In the business world of the Roaring Twenties, the schemes and scams of flimflam artists and confidence men were legendary. The absence of a strong regulatory system at the federal level to police the securities markets—the Securities and Exchange Commission was not established until 1934—aided, if not encouraged, financial frauds of all types. In all likelihood, the majority of individuals involved in business during the 1920s were scrupulously honest. Nevertheless, the culture of that decade bred a disproportionate number of opportunists who adopted an "anything goes" approach to transacting business. An example of a company in which this selfserving attitude apparently prevailed was Fred Stern & Company, Inc. During the mid-1920s, Stern's executives duped three of the company's creditors out of several hundred thousand dollars.

Based in New York City, Stern imported rubber, a raw material demanded in huge quantities by many industries in the early twentieth century. During the 1920s alone, industrial demand for rubber in the United States more than tripled. The nature of the rubber importation trade required large amounts of working capital. Because Stern was chronically short of funds, the company relied heavily on banks and other lenders to finance its day-to-day operations.

In March 1924, Stern sought a $100,000 loan from Ultramares Corporation, a finance company whose primary line of business was factoring receivables. Before considering the loan request, Ultramares asked Stern's management for an audited balance sheet. Stern had been audited a few months earlier by Touche, Niven & Company, a prominent accounting firm based in London and New York City. Touche had served as Stern's independent auditor since 1920. Exhibit 1presents the unqualified opinion Touche issued on Stern's December 31, 1923, balance sheet. Stern's management obtained 32 serially numbered copies of that audit report. Touche knew that Stern intended to use the audit reports to obtain external debt financing but was unaware of the specific banks or finance companies that might receive the audit reports. fter reviewing Stern's audited balance sheet, which reported assets of more than $2.5 million and a net worth of approximately $1 million, and the accompanying audit report, Ultramares granted the $100,000 loan requested by the company. Ultramares later extended two more loans to Stern totaling $65,000. During the same time frame, Stern obtained more than $300,000 in loans from two local banks after providing them with copies of the December 31, 1923, balance sheet and accompanying audit report.

Unfortunately for Ultramares and the two banks that extended loans to Stern, the company was declared bankrupt in January 1925. Subsequent courtroom testimony revealed that the company had been hopelessly insolvent at the end of 1923 when its audited balance sheet reported a net worth of $1 million. An accountant with Stern, identified only as Romberg in court records, concealed Stern's bankrupt status from the Touche auditors. Romberg masked Stern's true financial condition by making several false entries in the company's accounting records. The largest of these entries

involved a debit of more than $700,000 to accounts receivable and an offsetting credit to sales.

Following Stern's bankruptcy, Ultramares sued Touche to recover the $165,000 loaned to Stern. Ultramares alleged that the audit firm had been both fraudulent and negligent in auditing Stern's financial records. The New York Times noted that the resolution of the negligence claim in the Ultramares case would likely establish a legal precedent for future plaintiffs hoping to recover losses from audit firms. The novel aspect of the negligence claim stemmed from the absence of a contractual relationship between Touche and Ultramares. Touche's contract to audit Stern's December 31, 1923, balance sheet was made solely with Stern's management. At the time, a wellentrenched legal doctrine dictated that only a party in privity with another—that is, having an explicit contractual agreement with another—could recover damages resulting from the other party's negligence.

Another interesting facet of the Ultramares lawsuit involved the founder of Touche, Niven & Company, Sir George Alexander Touche. George Touche, who served for two years as the sheriff of London during World War I, merged his accounting practice in the early 1900s with that of a young Scottish accountant, John B. Niven, who had immigrated to New York City. The new firm prospered, and George Touche, who was knighted in 1917 by King George V, eventually became one of the most respected leaders of the emerging public accounting profession. John Niven also became influential within the profession. Ironically, Niven was serving as the president of the American Institute of Accountants, the predecessor of the American Institute of Certified Public Accountants, when Fred Stern & Company was declared insolvent. An issue posed by the Ultramares lawsuit was whether George Touche and his fellow partners who were not involved in the Stern audit could be held personally liable for any improper conduct on the part of the Touche auditors assigned to the Stern engagement. Ultramares raised that issue by naming each of the Touche partners as codefendants.

