Fred Stern & Company, Inc. was a rubber importer based out of New York City during the 1920s. This capital-intensive business was in high demand for numerous industries at the time. As such, Fred Stern & Co. relied heavily on lenders to finance its daily operations. In 1924, Fred Stern & Co. approached a finance company named Ultramares Corporation for a loan of $100,000. Before accepting the terms, Ultramares Corp. requested an audited balance sheet to serve as support for the loan.
A well-respected accounting firm named Touche, Niven & Co. had provided assurance for their statement a few months earlier, which allowed the deal to go through. The following year, in January 1925, Fred Stern & Co. filed for bankruptcy and Ultramares Corporation found itself suing Touche, Niven & Co. for fraud & negligence to recover $165,000 lost in the agreement. When reviewing the case thoroughly, there are various red flags, overlooked by Touche Niven that should have been clear indicators of fraudulent reporting by Fred Stern Co. Firstly, when commencing the audit in February, Touches’ auditor Siess had to complete the general ledger & trial balance himself.
It had not been posted since the prior April. This resulted in him reviewing some of his own work. Following this event, Stern’s accountant booked an additional entry debiting receivables and crediting sales in the amount of $700,000, more than doubling the accounts receivables account. As an explanation, he claimed that the entry represented December sales omitted from the accounting records. Additionally, while auditing inventory, Touches’ auditor discovered several errors, which caused the inventory record to be overstated by more than $300,000, an overstatement of 90%.
Also, while auditing payables, more errors appeared and the auditor discovered that the company had improperly pledged the same assets as collateral for several bank loans. We should also consider the absence of a strong regulatory system at the time as well as the old acquaintance and good relationship between the firm and the client as red flags, which may have led the auditing firm to under-evaluate the risks of the audit. This case led to a long legal battle between the defendant Touche Niven & Co. , and the plaintiff Ultramares Corporation.
In the first ruling, the jury found the audit to be negligent but not fraudulent; however, the judge set this finding aside based on the doctrine of privity, which protects auditors from third party suits. Essentially, this ruling states that in common law, only parties of the contract or relationship in place should be allowed to sue and claim damages. Other parties that used the information in the audit report to make decisions did not have an explicit contractual agreement with the auditors. Therefore, a third party could not sue the auditor for damages if the audit report was misleading and caused the third party to lose money.
The SEC of 1933 did not hold auditors legally responsible to these third parties. As we can see, auditing rules have changed quite substantially from the 1920s to today. Following this ruling, the plaintiff appealed the ruling where an intermediate appellate court reinstated the negligence verdict stating that by offering an unqualified report, Touche Niven & Co. had an obligation to Ultramares since they relied on this information to base their decision of lending money to Fred Stern & Co. Finally, Touche Niven appealed the ruling which as a result brought the case to the New York Court of Appeals where a final decision was established.
In a unanimous decision, the court, led by Judge Benjamin Cardozo ruled the defendant not guilty based on the same conclusion from the first ruling. He stated that the law should not admit “to a liability in an indeterminate amount for an indeterminate time to an indeterminate class. ” He believed that Touche, Niven was not guilty to third parties because its relationship was with Fred Stern & Co. period. It is important to mention that judge Cardozo went on to criticize the accounting firm for its audit of the Fred Stern Co.
financials and that had they sued on basis of gross negligence, they would have been successful. Distinction being the fact that blindly giving assent is as bad as committing fraud. To reiterate, the difference between negligence (which they sued for) itself and gross negligence is in fact a relationship that exist between the parties in dealing. This case established that an auditor could be sued by a primary beneficiary for damages from negligence. A primary beneficiary is a party that has a direct benefit from the audit.
Non-privity parties could also sue for gross negligence. This increased the auditor’s legal exposure to third parties. The SEC of 1934 reflected these changes and many others; one significant change was that auditor’s had a much higher litigation risk due to their new responsibility to third parties. The audit report in the 1920’s was very basic. The audit report was titled the “Certificate of Auditors” and said that the auditors had examined only the balance sheet accounts and these accounts were in line with the explanations and information given to the auditors.
It then said that the statement presented a true and correct view of the financial condition of the company. This is very different from the audit report used today. Today, the audit report is much more detailed to help auditors avoid liability. Instead of simply examining the balance sheet, now we audited the balance sheet, income statement, statement of retained earnings and cash flows. Beyond just simply stating that the accounts are in line with the explanations and information received, auditors state that we conduct the audit in line with Generally Accepted Auditing Standards and explain what this means.
In the 1920’s, where the audit report would have said that the statements present a true and correct view of the financial condition of the company, the report now state that the statements present fairly, in all material respects the financial position of the company, and that the operations and cash flows are in line with Generally Accepted Accounting Principles. Many changes in the auditing profession have required these changes to avoid confusion from financial statement users.
The decision of extending the liability of auditors to third parties had impacts on all parties involved in an audit (accounting firms, audit clients and third-party financial statement users). The question of whether the auditors are responsible for “socializing investment losses” became important. “Socializing investment losses and privatizing profits” can be defined as ” how businesses and individuals can successfully benefit from any and all profits related to their line of business, but avoid losses by having those losses paid for by society.
