Fred Stern & Company, Inc., a rubber importer based in New York City in the 1920s, heavily relied on lenders to finance its capital-intensive business. In 1924, the company approached Ultramares Corporation for a loan of $100,000. Ultramares Corp. requested an audited balance sheet before approving the loan, and Touche, Niven & Co., a reputable accounting firm, had provided assurance for the statement. However, in January 1925, Fred Stern & Co. filed for bankruptcy, leading Ultramares Corporation to sue Touche, Niven & Co. for fraud and negligence in an attempt to recover $165,000 lost in the agreement. Upon thorough review of the case, several red flags were overlooked by Touche Niven that should have indicated fraudulent reporting by Fred Stern Co. One such indicator was that Touches’ auditor Siess had to personally complete the general ledger and trial balance when starting the audit in February.
It had not been posted since the prior April, resulting in Stern reviewing some of his work. As a result, his accountant made an entry debiting receivables and crediting sales for $700,000. This entry more than doubled the accounts receivables account. Stern claimed that the entry was for December sales that were omitted from the accounting records. Furthermore, during the audit of inventory, Touches’ auditor found several errors. These errors caused the inventory record to be overstated by over $300,000, which is a 90% overstatement.
Additionally, during the audit of payables, the auditor found more mistakes and uncovered that the company had wrongly used the same assets as collateral for multiple bank loans. It is important to note that the lack of a robust regulatory system and the existing familiarity and positive rapport between the auditing firm and the client could be viewed as warning signs. These factors might have influenced the auditing firm to underestimate the risks associated with the audit. Consequently, this incident resulted in a prolonged legal dispute between the defendant, Touche Niven & Co., and the plaintiff, Ultramares Corporation.
The first ruling of the jury determined that the audit was negligent but not fraudulent. However, the judge disregarded this finding due to the doctrine of privity, which shields auditors from being sued by third parties. This ruling asserts that under common law, only parties involved in the contract or relationship are entitled to sue for damages. Other parties who relied on the audit report to make decisions did not have a direct contractual agreement with the auditors. Hence, if the audit report was deceptive and caused financial losses to a third party, they would not be able to sue the auditor for compensation.
The Securities and Exchange Commission (SEC) of 1933 did not make auditors legally responsible to third parties. Auditing rules have changed significantly since the 1920s. As a result of this ruling, the plaintiff appealed, and an intermediate appellate court reinstated the negligence verdict. The court stated that Touche Niven & Co. was obligated to Ultramares because they provided an unqualified report on which Ultramares relied when lending money to Fred Stern & Co. Touche Niven then appealed the ruling, bringing the case to the New York Court of Appeals, where a final decision was made.
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.
The financials could have been successfully sued for gross negligence if they had been blindly given consent, as blindly giving consent is as bad as committing fraud. It should be emphasized that the distinction between the negligence they sued for and gross negligence lies in the relationship between the parties involved in the transaction. This case set a precedent that allows a primary beneficiary to sue an auditor for damages caused by negligence. A primary beneficiary is a party that directly benefits from the audit.
Non-privity parties had the ability to pursue legal action against auditors for cases involving gross negligence, thus significantly increasing the auditors’ liability towards third parties. The Securities and Exchange Commission (SEC) of 1934 encompassed various changes, including the auditors’ heightened risk of litigation due to their newfound responsibility towards third parties. In the 1920s, the audit report was considerably simplistic, known as the “Certificate of Auditors,” which solely certified the examination of balance sheet accounts in accordance with explanations and information provided to the auditors.
The current audit report differs significantly from the historical one. The latter attested to the financial situation of the company as true and accurate. Conversely, the modern audit report provides more detailed information to protect auditors from liability. In addition to scrutinizing the balance sheet, auditors now also examine the income statement, statement of retained earnings, and cash flows. Furthermore, auditors not only confirm that the accounts align with explanations and received information but also state that the audit adheres to Generally Accepted Auditing Standards (GAAS) and elaborate on its implications.
In the 1920’s, the audit report would have declared that the financial statements accurately portray the company’s financial condition. Nowadays, the report asserts that the statements fairly represent the company’s financial position and that its operations and cash flows are in line with Generally Accepted Accounting Principles. These changes have been necessary in order to prevent confusion for users of financial statements.
The extension of auditors’ liability to third parties had consequences for all parties involved in an audit, including accounting firms, audit clients, and third-party financial statement users. The issue of whether auditors are responsible for “socializing investment losses” became significant. “Socializing investment losses and privatizing profits” refers to the ability of businesses and individuals to reap all profits from their business ventures but shift the burden of losses onto society.
Privatizing profits and socializing losses refers to the practice in which speculators or businesses are able to seek government assistance to cover their large losses instead of facing the repercussions themselves. In other words, when investors or creditors of an audit client experience losses due to misrepresentations on financial statements or fraud, auditors can be held liable alongside the audit client for compensating them. This extension of auditor liability aims to address such situations.
