Michael James Dailey
THE PENNSYLVANIA STATE UNIVERSITY

CYCLICAL ASPECTS OF TWENTIETH CENTURY AMERICAN ACCOUNTING

Abstract: A model of change in twentieth century American accounting is presented. The model describes three-phase cycles, each consisting of a reactive, a proactive, and synthesis phase. The text and Appendix illustrate and attempt to validate the model, and to make projections for the future.

The development of accounting in twentieth century America, as well as of accounting generally, has been chronicled in several excellent texts, some listed in the attached Bibliography, notably: A History of Accounting Thought; Management Accounting: An Historical Perspective; and A History of Accounting in America. These texts utilize a chronological approach, and the intent of this article is to restate these chronologies in a framework which interprets them as a cyclical pattern. A model is proposed that divides a cycle of events into three phases. Each cycle is initiated by a reactive phase, progresses through a proactive phase, and terminates with a synthesis phase.

The term “reactive” describes the response of the accounting profession to strong, external, environmental forces at the beginning of each cycle. These environmental forces may be political, financial, managerial,1 social, technological, or cultural.2 They call for a response from the profession, which takes various institutional actions, issues regulations and rulings, and resolves conflicts. At this stage, responses are reactions to pressure rather than coherent, structured formulations.

“Proactive” describes the processes and procedures occurring within the accounting profession itself to bring order to the resulting chaos. The proactive agents—professional accounting societies, state licensing boards, educators, individual practitioners, and even college/university accreditation agencies—pose questions, seek answers, compromise, and finally innovate to systematically change accounting. The resulting decisions, procedures, guidelines, etc. are the synthesis, which develops into the beginning phase of a new cycle as government and business force further innovative responses from accountants. The new responses generate their own problems and the shift to the proactive phase recurs

To illustrate the model, the article discusses twentieth century American accounting in three ways. The Appendix charts the re-active-proactive-synthesis phases of selected accounting topics. The text describes each cycle and its phases. Finally, implications for future directions of American accounting are projected.
Cycle 1: 1900-1939

The first decade of the twentieth century provided the American accounting profession with two powerful masters: industry, with its preference for nondisclosure; and financiers—mostly banks. Four reasons have been suggested for management secretiveness: a belief that the public had no right to information; a lack of any tradition of disclosure in the small, family owned predecessors of large industrial organizations; fear that disclosure would assist competitors; and the doctrine “let the buyer beware.”3 The accounting profession served the needs of this management class,4 and since most managements were very conservative, conservative accounting practices for fixed assets, inventory replacement, and dividend income were used by the accountants working for them.5 Conservatism, as used in accounting, means a method which tends to reduce the value of assets, and understate rather than overstate profits.6 However, management of another industry, corporation, or division of the same company might choose more liberal accounting methods. Bankers, of course, favored conservatism since it made loan repayment more likely and reduced the possibility of inflation.

During the first decade, two contrasting philosophies emerged variously labeled as the “Traditional American Creed” and “Pro-gressivism.”8 Social, economic, and legal theories emphasizing the rights of individuals and protecting ownership of tangible goods comprised the traditional American creed, whereas progressivism embraced the rights of the community, specifically stockholders, to information. The idea that government and corporate financial publicity served as a check against many public abuses was a progressivist creed. Business failures of the 1890s, resulting from stockwatering and overcapitalization, fueled the progressivists’ position. In response to such abuses, the federal government established the Industrial Commission in 1898. Its preliminary report, issued in 1900, suggested that an independent public accounting profession could provide a mechanism to curb them.9 The final report of the commission concluded that larger corporations should be required to publish annually a properly audited report so that the public and investors could not be deceived.10 Although these reforms were proposed, they were not enforced until the fourth decade of the century. This time lag occurred because busi-ness’s role in World War I caused a resurgence of the traditional American creed until the 1929 stock market crash. However, pro-gressivism encouraged the use of annual government budgets, adopted during the second decade.

