Question

Case Study Analysis: Fred Stern & Company, Inc. (Knapp):

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 1 presents 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.
After 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.1 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.

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.2 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.3 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.4
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.5
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.6
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.”7 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.8
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.

A case study analysis must not just summarize the case; it should identify key issues and problems, and outline and assess alternative courses of action.

• Does the problem or challenge facing the company come from a changing environment, new opportunity, a declining market share, or inefficient internal or external business processes?
• Identify strengths and weaknesses as well as alternatives.
• Examine the value creation functions of the company and specify alternative courses of action.
• What changes to organizational processes would be required by each alternative? What management policy would be required to implement each alternative?
• Identify the constraints that will limit the solutions available. Is each alternative executable given these constraints?
• Analyze the structure and control systems that the company used to implement its business strategies.
• Evaluate organizational change, levels of hierarchy, employee rewards, conflicts, and other issues that were important to the company you are analyzing.
• Make recommendations.

Answer 1

The case study analysis as as follows:

The problem has come from a declining market share & inefficient internal/external business processes. The internal environment of an organization refers to events, factors, people, systems & structures inside the organization.

The external environment are those that occur outside outside of the company that cause change inside organizations & most part being beyond the control of the company. Some of the acts & clauses were not created during that time. Fred Stern & Co were unable to maintain the finances of the company and relied on banks for a large sum. Bankers & money lenders that lent money to Stern Fred & Co were frauds and also a negligence on the part of Stern & Co, due to insufficient background verifications of the bankers before borrowing the sum. A new auditor @ Stern Fred & Co analysed that GL accounts were not properly maintained by the previous accountant. Therefore, Stern Co had hired without proper verifications of the candidate.

Many changes in the auditing profession have required these changes to avoid confusions from financial statement users. The decision of extending the liability of auditors to 3rd parties had impacts on all parties, involved in audit. The changes in the SEC of 1934 that arrived forced certain changes to the way the auditors had to approach their work. It is now their responsibility to ensure that the work being is enough to provide a high level of assurance to all the users of financial statements. The auditors would also have to be more careful when choosing their audit clients as they cannot choose anyone they are already doing consulting for. When conducting an audit auditors must ensure that all information influencing 3rd party users decisions is included in the financial statements. A company who is looking to secure new loans will want to minimize the current debt on their balance sheet, as well as showing high working capital ratio to ensure their creditors will loan them the desired financing. This stage of audit planning must be completed 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 new employees will work on the less risky accounts. A senior auditor might work on deferred revenues for a company receiving all of its revenues through exterior funding.