Ultramares Corporation v. Touche et al.: A Protracted Legal Battle

The Ultramares civil suit against Touche was tried before a jury in a New York state court. Ultramares' principal allegation was that the Touche auditors should have easily discovered the $700,000 overstatement of receivables in Stern's December 31, 1923, balance sheet. That error, if corrected, would have slashed Stern's reported net worth by nearly 70 percent and considerably lessened the likelihood that Ultramares would have extended the company a sizable loan.

A young man by the name of Siess performed most of the fieldwork on the Stern audit. When Siess arrived at Stern's office to begin the audit in early February 1924, he discovered that the company's general ledger had not been posted since the prior April. He spent the next few days posting entries from the client's journals to its general ledger. After Siess completed that task, Stern's accounts receivable totaled approximately $644,000. Stern's accountant, Romberg, obtained the general ledger the day before Siess intended to prepare a trial balance of the company's accounts. After reviewing the ledger, Romberg booked an entry debiting receivables and crediting sales for approximately $706,000. Beside the entry in the receivables account, he entered a number cross-referencing the recorded amount to the company's sales journal.

The following day, Romberg notified Siess of the entry he had recorded in the general ledger. Romberg told Siess that the entry represented Stern's December sales that had been inadvertently omitted from the accounting records. Without questioning Romberg's explanation for the large entry, Siess included the $706,000 in the receivables balance. In fact, the receivables did not exist and the corresponding sales never occurred. To support the entry, Romberg or one of his subordinates hastily prepared 17 bogus sales invoices.

In subsequent testimony, Siess initially reported that he could not recall whether he reviewed any of the 17 invoices allegedly representing Stern's December sales. Plaintiff counsel then demonstrated that "a mere glance" at the invoices would have revealed that they were forged. The invoices lacked shipping numbers, customer order numbers, and other pertinent information. Following this revelation, Siess admitted that he had not examined any of the invoices. Touche's attorneys attempted to justify this oversight by pointing out that audits involve "testing and sampling" rather than an examination of entire accounting populations. Thus, it was not surprising or unusual, the attorneys argued, that none of the fictitious December sales invoices were among the more than 200 invoices examined during the Stern audit.

The court ruled that auditing on a sample basis is appropriate in most cases. But, given the suspicious nature of the large December sales entry recorded by Romberg, the court concluded that Touche should have specifically reviewed the December sales invoices.

Verification by test and sample was very likely a sufficient audit as to accounts regularly entered upon the books in the usual course of business. . . . [However], the defendants were put on their guard by the circumstances touching the December accounts receivable to scrutinize with special care.

Ultramares' attorneys noted during the trial that Touche had even more reason than just the suspicious nature of Romberg's December sales entry to question the integrity of the large year-end increase in receivables. While auditing the company's inventory, Touche auditors discovered several errors that collectively caused the inventory account to be overstated by more than $300,000, an overstatement of 90 percent. The auditors also uncovered large errors in Stern's accounts payable and discovered that the company had improperly pledged the same assets as collateral for several bank loans. Given the extent and nature of the problems revealed by the Touche audit, the court ruled that the accounting firm should have been particularly skeptical of the client's accounting records. This should have been the case, the court observed, even though Touche had not encountered any reason in previous audits to question the integrity of Stern's management.

No doubt the extent to which inquiry must be pressed beyond appearances is a question of judgment, as to which opinions will often differ. No doubt the wisdom that is born after the event will engender suspicion and distrust when old acquaintance and good repute may have silenced doubt at the beginning.

The jury in the Ultramares case dismissed the fraud charge against Touche. The jurors ruled that the company's attorneys failed to establish that the audit firm had intentionally deceived Ultramares—intentional deceit being a necessary condition for fraud. Regarding the negligence charge, the jury ruled in favor of Ultramares and ordered Touche to pay the company damages of $186,000.