The second decade of the twentieth century also saw the growth of municipal, state, and federal government,11 adding to the num-ber of social pressure groups. Municipalities, most states, and the federal government through the National Budgeting and Accounting Act of 1921, tended to centralize government accounting. Initially, government accounting did not impact the business sector. However, the Sixteenth Amendment of the Constitution, passed in 1913, and the Excessive Profits Tax of 1917, forced accounting on business firms. “CPA’s had the immediate problem of helping thousands of business men who had never felt the need to make financial statements, and who now got their first statistical view of their total operations.”12 Naturally, business firms wanted accounting practices which would minimize payment of federal taxes, and these included asset-value write-ups that continued through the 1920s.13 Thus, during the third decade of the twentieth century, the growth of accounting practice included tax expertise, advising business, and preparing credit reports to bankers.14
During this third decade, the Investment Bankers Association of America sought to standardize financial reporting in the securities field. Standardization, it was believed, would protect the Association and investors, and forestall government regulation. However, its suggestions were rarely followed, perhaps because members of the Association were indifferent, did not understand the recom-mendations, feared losing industrial clients, felt that their reputation in offering a stock was enough for potential buyers, or even protected dubious securities by nondisclosure.

During the first three decades of this cycle, accountants had little liability to third parties (investors). Courts maintained that since investors were not party (privy) to the contract between a firm and its auditor, they did not have the right to sue auditors (privity of contract). State (Blue Sky) laws also had little impact partly because most companies operated in more than one state, and also because states failed to fund enforcement of their investor protection laws. However, security holders continued to sue ac-countants for fraud, negligence, and/or breach of contract, to try and recover losses. By the end of the 1920s investors were successful in some audit liability cases, and third party liability increased in the 1930s.

Thus, security holders, especially investors in securities quoted on the New York Stock Market and the Investment Bankers Association of America, provided the final pressure during this cycle. The New York Stock Exchange in 1922 required that all listed corporations file complete annual financial statements. Although resisted by some corporations and investment bankers, ninety percent of issuers listed were filing annually by 1926.17 However, these rules drove some corporations to over-the-counter dealers and provincial exchanges. These nonfiling firms were required to comply with annual reporting requirements in 1964.

A variety of accounting practices had developed to serve the needs of bankers, businesses, government, stock market investors, and others. Each group sought information for its needs while sometimes denying the information needs of other groups. At different times the American Institute of Accountants, the Investment Bankers Association of America, accounting educators, individual practitioners, investors, bankers, and some stock market authorities argued for stronger and more uniform accounting disclosure during the first three decades of the twentieth century. The financial crash of 1929 provided the occasion to switch from the reactive to the proactive phase of the cycle, and to heal rifts between user groups. In quick succession, the federal government and stock exchanges in association with accounting societies undertook the task of defining reporting and disclosure principles. Theory and practice research programs were initiated by accounting societies.

Banks still favored conservative disclosure rules, based on corporate ability to repay credit. Industries now favored, and used, asset write-downs, while investors wanted to evaluate a company’s value on the basis of current and predicted income. Accountants were caught between two factions, creditors and investors, in terms of the “fairness doctrine,” a concept that financial disclosure be meaningful to all users of financial statements.20 To resolve this conflict, the New York Stock Exchange and the American Institute of Accountants met and developed compromises published in the 1934 Audits of Corporate Accounts.21 Financial statements were intended to emphasize income rather than assets and liabilities, generally accepted accounting principles were to be followed, and independent public accountants were to annually audit and certify reports to stockholders.

The Securities and Exchange Act of 1934 gave the federal government power to enforce uniform accounting principles, as part of Roosevelt’s “New Deal” to reestablish investor confidence. The investor was viewed as the primary user of financial infor-mation. Accountants sometimes joined with management to oppose government intervention, but they were sensitive to the charge of being a ”tool” of management, and acknowledged that responsibility for decisions rested on management.22 Now to protect investors, conservatism via asset understatement, income smoothing, and write-downs of asset value became the compromise solution.

Thus, the synthesis phase of the first cycle produced the fairness doctrine, compromise via conservative disclosure rules, and audits by independent public accountants. These, especially the conservative disclosure rules, provided the seeds for the reactive phase of the next period.

Cycle 2: 1940-1959

The pressure groups during this second period were much the same as during the previous period; however, power shifts were evident. Investors were more militant and united in their demands for income disclosure. Accounting societies, notably The American Institute of Accountants, now the American Institute of Certified Public Accountants, and the American Accounting Association, had grown in numbers and gained power from working through the 1930s with the SEC. They had matured in their relationships with each other, with business and the public. The American Institute issued fifty-one Accounting Research Bulletins between 1939 and 1959. The Institute’s APB Opinions and the SEC’s Accounting Series Releases generally reinforced each other, especially in agreeing that financial statements should be designed for stockholders rather than banks.24 Later they would diverge over historical cost and inflation accounting. For example, some corporations tried to augment depreciation based on original cost with additional charges in order to reflect the impact of inflation. This was initially disallowed by the SEC, but the compromise of accelerated depreciation was accepted.25 Although LIFO inventory valuation was first permitted in 1938, it was not until the 1954 Revenue Act that LIFO became a major force in accounting, largely through its tax implications.

