Reference no: EM132759163

Called to Account

From the record of falsehood and betrayal with which Kreuger besmirched the very pillars of finance in the leading countries of the world has come, particularly in the United States, the erection of new safeguards for investors. In our Securities Act are to be found preventatives whose origin is to be traced definitively to the Kreuger experiences.

-K.L. Austin1

• News of Ivar Kreuger's suicide in March 1932 attracted great interest in the United States and Europe. Earlier profiles in publications such as Time and the Saturday Evening Post had made Kreuger a household name. People naturally wondered why one of the richest and most influential men in the world had taken his own life. Rumors of blackmail or syphilis abounded. One "witness" claimed that a letter from a famous actress had been found crumpled in Kreuger's hand.

• But four weeks later, when Price Waterhouse reported that $115 million of purported assets could not be accounted for, curiosity and pity turned to outrage. American investors held more than $250 million of securities issued by Kreuger's companies. The price of Kreuger & Toll stock dropped from $5 to 5¢ within weeks. Kreuger's American victims ranged from Rockefellers to widows and orphans.

Congressional action

• More than two years passed after the stock market crash of 1929 without substantive action from Congress. The factors that led to the crash were not easy for the general public to understand. Nor were they easy for Congress to address-especially with investment bankers, securities brokers, and other powerful business executives exerting their considerable political influence to stifle reform.

• But Kreuger's fraud captured the public's attention. Everyone wanted to know how his scheme worked. The New York Times published more than 300 articles about Kreuger's fraud during 1932 and 1933. Articles in Fortune, Business Week, and The Nation described the fraud and blamed accountants, investment bankers, directors, the stock exchanges, and ultimately the government for failing to protect the public.2 Millions of readers, attracted by the sensational aspects of the Kreuger fraud, received their first tutorial in the workings (and failings) of the American securities market. Pressure mounted for government action.

• On April 18, 1932, less than two weeks after Price Waterhouse issued its preliminary report on Kreuger's finances, Congressman Fiorello LaGuardia denounced on the floor of the House the "carelessness, indifference, or connivance of the New York Stock Exchange."3 Senators George Norris of Nebraska and Huey Long of Louisiana led a discussion of the Kreuger case in July and called for legislation to protect investors from "scoundrels who peddle blue-sky securities."4

• Franklin Delano Roosevelt was campaigning for the U.S. Presidency in 1932. FDR believed that securities regulation was a moral, as well as economic, issue. He often told the apocryphal story of a small village in New York that was devastated by the 1929 stock market crash. One hundred and nine of 125 families lost their savings and half of them lost their homes. Roosevelt blamed the New York Stock Exchange and the investment bankers for the villagers' misfortune. He promised federal legislation to require greater disclosure in the marketing of securities and to supervise stock exchanges.

On March 29, 1933, shortly after his inauguration, Roosevelt outlined his intentions in a speech to Congress:

• Of course, the Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn profit.

• There is, however, an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public.5

The Securities Act of 1933

• The Securities Act of 1933, often called the "truth in securities" law, was one of 15 major pieces of legislation signed by FDR during his first 100 days in office. With Congress passing an average of one major Bill per week, few senators or representatives completely understood what they were enacting. Legislators relied heavily on committees to draft legislation and trusted the committee chairmen to produce Bills worth voting for. Sam Rayburn of Texas, the powerful leader of the House Interstate Commerce Committee, was the man most responsible for guiding the Bill through Congress.

• The 1933 Act, which was modeled loosely on the British Companies Act, regulated the initial offering and sale of stocks and bonds to the public. The Act's primary goal was to ensure that investors received complete and truthful information about the securities offered for sale. To that end, it required corporations to register securities before offering them for sale to the public. Further, it required corporations to provide purchasers with a prospectus containing, among other things, an audited balance sheet and income statement.

• Congress adopted a "preventative" rather than "punitive" approach to regulation in drafting the 1933 Act. That is, Congress sought to prevent fraud by requiring all companies to publish a registration statement and prospectus before offering securities to the public. Such an approach burdened all companies in the hope of dissuading the (few) swindlers.

• Price Waterhouse partner George O. May testified at the Senate hearings and cautioned the senators against imposing overly burdensome regulations. "This is an absolutely unique thing," May testified, "and therefore I see danger in legislating against it. The public should always be protected, but there is always the question of balancing risks against the cost. If you erect machinery of protection that is too expensive you will kill industry. There is no use legislating when dealing with a super-crook."6

• But May's description of Kreuger as a "super-crook" was at odds with his own firm's investigative report. The Price Waterhouse auditors who examined Kreuger's accounting records in Stockholm reported that "the manipulations were so childish that anyone with but a rudimentary knowledge of bookkeeping could see the books were falsified."7 The report went on to state that "entries in [the] general books were palpably false, few entries even looking reasonable on the surface ...."8

• Unfortunately, no independent party had ever been granted access to Kreuger & Toll's accounting records. Congress concluded that requiring public corporations to open their books to auditors was a reasonable safeguard against future frauds. The vital question remaining was whether public accountants would continue performing corporate audits or whether Congress would establish a corps of government auditors to examine corporations' financial statements. Colonel Arthur H. Carter, a West Point graduate and a senior partner at Haskins & Sells, testified at the Senate hearings and urged the senators not to usurp the public accountants' role:

• SENATOR BARKLEY: Do you not think it is more in the interest of the public that is to buy these securities, if there is to be any checkup or any guarantee as to the correctness, that it be done by some government agency rather than by some private association of accountants?