The judge who presided over the Ultramares case overturned the jury's ruling on the negligence charge. In explaining his decision, the judge acknowledged that Ultramares' attorneys had clearly established that Touche had been negligent during its 1923 audit of Stern. Nevertheless, the judge ruled that the jury had overlooked the long-standing legal doctrine that only a party in privity could sue and recover damages resulting from a defendant's negligence.

Ultramares' attorneys quickly appealed the trial judge's decision. The appellate division of the New York Supreme Court reviewed the case. In a 3 to 2 vote, the appellate division decided that the trial judge erred in reversing the jury's verdict on the negligence charge. As appellate Justice McAvoy noted, the key question in the case centered on whether Touche had a duty to Ultramares "in the absence of a direct contractual relation." Justice McAvoy concluded that Touche did have an obligation to Ultramares, and to other parties relying on Stern's financial statements, although the accounting firm's contract was expressly and exclusively with Stern.

One cannot issue an unqualified statement [audit opinion] . . . and then disclaim responsibility for his work. Banks and merchants, to the knowledge of these defendants, require certified balance sheets from independent accountants, and upon these audits they make their loans. Thus, the duty arises to these banks and merchants of an exercise of reasonable care in the making and uttering of certified balance sheets.

Justice McAvoy and two of his colleagues were unwavering in their opinion that Touche had a legal obligation to Ultramares. Nevertheless, the remaining two judges on the appellate panel were just as strongly persuaded that no such obligation existed. In the dissenting opinion, Justice Finch maintained that holding Touche responsible to a third party that subsequently relied upon the Stern financial statements was patently unfair to the accounting firm.

If the plaintiff [Ultramares] had inquired of the accountants whether they might rely upon the certificate in making a loan, then the accountants would have had the opportunity to gauge their responsibility and risk, and determine with knowledge how thorough their verification of the account should be before assuming the responsibility of making the certificate run to the plaintiff.

Following the appellate division's ruling in the Ultramares case, Touche's attorneys appealed the decision to the next highest court in the New York state judicial system, the Court of Appeals. That court ultimately handed down the final ruling in the lengthy judicial history of the case. The chief justice of New York's Court of Appeals, Benjamin Cardozo, was a nationally recognized legal scholar whose opinions were given great weight by other courts.

Justice Cardozo and his six associate justices ruled unanimously that the judge who presided over the Ultramares trial had properly reversed the jury's decision on the negligence claim. Justice Cardozo reiterated the arguments made by Justice Finch. He maintained that it would be unfair to hold Touche legally responsible to a third party, unknown to Touche when its audit was performed, that happened to obtain and rely upon Stern's audited balance sheet. However, Justice Cardozo went on to suggest that had Ultramares been clearly designated as a beneficiary of the Stern-Touche contract, his ruling would have been different.

Unfortunately for the accounting profession, Justice Cardozo's opinion did not end with his commentary on the negligence question in the Ultramares case. After resolving that issue, he sharply criticized Touche's audit of Stern. The judge implied that Ultramares might have been successful in suing Touche on the basis of gross negligence: "Negligence or blindness, even when not equivalent to fraud, is none the less evidence to sustain an inference of fraud. At least this is so if the negligence is gross. . . . [In the Ultramares case] a jury might find that . . . [the Touche auditors] closed their eyes to the obvious, and blindly gave assent."

 

 Questions:

A. 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?

B. 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.

C. 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.

D. 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.

E. When assessing audit risk, should auditors consider the type and number of third parties that may ultimately rely on the client's financial statements? Should auditors insist that audit engagement letters identify the third parties to whom the client intends to distribute the audited financial statements? Would this practice eliminate auditors' legal liability to nonprivity parties not mentioned in engagement letters?

Answer rating: 100% (QA)

A Benefits Increased Accountability Extending auditors liability to thirdparty financial statement users can enhance accountability in the financial reporting and auditing processes This accountabilit... View the full answer