Privatizing profits and socializing losses suggests that when large losses occur for speculators or businesses, they are able to successfully lobby government for aide rather than face the consequences of said losses. “1 In other words, when losses are occurred by the investors or creditors of an audit client, the auditors would be as liable to them as the audit client itself to compensate for the losses occurred due to misrepresentations on the financial statements or in case of fraud. This is basically what extending the liability of auditors did.
The changes in the SEC of 1934 and the new laws that arrived after that, forced certain changes to the way the auditors had to approach their work. It is now their responsibility to ensure that the work being done is enough to provide a high level of assurance to all the users of financial statements. This means ensuring that they do their due diligence, in case that there is misrepresentations in the financial statements audited or fraud and that they are being sued for gross negligence. The auditors would have to prove that they did the work necessary to provide that high level of assurance.
The auditors would also have to be more careful when choosing their audit clients as they cannot chose anyone they are already doing consulting for (remain independent). However, the fact that the consulting firms and auditing firms are now separate for the same client eliminates the “lowballing” of audit fees. The change to the liability of auditors also impacted the audit clients because they are no longer the only one responsible in case of misrepresentations if the financial statements. However, since the auditing firms no longer “lowball” their fees, the clients will now have to pay more for the same audit.
The change also impacted the third-party financial statement users. They now have more peace of mind when it comes to the information they are reading since they know the auditors know that they have to keep them in mind when doing their audit. This fact is enforced by the idea that the third-parties now have insurance from the auditors that if any misrepresentations occur in the financial statements that incurred losses for the investors or creditors of the audit client, they can now recover some (or all) of it by suing the auditors for gross negligence.
The decision of extending the liability of auditors to third-parties was made by courts. This brought up the question: Who should have the authority to chose who should socialize the investment losses? Since the accounting profession is supposed to be self-governing, this question is valid. The Canadian Institute of Chartered Accountants (CICA) is the association responsible of their members when they break the code of conduct in Canada. It hands penalties to the members but also sets guidelines as to what is ethically expected of them. However, they do not have the authority to serve as a court because they are not considered impartial.
An argument can be made to say that the government should protect the investments. The government can do such a thing by developing laws that will help the courts make their decisions. An example of the government making a law to help determine who is responsible in case of fraud would be Bill C198 (the equivalent of Sarbanes-Oxley for Canada). Since it is the courts’ duty to “uphold the rule of law (…) and enforce laws in a fair and rational manner”2, it is their responsibilities as impartial party to determine who is responsible for the losses occurred in cases of fraud.
When conducting an audit, auditors must ensure always ensure that any and all information influencing third party user’s decisions is included in the financial statements and/or attached notes. To ensure this, the auditor must determine these users. Knowing and understanding the third party users will inform the auditor of management’s desired results and will therefore enable the auditor to conduct the audit more efficiently.
For example, a company who is looking to secure new loans will want to minimize the current debt on their balance sheet as well as show a high working capital ratio to ensure their creditors will loan them the desired financing. Contrary to this example would be companies entering the stock market. With the launch of an IPO, companies want to show profitable results as well as increasing growth to ensure a high stock price. This is especially true for companies whose loans are secured by their stock (i. e. Enron with its stock trigger).
This stage of the audit planning must be completed/updated every year since management’s goals may vary from year to year. The auditor will then use management’s biases to organize the audit. More experienced auditors will work on the “riskier” accounts, whereas newer employees will work on the “less risky” accounts; thus explaining why the junior accountant will be responsible for auditing the cash section while the senior auditor might work on deferred revenues for a company receiving all of its revenues through exterior funding.
Knowing and understanding the third parties’ needs will ensure a more efficient audit. However, even with all improvements made to the accounting world, cases like these still happen today. In a recent case involving a very reputable accounting firm, Ernst & Young, audited fraudulent financial statements of Sino-Forest made their way to the public. Evidently, this led to many losses, specifically for Sino-Forest’s shareholders who investment decision was based on the company’s financial statements.
During their audit, Ernst & Young failed to discover that management “materially overstated the size and value of its forestry assets”. 3 Ernst & Young had to pay a $117M settlement of a shareholder class-action lawsuit. 4 Due to cases like these, changes are continuingly made to auditing standards to adopt when new issues surface. The case brought up a possible change: the inclusion of the third party users in the audit report. Evidently, clients would be resistant to this change as it would limit their options.
If a client discovers later on in the year a shortage of cash but did not mention a creditor in the audit report, creditors might not want to finance their activities solely on that basis. Furthermore, due to the importance and the quantity of users relying on the financial statements, enumerating all of them in the audit report would be impractical and unnecessary. Auditors need to remain diligent when conducting their work and limiting their responsibilities’ to a specific number of individuals would not benefit the public.
We would not want another case like this one to enable an auditor to conduct a negligent audit without suffering the necessary repercussions. In conclusion, the accounting world is an ever evolving practice. New rules and regulations are approved every year when loopholes are discovered and abused. The accounting profession has surely matured since the 1920s. Who knows what other changes will be made in the future. Maybe auditors will need to disclose a summary of all unadjusted misstatements or even need to create a different audit report for every different user.