The most dramatic changes were the increase of federal spending and inflation. World War II had a tremendous impact on capital expenditures. Since winning the war, as opposed to expected return on investment, was the criterion for capital expenditures, few capital budgets were studied until the 1950s. Later, the emergence of fund accounting by government agencies, high defense spending resulting from the Cold War, and the switch to performance budgets by the Defense Department in 1949, had the accounting profession racing to catch up with new responses to government and business innovations.

The proactive part of the cycle was affected by public ignorance and mistrust of financial statements,27 fed by the multiplicity of generally accepted accounting principles. Reduction of alternatives seemed to be the logical solution. The accounting societies undertook this task. Basic issues were asset valuation, depreciation, inventory pricing and corporate consolidations.28 However, the cycle ended with an increase in acceptable reporting practices, resulting from compromises based on how widely a practice was used rather than merit.29 Innovations were the proliferation of practices rather than a re-evaluation of the underlying principles. The synthesis of this period, multiple accounting principles, causes confusion and difficulty in today’s third cycle.

Cycle 3: 1960 to Present

The pressure groups of the second period remain, although power shifts are again evident. Inflation has gained prominence, and so has federal government spending. Conglomerate formation and dissolution require major accounting responses. New forces during this era are those involved in computer accounting and auditing, transnational corporations, franchise firms, consumer protection groups, government regulatory agencies, and self-regulation by the accounting profession itself.

The Program Planning Budget System, adopted by the Defense Department in 1961 and the entire federal government in 1968,30 requires projections into the future, while public accountants have restricted themselves to historical data. Federal laws and agencies currently involved in regulating accounting include the Employee Retirement Income Security Act (ERISA), the Securities and Exchange Commission (SEC), Federal Trade Commission (FTC), General Accounting Office (GAO), Occupational Safety and Health Act (OSHA), Internal Revenue Service (IRS), Interstate Commerce Commission (ICC), Federal Communications Commission (FCC), Federal Power Commission (FPC), Department of Housing and Urban Development (HUD), and Department of Defense (DOD).31 Not only federal agencies, but the grants funded by these agencies have increased the demand for accounting expertise, especially in the suggested formulation of cost-benefit budgets32 to justify repeated funding of the grants and their parent agencies. Federal taxation is a speciality in itself.

In addition, municipalities and states make investments and compete with business for investor funds. These government bodies also require accounting expertise. Budgets for nearly bankrupt cities such as New York and Cleveland have added to the demand for innovation by accountants.

Innovation is also needed for conglomerate formation and dis-solution, and multinational corporations. Transnational corporations have larger and more complex accounting systems than many countries. They have problems of comparable financial information encompassing fluctuating monetary values, legal deficiencies and potential liabilities under the Foreign Corrupt Practices Act of 1977.33

Franchise growth is a recent phenomenon. Fast food franchisers as well as franchisers in other areas present their own reporting problems. In contrast, the franchisees are often unaware of these complexities.

Consumer protection in the form of the social responsibility of accountants reached new heights following the social upheavals of the sixties and the disenchantment of the post-Vietnam and Watergate eras. The SEC, Congress, and courts all responded to the issues raised. SEC rulings and congressional hearings center primarily on the issues of independence in connection with the management advisory services offered by CPA firms, and the continued service by one audit firm of the same client, as well as the effectiveness of the Foreign Corrupt Practices Act. At the same time, the courts have responded to litigation regarding the liability of accounting firms in respect of both publicly held and private corporations. The thrust of all three, the SEC, Congress, and the courts seems to converge on a detective role for accountants, as in the 1136 Tenants’ Corporation v. Rothenberg Company suit in New York State.35 Against this, the U.S. Supreme Court’s 1976 decision in Hochfelder v. Ernst & Ernst further defined “material fact” and auditor liability to reduce third party liability of accountants.

Accentuating these problems are the advent and growth of computer accounting and auditing. Computers increase in sophistication faster than auditing controls. Understanding and controlling information constantly taxes both accountants and those developing and using computers.

