nation can trace its auditing roots back to examples where managers were
separated from and reporting back to the owners or creditors. 
In the United Kingdom, the South Sea Bubble in 1720 highlighted a need for
independent monitoring of claims made by promoters of share offerings in a 
27

---

public stock market. It was more than a century later, however, before the audit
profession was created as a by-product of the industrial revolution, with the 
enactment of company legislation. The first professional organization of account-
ants was the Institute of Chartered Accountants of Scotland (ICAS), which
received its Royal Charter in 1854, followed 26 years later by the combination of
several local professional accounting societies in the Institute of Chartered
Accountants of England and Wales (ICAEW). These professional accountants and
auditors also played a significant role in the development of the accounting 
profession in the United States as they were sent there to ‘protect’ the capital 
provided by British investors to develop American railroads and industry in the
late nineteenth century (Davidson and Anderson, 1987). Of the ‘Big 6’ global
audit firms that operated in the 1990s, all but Arthur Andersen can trace its roots
back to members of the English or Scottish Institutes. The professional society of
accountants in the United States evolved from a small local organization founded
in New York in 1887 to become the American Society of Certified 
Public Accountants in 1921 and finally the American Institute of Certified Public
Accountants (AICPA) in 1957 (O’Connor, 2002). In many other countries either
where the role of accounting reports was more closely matched with tax reports,
or where governments played a larger role as suppliers of capital to industry, a
‘statutory auditor’ was appointed to report on compliance with laws rather than
on economic activity. 
History suggests that a private demand for audit services exists whenever man-
agers are separate from the suppliers of capital. The services provided and the
scope of the ‘reports’ that are made by auditors will vary with the nature of this
demand. For example, in Germany the large universal banks ‘owned’ the audit
firms to ensure independent validation of the accounts of companies to which
they supplied capital.
20
When we consider that much of the early capital, 
especially in countries with universal banking systems, was provided by ‘private
placement’ of debt rather than equity issues, it is likely that early voluntary audits
provided sufficient information to support a ‘credit rating’. Thus, the creation of
a separate rating business, discussed in the next chapter, is not independent of the
changing role of auditing over time. More generally, the auditor’s role evolved
from providing information to a select group of suppliers of capital to a broader
set of users, with a transformation of the auditors’ reports from a private to a 
public good. 
While private demand for audits providing independent validation of accounts
existed for centuries, the growth of public markets for equity was the primary 
catalyst for a shift of the audit report to a public good. The two largest equity 
markets at the beginning of the twentieth century were in the United Kingdom
and the United States. The United Kingdom had already enacted its Companies
Act that made audit opinions a statutory obligation. There was, however, no 
similar federal legislation in the United States until the stock market crash of 1929
convinced the public that auditors were not sufficiently independent of 
managers. The US regulatory response was the Securities Act of 1933, which led to
the requirement that companies offering shares to the public must submit regular
financial statements certified by an independent public or certified accountant.
The Securities Exchange Act of 1934 created the Securities and Exchange
Commission (SEC), which was given jurisdiction over the accounting profession
and its rules.
21
From the New Deal until the recent enactment of the Sarbanes-Oxley Act of
2002, the SEC delegated its accounting and auditing rule-making authority to 
private standard setting bodies with self-regulation and SEC oversight. In finan-
cial accounting, standard setting was initially delegated to AICPA committees; but
28 Conflicts of Interest in the Financial Services Industry

---

perceived conflicts of interest led to a series of reforms that gradually evolved into
an independent Financial Accounting Standards Board (FASB) in the early
1970s.
22
For auditing, in contrast, the AICPA retained its standard setting role
with the Auditing Standards Board writing the principles and rules for indepen-
dentauditors. Most of these rules pertained to the conduct of an audit and the
nature of the reports the auditor provided, but there were also rules for oversight
and self-regulation. Specifically, under the AICPA rules, auditors were required to
have other audit firms perform peer reviews of their work; and there was a Public
Oversight Board that provided an additional level of oversight on auditors and
audit firms. 
In response to the recent spate of business and audit failures the AICPA’s 
self-regulatory efforts have been called into question. As a result, the 
Sarbanes-Oxley Act of 2002 established the Public Company Accounting
Oversight Board (PCAOB). Under the SEC’s oversight, the PCAOB will register 
public accounting firms, and establish rules for auditing, quality control, ethics,
independence and other standards. In addition, it will conduct inspections of
accounting firms and when needed carry out investigations and disciplinary 
proceedings and impose sanctions. The PCAOB has indicated its intention to take
over the rule-making authority for auditing standards, while leaving accounting
rules in the hands of the FASB, at least for now. 
The evolution of accounting and auditing standards has followed a similar path
in the United Kingdom, with the ICAEW having responsibility for standard 
setting in both areas until recently. An Accounting Standards Board (ASB) was 
created along the lines of the FASB in 1990. The United Kingdom’s ASB is appoint-
ed by the Financial Reporting Council (FRC), a body that is supposed to be 
independent of the professional societies, being the ‘guardian’ of the ‘Combined
Code’ of the Listing Rules and the accounting and auditing aspects of the
Companies Act (ICAEW, 2003b). 
Recently most European countries have sought to find a balance between their
national standards, which evolved independently, and the regulations imposed
by the European Commission on EU members. In 2002, the European
Commission published a report, ‘Statutory Auditors’ Independence in the EU: A
Set of Fundamental Principles’, that the ICAEW (2003c) accepted as best practice
in areas not already covered by existing guidelines, in advance of a comprehen-
sive review. The European Commission has also mandated that by 2005 all
European listed companies, with a few exceptions, should employ the
International Accounting Standards.