The SEC of 1934 and subsequent laws ushered in changes that necessitated auditors to alter their approach to their work. Auditors now bear the responsibility of ensuring that their efforts offer a substantial level of assurance to financial statement users. This entails diligently performing their duties to uncover any misrepresentations or fraud in the audited financial statements, and to avoid being sued for gross negligence. Auditors must be able to substantiate that they executed the necessary work to provide this heightened level of assurance.
The auditors must exercise caution in selecting their audit clients as they are prohibited from choosing those for whom they already provide consulting services (to ensure independence). Nevertheless, the separation of consulting and auditing firms for the same client prevents the practice of offering excessively low audit fees. The altered liability of auditors also affects audit clients, as they are no longer solely responsible for misrepresentations in financial statements. However, due to the elimination of lowballing fees by auditing firms, clients will now have to pay a higher amount for the same audit.
The change has also affected third-party financial statement users, who now have a greater sense of security about the information they are reading. This is because auditors are aware that they need to consider these users when conducting their audits. This notion is reinforced by the fact that auditors now provide insurance to third parties. If any misrepresentations in the financial statements result in losses for investors or creditors of the audited client, these third parties can now potentially recover some or all of those losses by suing the auditors for gross negligence.
The courts made the decision to extend auditors’ liability to third parties, which raised the question of who should decide who bears the investment losses. As the accounting profession is self-governing, this question is significant. The Canadian Institute of Chartered Accountants (CICA) is responsible for disciplining its members who violate the code of conduct in Canada. It imposes penalties and establishes ethical expectations for its members. However, since the CICA is not considered impartial, it does not have the authority to act as a court.
One could argue that the government should safeguard investments by implementing laws that assist courts in making decisions. An illustration of such a law is Bill C198, which serves as Canada’s version of the Sarbanes-Oxley Act and aids in identifying those accountable for fraud. As it is the courts’ obligation to “uphold the rule of law (…) and enforce laws in a fair and rational manner,” it falls upon them, as unbiased entities, to ascertain liability for financial losses resulting from fraud.
When conducting an audit, it is crucial for auditors to always ensure that any information affecting the decisions of third-party users is included in the financial statements or attached notes. To accomplish this, auditors must identify these users and comprehend their needs and expectations. By knowing and understanding the third-party users, auditors will be able to conduct the audit more efficiently to achieve management’s intended outcomes.
For instance, when a company seeks new loans, it aims to reduce its existing debt on the balance sheet and demonstrate a strong working capital ratio, assuring lenders of their ability to repay the desired financing. Conversely, companies entering the stock market, especially through an initial public offering (IPO), strive to exhibit profitability and accelerating growth to bolster the stock price. This becomes crucial for companies whose loans are guaranteed by their stock value, such as Enron with its stock trigger.
Every year, the audit planning stage must be completed or updated as management’s goals can change. The auditor will utilize management’s biases to structure the audit. Typically, more experienced auditors handle accounts that are deemed higher risk, while newer employees handle accounts that are considered lower risk. This is why a junior accountant is responsible for auditing the cash section, while a senior auditor may handle deferred revenues for a company that receives all its revenues from external funding.
Understanding the needs of third parties is crucial for an efficient audit, but despite advancements in accounting, such cases still occur. Ernst & Young, a reputable accounting firm, recently audited fraudulent financial statements of Sino-Forest, resulting in significant losses for the company’s shareholders who relied on these statements to make investment decisions.
During their audit, Ernst & Young neglected to identify that management had exaggerated the extent and worth of its forestry assets. As a consequence, Ernst & Young was legally obligated to pay a settlement of $117M in response to a lawsuit brought by shareholders. These types of cases serve as catalysts for ongoing modifications to auditing standards, aimed at addressing emerging concerns. In fact, this specific case prompted consideration for a potential alteration: including third-party users in the audit report. Understandably, clients would likely oppose this amendment due to its potential restriction of their choices.
If a creditor is not mentioned in the audit report, and the client discovers a cash shortage later in the year, it may deter creditors from providing financing. Additionally, including all users of the financial statements in the audit report would be impractical and unnecessary due to their importance and quantity. Auditors should maintain diligence in their work and limiting their responsibilities to a specific number of individuals would not be advantageous for the public.
It is important that we prevent a situation similar to this one, where an auditor can perform a negligent audit without facing the appropriate consequences. In conclusion, accounting is a continuously evolving field. Each year, new rules and regulations are established to address loopholes that have been identified and exploited. The accounting profession has undoubtedly progressed since the 1920s, and it is unclear what other modifications will occur in the future. Perhaps auditors will be required to disclose a summary of all unadjusted misstatements or even produce distinct audit reports for each individual user.
