In the business world of the Roaring Twenties, the schemes and scams of flim-flam 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 self-serving 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, had 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.

Questions
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?
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.
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.
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.
5. 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?