First Securities Company of Chicago

The critical issue in this case study is the responsibility of auditor. Should Ernst & Ernst be civilly liable for defrauded investors of First Securities Company of Chicago under Securities Exchange Act of 1934 under Rule 10b-5.

 According to Securities Exchange Act of 1934 under Rule 10b-5, plaintiff which was the defrauded investor Hochfelder needed to prove that Ernst & Ernst intentionally manipulate the escrows investors.

 Ernst & Ernst had audited First Securities Company of Chicago for two decades, Ernst & Ernst should have noticed Nay’s “mail rule” policy could lead to potential internal control weakness and misleading financial statement.

 Defrauded investors were not properly informed or obtained information about the securities they invested in “escrow syndicate” account which Nay personally dealt with.

 Since Nay was the president of First Securities Company of Chicago and he only dealt with his closest friends whom trusted Nay fully, it was hard to detect by others that Nay made these outside deals with his friends.

Questions

1. Under present technical standards, would auditors be required to disclose a company policy similar to Nay’s mail rule that they discover during an audit? Explain. Assuming such disclosure had been required at the time this case took place, would that disclosure have resulted in the mail rule being discontinued?

Under present technical standards, auditors are required to disclose company policy similar to Nay’s mail rule, and it’s important for auditor to be aware and further investigate unreasonable or doubtful company policy if it leads to internal control weakness or possibly fraud scheme. They are also required to report their assessment of internal controls and their opinion on management’s assessment of internal control over financial reporting. If such disclosure had been required at the time this case took place, I believe the mail rule could be discontinued since it can lead to possible fraud scheme.

2. Ernst & Ernst argued that the mail rule was not relevant to its audits of First Securities since that rule only involved personal transactions of Nay and the escrow investors. Do you agree? Why or why not?

The mail rule was relevant to the audits because auditor relied upon management’s financial information to report their opinions on a company. It’s crucial that auditors should have attested every possible or doubtful piece of financial information that could be misrepresented by managements as well.

3. Define negligence as that term has been used in legal cases involving independent auditors. What is the key distinction between negligence and fraud? Between recklessness and fraud? For all three types of professional misconduct, provide an example of such behavior in an audit context.

Negligence is defined as failure to exercise that degree of care a person of ordinary prudence (a reasonable person) would exercise under