Thus, accounting from 1960 to the present has had to deal with conflicts of government agencies versus business, and often each other; the public versus business and often the accounting pro-fession; the Courts versus Congress; SEC regulations versus trans-national corporations; and the computer versus all of the above. The proactive phase of this cycle affects the watchdog role of the auditor, the independence of accountants, the development of theories and principles of accounting for transnational corporations, accounting for inflation, government accounting and computer sys-tems. The accounting profession responds by compromises and dealing with problems on a continuing basis. Its internal actions include the replacement of the Accounting Principles Board by the Financial Accounting Standards Board (FASB) in 1973. This showed recognition of the interests of other pressure groups. External actions include congressional investigations such as those of Moss and Metcalf. Professional schools of accountancy have been established at a number of universities where the teaching of ac-counting by functional specialization areas has accelerated. Specializations include financial accounting, auditing, cost and managerial accounting, international accounting, advisory services, taxation, not-for-profit and government accounting, regulatory agency accounting, and specialized accounting by industry.

The evolving synthesis of this third cycle sees the accounting profession maintaining management accounting services (MAS) and successfully resisting requirements that clients change auditors frequently. However, the AICPA has abandoned its ban on advertising while maintaining one on uninvited direct solicitation. In addi-tion, the AlCPA’s board since 1977 includes three representatives of the public. Between 1972 and 1978 the SEC added regulations on peer review, interim reporting, replacement-cost disclosure, voluntary forecasting, and disclosure of services and fees (if they exceed three percent of audit fees) performed by auditors. (The last was rescinded in the fall of 1981.39) Notable is the acceptance by the accounting profession and government regulators of the need for a diversity of principles and theories. This proliferation of generally accepted auditing standards and accounting principles must confuse the most conscientious accountant or investor. The confusion extends to the scope and definition of accounting, of auditing and of financial reporting. For this reason, not only third party lawsuits but also client lawsuits have been increasing in number and amount of damages sought.40 There are unresolved difficulties with financial, cost and managerial accounting for inflation in different countries with varying inflation rates. These may be-come the problems of the next cycle.

Conclusion

The implications and applications of the model presented for future directions in accounting depend upon the acceptance of a pattern of cycles, and acknowledgement that external forces partially define the accountant’s role. The economic policies of the 1980s may cause patterns of post World War I and World War II to recur, as business is favored and single-issue groups, or groups hostile to business, are ignored. The future directions may bring continual if not intensified challenges to accounting tradition, supporting Sterling’s challenge to the use of conventional financial statements, based on historical cost, for managerial decision-making.41 However, the accounting profession has now developed mechanisms to anticipate and/or respond to different factions, to handle the ensuing discontinuities, and to discover answers both of compromise and innovation. Committees meet on a continuous basis and communicate in a non-crisis environment. Even if crises should arise, professional accounting societies and state boards are in place to handle them. Accountants react, proact, and synthesize because accounting principles cannot be formulated in a vacuum, outside the confines of social reality.

APPENDIX

PHASES OF SELECTED TOPICS IN TWENTIETH CENTURY AMERICAN ACCOUNTING

Topic/Period
Reactive Phase Pressures
Proactive Phase
Synthesis

Third Party Liability

1900-1930 Accounting firms v. third parties, Court decisions, State Blue Sky Laws.
1931 -1940 Accounting firms v. third parties, Court decision—New York Rule.
1938-1968 New York Law.

Maintain the primacy of privity concept.
Maintain the primacy of privity concept.

Seaver v. Ransom 224 N.Y. 223, 120 N.E. 639 (1918) maintained privity concept.
Landell v. Lybrand 264 Pa. 406, 107 A. 783 (1919), maintained privity concept and defendants must intend to deceive investor.
State Blue Sky Laws were unenforceable.

Ultramares Corp. v. Touche, Niven and Co. 255 N.Y. 170, 174 N.E. 441 (1931) Plus State Street Trust v. Ernest 278 N.Y. 104, 15 N.E. 2d 416 (1938) became The New York State Rule—lasted 30 years.

1) Gross negligence would equal fraud.
2) The third party had to be the primary user of the audit and this was known to the accountant.
3) Services of public accountants were primarily to the firm.
4) Desire to protect the accounting and other professions.

Topic/Period
Reactive Phase Pressures
1933-present 1929 Crash,
Federal regulations.
U. S. Supreme Court.

Proactive Phase
Privity concept,
“good faith,”
Generally accepted accounting
principles.
Negligence is not “aiding and abetting” fraud.

