By significantly increasing corporate tax rates and the complexity of federal tax laws, the U.S. Congress virtually mandated that businesses use the services of professional tax consultants, providing the catalyst for the development of the emerging profession of public accountancy.
The War Revenue Act, passed into law on October 3, 1917, significantly modified the existing corporate tax structure in the United States through the enactment of an excess-profits tax. Tax rates were increased from 1 to 12 percent with the avowed intention of raising revenue to defray costs associated with conducting World War I. Prior to this act, business income taxation had been so insignificant in amount that it was considered, for all intents and purposes, a nonexistent factor in the U.S. business environment.
Although this tax legislation affected all people in the United States, its most important consequences were reserved for management, shareholders, and the emerging profession of public accountancy. For the first time, it was abundantly evident that Congress would utilize its new powers under the Sixteenth Amendment
The history of income tax law in the United States, and the genesis of the War Revenue Act of 1917, can be traced to the Revenue Act of July 4, 1861.
A major obstacle to development of a far-reaching income tax during the later half of the nineteenth century and the first two decades of the twentieth century was the Constitution of the United States. The Constitution did not provide for an income tax without a proper apportionment of the tax burden among the states with respect to their populations. Such an apportionment would be extremely difficult, if not impossible. Congress, however, chose to overlook questions of constitutionality and enacted numerous tax provisions between 1870 and 1894. With each law, the judicial branch of government came into play. Ultimately, in Pollock v. Farmers’ Loan & Trust Company (1895),
The Sixteenth Amendment to the U.S. Constitution, which was ratified on February 25, 1913, gave Congress the constitutional power to lay and collect taxes on income, from whatever source derived, without any apportionment among the individual states. On October 3, 1913, the first constitutionally valid income tax, based on the cash receipts/disbursements concept as originally articulated in 1861, was enacted in the Revenue Act of 1913.
Yearly revenue-raising measures were enacted between 1914 and 1917 to replace the respective tax provisions as each expired. None was more complex or significant than the Revenue Act of 1913. These acts provided little evidence that Congress had more than a transitory and minimal interest in income taxation. It was widely believed that an insignificant tax bill would be enacted each year and that ultimately the necessity to raise revenue for the government would disappear, bringing an end to the income tax.
This simplistic, naïve belief and hope collapsed with the entry of the United States into World War I. Rapidly expanding business activity accompanied the war effort, leading to a dramatic increase in corporate profitability. Concurrently, the leaders of the United States were faced with a mandate to raise substantial sums of revenue in support of the war effort. The obvious course of action, given the relatively new congressional power to tax income, was to enact a scheme of corporate income taxation. Thus, with two objectives in mind—dampening corporate profitability and financing the military effort—Congress enacted the War Revenue Act of 1917, forever changing the business environment in the United States.
Passage of the excess-profits tax legislation had two critical effects on virtually every business in the United States. First, the corporate tax burden was, for the first time, increased to significant levels. Required payments to the government substantially decreased the profitability of many businesses and diminished the funds available for distribution to managers and shareholders in the form of salaries and dividends.
Second, the law added a high level of complexity and regulation to the already complex nature of American commerce. Businesses needed dependable, verifiable data on earnings to comply with the provisions of this legislation and to satisfy the accountability demands of the revenue service. Further, of paramount importance to business managers and shareholders was the need for expert knowledge and assistance to ensure that businesses did not pay too much in income tax. Therefore, the most immediate and far-reaching impact of the legislation on business and commerce was the attention it focused on the evolving need for competent professionals schooled in the fundamentals of income determination and the complexities of tax law. The question became, Who would fill this void?
The practice of public accountancy in the United States in the early 1900’s was evidenced by a limited usefulness to businesses. Businesses seldom sought out the advice of public accountants except in cases of fraud detection. Businesses were characterized by either common ownership and management or limited outside ownership with majority stockholders as management. The financial information desired by these parties concerned primarily calculations of net worth; they were not interested in measuring yearly performance. Accounting data were developed, as deemed necessary, by management and bookkeepers inside a company. Secrecy was the hallmark of the day, with little, if any, operational or financial information being supplied to anyone outside the management circle. When information was supplied to outside parties, it was of questionable value, as no mandated set of financial statements had been agreed upon. Exacerbating the situation further, what was published was lacking in conformity to any accounting standards of consistency or comparability. No rules of taxation or generally accepted accounting principles existed to guide the process.
Into this unregulated environment came the War Revenue Act of 1917, containing significant tax provisions that demanded proper accounting and reporting of taxable income in accordance with a detailed set of rules. A determination and assessment would be made concerning a business’s required, perhaps significant, payment to the government based on the contents of a self-prepared tax return. The net effect was to force businesspeople to direct attention to the income statement (tax return) and the proper determination of net income (taxable income). Management and owners were spurred to keep better internal accounting records, to keep such records in a consistent fashion in accordance with tax rules, to take an active interest in providing an accurate and proper accounting to the taxing authorities, and—most important to the emerging profession of accountancy—to seek competent advice from external tax professionals to ensure accuracy and to mitigate the substantial effects of the new tax provisions.