The Securities Exchange Act of 1934

• Within a year of passing the 1933 Act, Congress began drafting a far more extensive piece of legislation to regulate securities trading. The Securities Exchange Act of 1934 sought to end many abusive practices that had been common during the 1920s. For example, the Act forbade "wash sales" (i.e., successive buy and sell orders) which had been used to give the impression of active trading. The Act also regulated insider trading and limited the amount of credit a broker could extend to a customer to finance securities purchases.

• The provision having the greatest impact on accountants was a requirement that public corporations file an annual report (Form 10-K) containing audited financial statements. Thus, the 1934 Act ensured a steady stream of revenue to the public accounting profession. All public corporations had to be audited annually and only CPAs were authorized to sign audit reports.

• The 1934 Act also established a new federal agency, the Securities and Exchange Commission, to administer and enforce federal securities laws. The SEC's Division of Corporate Finance reviews the annual, quarterly, and special reports filed by corporations as well as the registration statements for public offerings. The Division of Market Regulation oversees securities exchanges. The Division of Investment Management regulates securities brokers and dealers. The Division of Enforcement investigates suspected violations of securities laws and has the authority to levy fines, delist securities, and ban brokers or accountants from working in the securities market.

• The SEC is governed by five commissioners appointed by the U.S. President with the advice and consent of the Senate. To ensure bipartisan representation, not more than three commissioners may belong to the same political party. Joseph P. Kennedy, father of future President John F. Kennedy, served as the Commission's first chairman in 1934-1935.

McKesson & Robbins

• The media frenzy surrounding Ivar Kreuger's fraud eventually died down and the public's interest in accounting waned. But the discovery of a $19 million fraud at McKesson & Robbins in late 1938 put accountants and auditors back in the spotlight. Banner headlines announced F. Donald Coster's suicide. The Musica/Coster story was a newspaperman's dream-bribery, bootlegging, blackmail, and bloodshed. There were even allegations (later determined to be false) that Coster had illegally smuggled thousands of rifles to Generalissimo Franco's fascist troops in Spain.

• After the more prurient aspects of the scandal had been exhausted, journalists turned their attention to the auditors' failure to detect the massive fraud. Newsweek said the McKesson & Robbins fraud raised "the question of whether ... present accounting methods are adequate," and later opined that "existing laws and practices are not adequate to protect the public and stockholders of giant U.S. industries if the top officials are not honest."10 Business Week predicted in January 1939 that Coster's "misdeeds" were "bound to accelerate reforms in American corporate and accounting procedure."11

An editorial in the February 1939 Journal of Accountancy bemoaned the news media's renewed interest in accounting:

• Like a torrent of cold water, the wave of publicity raised by the McKesson & Robbins case has shocked the accountancy profession into breathlessness. Accustomed to relative obscurity in the public prints, accountants have been startled to find their procedures, their principles, and their professional standards the subject of sensational and generally unsympathetic headlines.12

The SEC investigates

• The McKesson & Robbins scandal threatened to destroy the public's fragile faith in the securities markets less than five years after Congress shored up the public's confidence with the Securities Acts. Quick action was needed to avoid another stock market crash. The SEC commenced an investigation on December 29, 1938 with the dual objectives of determining whether the Price Waterhouse auditors had complied with accepted auditing standards of the time and whether those standards were adequate to ensure the reliability and accuracy of financial statements.

• The SEC convened hearings from January 5 through April 25, 1939. Forty-six witnesses provided 4,587 pages of testimony and an additional 3,000 pages of exhibits. The topics discussed at the hearings ranged from the basic responsibilities of auditors and the meaning of the auditor's report to the ratio of accounting firm partners to staff and the specific procedures used to test various balance sheet accounts.

• While the SEC conducted its investigation, auditors frantically reviewed their own procedures with the goal of adopting improvements before the SEC mandated more draconian changes. The most authoritative compilation of auditing procedures at the time was a brochure entitled Examination of Financial Statements by Independent Public Accountants, published by the Institute of Public Accountants (the "Institute") in 1936. In early 1939, the Institute appointed a committee, chaired by Patrick Glover, to consider whether auditing procedures should be amended in light of the failures at McKesson & Robbins.

• By May 1939, Glover's committee had completed the first draft of its recommendations. The report recommended that auditors observe clients' physical inventory counts and confirm receivables via direct communications with debtors. Both procedures were recommended as best practices in the Institute's 1936 compilation of auditing procedures, but were not mandatory. The report also suggested that auditors be engaged or nominated by the board of directors rather than by company management. The recommendations were approved, with only minor revisions, by the members of the Institute at their 1939 annual meeting, and the substance of the report was published in Statements on Auditing Procedure No. 1, "Extensions of Auditing Practice."

