LO 2-2, 2-3, 2-4 2.64 Comprehensive Principles Case Study. Ray, the owner of a small entity, asked Holmes, CPA, to conduct an audit of the entity's records. 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 auditors' report within three weeks. Ray agreed to pay Holmes a fixed fee plus a bonus if audit can be completed in time to meet the entity's deadlines for providing audited financial statements to a lender. d. Based on the effectiveness of the entity's internal control, you have assessed control risk at low levels and decided that a smaller number of customer accounts need to be confirmed. e. An entity has contacted you about performing its audit engagement. This entity became aware of your firm because the husband of one of your partners is currently serving as the entity's chief financial officer. f. One of your clients is currently a potential defendant in several cases because of the damage caused by one of its products. Because this entity does not believe that it is likely to receive an unfavorable outcome from this litigation, it did not disclose the potential litigation in the footnotes accompanying their financial statements. g. You are performing tests of the client's controls over the processing of revenue transactions to determine whether these controls are operating effectively and can be relied upon to prevent or detect misstatements. h. One of your supervisors has requested a number of clarifications based on her review of your work on an audit engagement. A subsequent meeting with her has resolved these clarifications, and you both have concluded that your work supports the opinion on the client's financial statements. LO 2-2, 2-3, 2-4 2.66 Fundamental Principles (Comprehensive). Identify which of the major fundamental principles (responsibilities, performance, or reporting) is most closely related to each of the following: a. The need for auditors to consider their financial relationships with prospective clients. b. An auditor has raised some questions with respect to management's response to various inquiries concerning pending litigation facing the client. c. The auditors' consideration of the effectiveness of the entity's internal control on the nature, timing, and extent of substantive procedures. d. The auditors' evaluation of the magnitude of a misstatement 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 the 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 unmodified auditors' 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 capitalizing interest. Required: Briefly describe each of the principles and indicate how the action(s) of Holmes resulted in a failure to comply with these principles. (AICPA adapted) LO 2-2, 2-3, 2-4 2.65 Fundamental Principles (Comprehensive). In each of the following, identify which of the elements of the fundamental principles is most applicable. In addition, discuss what action(s) (if any) you believe auditors should take with respect to these issues. a. An entity has contacted you about performing its audit engagement. You have not previously served a client in the entity's industry, which has many industry-specific accounting issues that are both technical and complex. b. An entity has entered into a number of lease agreements. Based on the requirements of GAAP, you believe that these obligations meet the criteria for being classified as capital leases; however, the entity has elected to treat these leases as operating leases, providing full and complete disclosure of this treatment in the footnotes to the financial statements. c. Because of a disagreement with its current auditors, an entity has contacted you about conducting its current-year audit. However, because the previous auditors have just recently resigned from the engagement, you have some questions as to whether an