The adoption of the cash receipts/disbursements concept for tax reporting was of paramount importance. This approach required a specific set of rules for determining taxable income, rules based on sound accounting principles. Such a methodology placed public accountants, who were really master bookkeepers, in a preferred position because they alone possessed the necessary training and skills to respond successfully to businesspeople’s immediate need for reliable tax information. These skills also enabled them to respond to the changing tax environment of the future.
The potential for the profession was apparent, and public accountants were quick to respond. Leaders among the practitioners of the day were able to convince the business public, through exceptional service, that public accountants possessed the intelligence and initiative to cope with the new legislation. Norman L. McLaren has suggested that the War Revenue Act was the greatest single factor responsible for elevating the status of public accountants from master bookkeepers to members of an honored profession. He estimated that less than 10 percent of the businesses in the United States regularly used the services of public accountants prior to this historic event.
Corporate tax returns opened wide and profitable avenues for service, providing an impetus for the development of public accountancy in the United States. Educators such as Arthur E. Andersen of the accounting department at Northwestern University recognized that a system of formal education was a fundamental ingredient for the successful emergence of the profession. He had prepared a textbook for publication in 1917, perhaps the first such available, titled Complete Accounting Course. During the 1917-1918 academic year, Andersen expanded his curriculum by offering a course of six lectures on the wartime and excess-profits taxes. The lectures were well attended by prominent service professionals and business executives.
Other universities throughout the country, envisioning the instrumental part public accountants would be expected to play in the modern business world, reorganized their course offerings to provide intensive training in accountancy and taxation. Authors responded by publishing an array of books aimed at accountants in school and already in practice. Robert H. Montgomery, a prominent public accountant and influential member of the American Association of Public Accountants, wrote a tax treatise that, through yearly updates, would become the standard for accounting education and a required volume in the professional libraries of all practitioners.
The single most important long-term outcome of the War Revenue Act of 1917 was its demonstrated ability to raise significant amounts of revenue. It became clear to Congress that a readily available source of funds existed. New and expansive tax laws were developed and enacted in yearly revenue acts over the next two decades. This litany led to the permanent codification of the income tax system with passage of the Internal Revenue Code of 1939 (recodified in 1954 and 1986). For businesspeople, shareholders, and professional accountants, the income tax became a persistent feature in the business environment, and its presence elevated public accountants to positions of prominence as valuable members of business management teams.
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Arthur Andersen & Company. The First Fifty Years, 1913-1963. Chicago: Author, 1963. Historical account summarizes the development of one of the largest accounting firms in the world. Includes a chapter on the period from 1913 to 1920, with a section describing the impact of federal income tax law on the advancement of the profession of accountancy. Articulates the significant contributions and accomplishments of Andersen as a university professor. -
Brundage, Percival F. “Milestones on the Path of Accounting.” Harvard Business Review 29 (July, 1951): 71-81. An excellent overview of the growth of the accounting profession in the United States prior to 1950. A section assesses the impact of war and taxes on the profession, identifying World War I as a milestone. -
Chatfield, Michael. A History of Accounting Thought. Hinsdale, Ill.: Dryden Press, 1974. Covers the earliest development of accounting methods, the industrial era, and concepts of accounting theory. Chapter 15 concentrates on income taxation in the United States. Provides an excellent overview concerning the temporal evolution of revenue statutes and their importance to the development of accounting as a profession. -
Edwards, James Don. History of Public Accounting in the United States. East Lansing: Michigan State University Press, 1960. Offers a comprehensive analysis of the significant historical developments in public accountancy, emphasizing the growth and development of the profession in the United States. Chapter 6 concentrates on the period from 1913 to 1928, inclusive of the early years of income taxation. Extremely informative and readable. An excellent source for students at all levels. -
McLaren, Norman L. “The Influence of Federal Taxation upon Accountancy.” Journal of Accountancy 44 (December, 1937): 426-439. A lighthearted, thoroughly enjoyable depiction of the development of the accounting profession specifically addressing the significance of the income tax. Helpful for anyone interested in the history of accounting. -
Miranti, Paul J., Jr. Accountancy Comes of Age: The Development of an American Profession, 1886-1940. Chapel Hill: University of North Carolina Press, 1990. Highlights major events in the history of the accounting profession in the United States. -
Previts, Gary John, and Barbara Dubis Merino. A History of Accountancy in the United States: The Cultural Significance of Accounting. Rev. ed. Columbus: Ohio State University Press, 1998. Chronicles the history of the accounting profession in the United States, from the colonial period to the late 1990’s. Addresses accountancy from social, economic, and political perspectives. Chapters 5 and 6 cover the eras immediately before and after World War I. Includes bibliography and index.
U.S. Government Begins Using Cost-Plus Contracts
World War I
American Institute of Accountants Is Founded
McKinsey Founds a Management Consulting Firm
Ultramares Case Establishes Liability for Auditors