John Peter was an audit partner in the firm of Banana, Orange & Company. He was in the process of reviewing the audit files for the audit of a new client, Tom Resources. Tom was in the business of heavy construction. John was conducting his first review after the audit was substantially complete. Normally, he would have done an initial review during the planning phase as required by his firm's policies; however, he had been overwhelmed by an emergency with his largest and most important client. He rationalized not reviewing audit planning information because (1) the audit was being overseen by Marry Sarah, a man­ager in whom he had confidence, and (2) he could "recover" from any problems during his end-of-audit review. Now John found that he was confronted with a couple of problems. First, he found that the firm may have accepted Tom without complying with its new-client acceptance procedures. Tom came to Banana, Orange & Company on a recommendation from a friend of John's. John got "credit" for the new business, which was important to him because it would affect his compensation from the firm. Because John was busy, he told Sarah to conduct a new-client acceptance review and let him know if there were any problems. He never heard from Sarah and assumed everything was okay. In reviewing Sarah's pre-audit planning documentation, he saw a checkmark in the box "Contact prior audi­tors" but found no details indicating what was done. When he asked Sarah about this, she responded with the following:

"I called Gardner Smith (the responsible partner with Tom's prior audit firm) and left a voicemail message for him. He never returned my call. I talked to Ted Tom about the change, and he told me that he informed Gardner about the change and that Gardner said, 'Fine, I will help in any way I can.' Ted said Gardner sent over copies of analyses of fixed assets and equity accounts, which Ted gave to me. I asked Ted why they replaced Gardner's firm, and he told me it was over the tax contingency issue and the size of their fee. Other than that, Ted said the relationship was fine."

The tax contingency issue that Sarah referred to was a situation in which Tom had entered into litigation with a bank from which it had received a loan. The result of the litigation was that the bank forgave several hundred thousand dollars in debt. This was a windfall to Tom, and they recorded it as a gain, taking the position that it was non-taxable.

The prior auditors disputed this position and insisted that a contingent tax liability existed that required disclosure. This upset Tom, but the company agreed in order to receive an unmodified opinion. Before hiring Banana, Orange & Company as their new auditors, Tom requested that the firm review the situation. Banana, Orange & Company believed the contingency was remote and agreed to the elimination of the disclosure.

The second problem involved a long-term contract with a customer in Mauritius. Under accounting standards, Tom was required to recognize income on this contract using the percentage-of-completion method. The contract was partially completed as of year-end and had a material effect on the financial statements. When John went to review the copy of the contract in the audit files, he found three things. First, there was a contract summary that set out its major features. Second, there was a copy of the contract written in French. Third, there was a signed confirmation confirming the terms and status of the contract. The space requesting information about any contract disputes was left blank, indicating no such problems.

John's concern about the contract was that to recognize income in accordance with accounting standards, the contract had to be enforceable. Often, contracts contain a can­cellation clause that might mitigate enforceability. Because he was not able to read French, John could not tell whether the contract contained such a clause. When he asked Sarah about this, she responded that she had asked the company's vice president for the Mau­ritius division about the contract and he told her that it was their standard contract. The company's standard contract did have a cancellation clause in it, but it required mutual agreement and could not be canceled unilaterally by the buyer.

Required

1. Evaluate and discuss whether Banana, Orange & Company complied with auditing Required standards in their acceptance of Tom Resources as a new client. What can they do at this point in the engagement to resolve deficiencies if they exist?
2. Evaluate and discuss whether sufficient audit work has been done with regard to Tom's Mauritius contract. If not, what more should be done?
3. Evaluate and discuss whether John and Sarah conducted themselves in accordance with auditing standards.