Fred Stern & Co Acc492 Case Study

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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 ¡§socialize¡¨ investment losses by extending auditors¡¦ 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. Auditors¡¦ 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 auditors¡¦ 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 ¡V brokers, dealers, and exchanges ¡V 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...
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