Synthesis
1934—accountant could use a “good faith” defense.
1942 SEC Rule 10b-5 (17 C.F.R. 240 10b-5).
Accountants guilty if they knowingly or unknowingly assist in fraud. 15 U.S. Code 77X (1970) Criminal as well as civil liability on public accoun-tants.
Hochfelder v. Ernst & Ernst, 503 F. 2d 1100 (7th Cir. 1974) Rev’d 96 S. Ct. 1375 (1976) No liability in cases of neglect.

Auditing 1900-1905
1905-1933
1933-1940 1940-1960

Banks, industry.
Shareholders, banks, industry.
Shareholders, banks, industry, government, liability of auditors. Shareholders, banks, industry, government, liability-accountant-

Detailed check for accuracy of historical data for firm, banks.
Detailed check for accuracy of historical data for firm, banks.
Check for accuracy of historical data by testing. Add Manage-ment Advisory Services. Check for accuracy of historical data by testing. Management Advisory Services.

Detect fraud & clerical error through checking detail, some tests, no recog-nition of internal controls.
Determine fairness and detect fraud & clerical errors by testing, and detailed analysis, some recognition of internal controls, install accounting systems.
Determination of fairness, detection of fraud & errors by testing and some internal controls.
Determination of fairness, detection of fraud and error by testing—substantial internal controls review.

Topic/Period 1960-present

Reactive Phase Pressures
Shareholders, banks, industry, government, liability, Foreign Corrupt Practices Act (1977), SEC, courts.

Synthesis
Proactive Phase
Check for accuracy of historical Determination of fairness includes fraud data by testing. Develop trans- and error—primarily done through in-national controls, peer review. ternal controls, peer review.

Financial Accounting

1900-1931 Industry, creditors,
shareholders, courts, American Institute of Accountants, Investment Bankers of America, American Institute of CPAs.
1931 -1940 Business, shareholders,
creditors, stock exchanges, Securities Acts 1933 and 1934, SEC.
1940-1960 SEC, industry, industriali-
zation, cost and managerial accounting, inflation, Accounting Research Bulletins, Investors,
1960-present Numerous government agencies,
inflation, investors. Foreign Corrupt Practices Act, 1977, transnational companies, franchisers and franchisees.

Serve client and creditors. Conservative accounting practices, asset-value write-ups.
Conservatism, income smoothing, discourage estimates of future earnings or appraisals of any kind.
Supplementary schedules; LIFO.
Generally accepted accounting practices.
Little information to third parties, Liquidity focus.

Generally accepted accounting principles. Switch to considering investors to be beneficiaries of financial statement. Asset write-downs.
Earning power, less reliance on his-torical cost, supplement conventionally-prepared financial statements with statements of general price-level changes, most detailed financial statements in the world.

Supplementary schedules, special generally accepted accounting princi-ples for small businesses.

FOOTNOTES
1Parker, p. 15.
2Baladouni, p. 59.
3Hawkins, p. 141.
4Chatfield, p. 232.
5May, Memoirs and Accounting Thought of George O. May, p. 23.
6Hatfield, p. 99.
7Garner, p. 321.
8Previts and Merino, p. 128.
9Preliminary Report . . . , p. 35.
10Final Report . . . , p. 82.
11Cleveland and Buck, p. 124.
12Chatfield, p. 207.
13Zeff, p. 293.
14Previts and Merino, p. 204.
15Hawkins, pp. 151-152.
16Davies, pp. 108-109.
17May, Twenty-five Years of Accounting Responsibility, Vol. 2, p. 54.
18Chatfield, p. 276.
19Storey, p. 3.
20Devine, pp. 129-130.
21American Institute of Accountants, Audits of Corporate Accounts.
22Landis, pp. 1-15.
23Paton, p. 266.
24Chatfield, p. 280.
25Previts and Merino, p. 273.
26Chatfield, p. 181.
27Storey, pp. 36-37.
28Chatfield, p. 295.
29Storey, p. 49,
30Chatfield, p. 199.
31Previts and Merino, pp. 332-334.
32Kreps, p. 14.
33Tipgos, p. 28.
34″0fficial Releases,” pp. 130-133.
351136 Tenants’ Corporation v. Rothenberg & Co. 36.
36Hochfelder v. Ernst & Ernst.
37Sedgwick, p. 58.
38Previts and Merino, p. 307. 39″News Report,” p. 7.
40″Lawsuits—They Could Happen To You,” p. 8. 41Sterling, p. 107.

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