Fred Stern & Co Acc492 Case Study

Week Five Case Studies

Team D

ACC 492

January 15, 2007

CASE 8.1

FRED STERN & COMPANY, INC.

1. Observers of the accounting profession suggest that many courts attempt to ÐŽ§socializeЎЁ investment losses by extending auditorsÐŽ¦ liability to third-party financial statement users. Discuss the benefits and costs of such a policy to public accounting firms, audit clients, and third-party financial statement users, such as investors and creditors. In your view, should the courts have the authority to socialize investment losses? If not, who should determine how investment losses are distributed in our society?

The word "socialize" is used to suggest a socialist society in which profits and losses are shared by and distributed to the general public by the central government through taxation, legistration, social welfare, or some other legal means. In contrast, the capitalist society is rewarded to the risk takers alone (the auditors in this case).

Until the case of Ultramares Corp. v. Touche, auditors admitted no liability whatsoever to third parties. The judgment in Ultramares reaffirmed the principle that a fraudulent accountant, not a negligent one, would be liable to third parties misled by his or her statements. This case has had an impact on the work of auditors in terms of the care they exercise in preparing the auditor's report. Coercive forces compelled auditors to adopt behaviors to do what it takes to protect them from third-party liability by producing high-quality work.

The auditor owes a duty of care to the particular third party. The range and number of persons who could suffer loss consequent upon negligent performance of the audit function is large, and may include existing shareholders of the company in question, potential investors (future shareholders), and banks and trade creditors, all of whom may have relied on the audit report.

2. AuditorsÐŽ¦ legal responsibilities differ significantly under the Securities Exchange Act of 1934 and the Securities Act of 1933. Briefly point out these differences and comment on why they exist. Also comment on how auditorsÐŽ¦ litigation risks differ under the common law and the 1934 Act.

Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 to restore investor confidence in our capital markets by providing more structure and government oversight. The main purposes of these laws can be reduced to two common-sense notions:

„« Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.

„« People who sell and trade securities ÐŽV brokers, dealers, and exchanges ÐŽV must treat investors fairly and honestly, putting investors' interests first.

Companies raise billions of dollars by issuing securities in what is known as the primary market. Contrasted with the Securities Act of 1933, which regulates these original issues, the Securities Exchange Act of 1934 regulates the secondary trading of those securities between persons often unrelated to the issuer.

Under the 1933 Act, plaintiffs do not have to prove fraud, gross negligence, or even negligence on the part of auditors. Essentially, plaintiffs must only establish that they suffered investment losses and that the relevant financial statements contain material errors or omissions.

The injured third parties may seek to recover from auditors under common law or statutory law, but under the Securities Exchange Act of 1934, accountants may be held liable to actual buyers and sellers of public securities for fraud or gross negligence.

3. The current standard audit report differs significantly from the version issued during the 1920s. Identify the key differences in the two reports and discuss the forces that accounted for the evolution of the audit report into its present form.

A financial statement audit report is an independent qualified public accountantÐŽ¦s opinion of the organizations financial statements. It serves two principal roles. First, it assures participants that the financial statements fairly present the financial condition of the organization and that the organization is generally operated in accordance with its terms. Second, the audit report completes the organizations compliance requirements.

Before the Great Crash of 1929, there was little support for federal regulation of financial documentation. This was particularly true during the post-World War I surge of securities activity. Proposals that the federal government require financial disclosure and prevent the fraudulent sale of stock were never seriously pursued.

The 1920ÐŽ¦s era was characterized by the growth of corporations, more widespread public ownership of stock and the separation of ownership and management. These developments created a need to further standardize the distribution of information to investors. After the Great Crash in 1929, it became clear that audit reporting standards were needed for all public companies, so in 1933 and 1934 Congress created the SEC and gave it authority to prescribe financial accounting and reporting standards.

4. Why was it common in the 1920s for companies to have only an audited balance sheet prepared for distribution to external third parties? Comment on the factors that over a period of several decades resulted in the adoption of the financial statement package that most companies presently provide to external third parties.

In the 1920ÐŽ¦s , the balance sheet provided to creditors and third parties a clear picture of the companies financial position. At the time, third parties were only requiring the balance sheet as sufficient financial information. Although the auditing profession was in it's infancy in the early 1920's, generally accepted auditing procedures had not yet been developed at that time so the balance sheet was considered the reliable financial source required.

5. When assessing audit risk, should auditors consider the type and number of third parties that may ultimately rely on the clientÐŽ¦s financial statements?

In an audit, the auditorÐŽ¦s