Ray, the owner of a small, privately-held entity, asked Holmes, CPA to conduct an audit of the entities' financial statements. Ray told Holmes that the audit was to be completed in time to submit audited financial statements to a bank as part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor's report within three weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if the loan was granted. Holmes hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes told the students not to spend time reviewing Ray's internal controls but instead to concentrate on proving the mathematical accuracy of the ledger accounts and on summarizing the data in the accounting records that support Ray's financial statements. The students followed Holmes' instructions and, after two weeks, gave Holmes the financial statements, which did not include footnotes. Holmes studied the statements and prepared an unqualified auditor's report. The report, however, did not refer to generally accepted accounting principles or to the fact that Ray had changed to the accounting standard for capitalized interest.

Identify all of the violations of the Fundamental Principles described in the text. Be clear on what action violated which principle and why. Note that there may be more than one violation of each of the three principles and you are to cover all the violations you can find.

I want you to think like an attorney when answering the following two questions and defend your answers based the specifics of the laws and legal precedents mentioned in Module C.

After the audit was completed, Ray used the financial statements to secure a loan from a bank. Within a year, Ray was unable to make payments on the loan. In the process of investigating the reason why, the bank determined that the financial statements were material misstated. Ray, however, was near bankruptcy and could not pay off the loan. The bank sued Holmes for the balance due on the loan. Given the violations you discussed above, do you think the bank will prevail? You answer should provide an analysis of the legal issues involved to include what basis the bank would have to sue and a clear statement of why or why not you think the bank would prevail.

Now assume that instead of applying for a bank loan, Ray used the financial statements as part of a prospectus for an initial public stock offering (IPO). George, a potential investor, read the prospectus and did a comprehensive analysis of the financial statements as a basis for his decision to buy a significant portion of stock in the new corporation. A year later, the firm was doing so badly that its stock price was down to 10% of what it was after the IPO. George sued both the new corporation and Holmes for his investment losses. During the trial, George was able to show that the financial statements were materially misstated in key areas that affect firm value. Under what conditions would George be able to recover at least a portion of his losses from Holmes? Be sure to be clear and thorough in addressing all the sources of liability of Holmes to George in this case and any defenses that Holmes might be able to use.