• The SEC's final report on the McKesson & Robbins fraud, released in 1940, recommended reforms of auditor engagement and reporting practices.13 Noting that Coster had hired Price Waterhouse without input from McKesson & Robbins' board and that board members did not receive copies of the engagement letter or long-form audit report, the SEC recommended:

• Election of auditors for the current year by a vote of the stockholders at the annual meeting.

• Establishment of a committee, selected from non-officer members of the board of directors, to nominate auditors and arrange the details of the engagement.

• The short-form audit report (or opinion) should be addressed to the stockholders and copies of all other reports should be delivered by the auditors to each board member.

• Auditors should attend stockholder meetings to answer questions and should report whether they were given access to all the information they required.

• The SEC also recommended that auditors spend more time independently verifying assets rather than simply testing the accuracy of the client's accounting records. The SEC concluded, "The time has long since passed, if it ever existed, when the basis of an audit was restricted to the material appearing in the books and records."14 The report called for "a material advance in the development of auditing procedures whereby the facts disclosed by the records and documents of the firm being examined are to a greater extent checked by the auditors through physical examination or independent confirmation."15

• Other SEC recommendations included more thorough assessments of internal controls and more extensive background investigations of new clients.

Conclusion

• The Kreuger & Toll and McKesson & Robbins frauds were the most significant accounting scandals of the first half of the twentieth century. During the first 30 years after New York passed the first CPA legislation in 1896, more than 12,000 accountants earned the CPA designation and investors came to expect corporations to provide audited balance sheets. But the future of the public accounting profession hung by a thread in 1933 as Congress contemplated establishing a corps of government auditors to perform corporate audits.

• Ultimately, accountants and auditors benefited from Ivar Kreuger's chicanery. The Securities Acts of 1933 and 1934 increased the demand for public accountants' services by mandating that all public corporations file audited financial statements. Public accountants were perceived as watchdogs protecting innocent investors from swindlers such as Kreuger.

• Five years later, faith in the public accounting profession was almost destroyed by the revelation that a twice-convicted fraudster had deceived the most respected public accounting firm in the world. Powerful voices in government and the media questioned auditors' procedures and demanded reform.

• But once again, public accountants escaped relatively unscathed. The SEC declined to prescribe detailed audit procedures. The Commission commended Patrick Glover's committee for drafting new audit requirements in the wake of the McKesson & Robbins crisis. The American Institute of Accountants established the first permanent committee to write auditing standards in 1939. The Committee on Auditing Standards and its successors, the Auditing Standards Executive Committee and the Auditing Standards Board, were permitted to write auditing standards for the next six decades.

The February 1939 Journal of Accountancy editorial concluded:

• We feel that in the long run this publicity will not be entirely harmful to the profession. On no other occasion has there been as much public discussion about accounting simultaneously in all parts of the country. The importance of independent audits and of accounting procedure will not be forgotten. We predict that in the future auditors will encounter less resistance to examinations of wider scope and less effort to place limitations on their work than in the past.16

• While this might have sounded like wishful thinking during the depths of the McKesson & Robbins scandal, audits did expand in scope and frequency in subsequent years. The next 60 years were a time of growth and prosperity for the public accounting profession.

Notes

1 K.L. Austin, "Ivar Kreuger's Story in Light of Five Years," New York Times, March 7, 1937.

2 See, for example, Max Winkler, "Playing With Matches," The Nation, May 25, 1932.

3 Dale Flesher and Tonya Flesher, "Ivar Kreuger's Contribution to U.S. Financial Reporting," Accounting Review 61 (July 1986): 426.

4 Ibid.

5 James M. Landis, "The Legislative History of the Securities Act of 1933," George Washington Law Review 28 (October 1959): 30.

6 "Man Who Trapped Kreuger Describes Deals to Senators," New York Times, January 12, 1933.

7 "Ivar Kreuger III," Fortune, July 1933, 72.

8 Ibid.

9 John L. Carey, The Rise of the Accounting Profession: 1937-1969 (New York: American Institute of Certified Public Accountants, 1970), 186-188.

10 "Musica Case Presages New Steps to Safeguard U.S. Investors," Newsweek, December 26, 1938, 9; "Ledgers and Legends," Newsweek, January 2, 1939, 12.

11 "After Coster, Accounting Reform," Business Week, January 7, 1939, 15.

12 "The McKesson & Robbins Case," Journal of Accountancy 67 (February 1939): 65.

13 Securities and Exchange Commission, Accounting Series Release No. 19, In the Matter of McKesson & Robbins, December 5, 1940.

14 Ibid.

15 Ibid.

16 "The McKesson & Robbins Case".

Problem 1: How did the Securities Act of 1933 attempt to prevent financial frauds?

Problem 2: How did the Securities Act of 1934 attempt to prevent financial frauds?

Problem 3: What changes in auditing practices did the SEC recommend after investigating the McKesson & Robbins fraud?