Chapter 1 Key Topics (LO 1-6) Common characteristics of assurance, attestation, and audit services Similarities between all three services: • An independent accounting firm takes information prepared by someone else and then compares it to an established set of criteria. • The independent accounting firm provides a written report about the results of the service performed. • The services add credibility, or integrity, to the information, which makes it more useful for decision making. Assurance Services: • Definition: Independent professional services that enhance the quality of information for decision-makers. • Scope: The broadest category, covering any service that improves the credibility or quality of information. Examples include risk advisory services, website security assessments, and data integrity services. • Objective: To improve the reliability and relevance of both financial and non-financial information, aiding decision-making. Attestation Services: • Definition: A subset of assurance services where an independent CPA reports on the reliability of financial or other information that is the responsibility of another party. • Scope: Includes services like financial forecasts, reviews of financial statements, and System and Organization Controls (SOC) reports. • Objective: To provide a report on the subject matter or assertion made by another party, thereby enhancing the reliability of the information. Audit Services: • Definition: The most specific and narrow type of attestation service, involving the examination of financial statements and internal controls to form an opinion on their accuracy and compliance with applicable standards. • Scope: Primarily focuses on historical financial statements and the effectiveness of internal controls over financial reporting (ICFR). Objective: To provide an opinion on whether the financial statements are presented fairly in accordance with a financial reporting framework (e.g., GAAP, IFRS) and whether internal controls are effective Explain the term “reasonable assurance” • Definition: A high but not absolute level of assurance that the financial statements are free from material misstatement due to fraud or error. Absolute assurance is not possible due to the inherent subjectivity in financial reporting and the practical limits of auditing (e.g., sampling techniques). Demand for audit services • Remoteness. Most financial statement users do not have access to the company under review. This makes it difficult to determine whether the information contained in the financial statements is a fair presentation of the entity and its activities for the relevant period. • Complexity. Financial statements are complex, the amounts are often affected by significant estimates, and the disclosures often require significant knowledge and experience to evaluate. Most financial statement users do not have the accounting and legal knowledge to assess the reasonableness of complex accounting and disclosure choices being made by the company. • Competing incentives. Company managers have an incentive to disclose the information contained in the financial statements in a way that presents their performance in the best possible light. Users may find it difficult or impossible to identify when management is presenting biased information. • Reliability. Financial statement users are concerned with the reliability of the information contained in the financial statements. Since they use that information to make decisions that have real consequences, it is very important that users can rely on the information contained in the financial statements. Management (preparer) versus auditor responsibilities Preparer Responsibility 1. Fair Presentation and Compliance: Ensuring that the information in the financial statements is presented fairly and in accordance with the applicable financial reporting framework, such as GAAP. 2. Internal Controls: Designing, implementing, and maintaining effective internal controls related to the preparation and fair presentation of the financial statements. 3. Providing Information: Granting auditors access to all necessary records, documentation, and personnel relevant to the audit. Management must also provide any additional information the auditors may need to complete their audit. Auditor Responsibilities 1. Conducting the audit in accordance with the appropriate auditing standards. Auditing standards provide minimum requirements and guidance for the performance of an audit. 2. Planning and performing the audit with professional skepticism. Professional skepticism is an attitude adopted by auditors when conducting an audit. It means auditors remain independent of the entity, its management, and its staff when completing the audit work. In a practical sense, it means auditors maintain a questioning mind and thoroughly investigate all evidence presented by their client. Auditors must seek independent evidence to corroborate, or confirm, information provided by their client. Auditors must be suspicious when evidence contradicts documents held by their client or inquiries made of client personnel, including management and those charged with governance. 3. Planning and performing the audit with professional judgment. Professional judgment relates to the application of relevant training, knowledge, and experience that auditors use while making informed audit decisions in conducting an audit. Auditors must use their judgment throughout the entire audit. For example, auditors must use judgment when determining if an information source is reliable. They must also use judgment when deciding if enough audit evidence has been gathered to support the audit opinion. Nature of audit procedures Who are “those charged with governance”? • those charged with governance persons: with responsibility for overseeing the strategic direction of the entity and the obligations related to the accountability of the entity (board of directors, audit committee, internal auditors, shareholders, and senior management). Purpose and authority of the PCAOB Purpose of the PCAOB: 1. Protect Investor Interests: The PCAOB’s main goal is to safeguard the interests of investors by ensuring that the audits of public companies are performed with integrity and according to established standards. 2. Improve Audit Quality: The PCAOB oversees audit processes to enhance the quality, transparency, and reliability of audits, which ultimately increases the trustworthiness of financial statements. 3. Promote Compliance: The PCAOB ensures that public accounting firms comply with its standards and procedures, which contributes to maintaining public trust in financial reporting. Authority of the PCAOB: 1. Issuing Auditing Standards: The PCAOB creates and enforces Auditing Standards (AS) for audits of public companies. These standards provide minimum requirements and guidance for performing audits. Initially, the PCAOB adopted existing professional auditing standards but has since issued its own standards that replace some of those interim standards. 2. Regulating Public Company Audits: Accounting firms that want to audit public companies must register with the PCAOB and follow its Auditing Standards. The PCAOB has the authority to inspect the audit work of registered firms to ensure compliance with its standards. 3. Disciplinary Authority: The PCAOB has the power to impose disciplinary actions on firms that do not comply with its standards, including: o Revoking a firm’s registration, which prevents the firm from auditing public companies. o Imposing monetary fines. o Banning individuals from participating in public company audits Components of standard audit reports, including differences between those for public and private companies For Private Companies (Unmodified Report): 1. Title: "Independent Auditor’s Report" (emphasizing the auditor’s independence). 2. Address: Report is addressed to the company’s owners or shareholders. 3. Opinion Section: Auditor’s opinion that the financial statements present fairly the company's financial position in accordance with GAAP. 4. Basis for Opinion: States that the audit was conducted following GAAS (Generally Accepted Auditing Standards), and the auditor was independent. 5. Responsibilities of Management: Highlights management's responsibility for preparing the financial statements and maintaining internal controls. 6. Auditor’s Responsibilities: Describes the auditor’s role in providing reasonable assurance that the financial statements are free from material misstatement. 7. Signature, Location, Date: The audit firm’s name, city, and the audit completion date. For Public Companies (Unqualified Report): 1. Title: "Report of Independent Registered Public Accounting Firm" (adds "Registered" to indicate PCAOB registration). 2. Address: Report is addressed to shareholders and the board of directors. 3. Opinion Section: Similar to private company but includes reference to multiple years if applicable. 4. Audit of Internal Controls: Public company reports include an additional opinion on internal controls over financial reporting (ICFR). 5. Basis for Opinion: Similar to private companies but mentions compliance with PCAOB standards and independence under SEC rules. 6. Scope Paragraph: Explains how the audit was conducted under PCAOB standards and the professional judgments made during the audit. 7. Critical Audit Matters (CAM): Unique to public companies, CAM discusses any especially challenging or subjective aspects of the audit. 8. Signature, Location, Date: Same as private companies but includes the year the firm became the company’s auditor. Key Differences: • Public company reports must include an audit of internal controls and a Critical Audit Matters section, which are not required for private companies. • GAAS (for private companies) versus PCAOB standards (for public companies) are the auditing standards referenced. Chapter 2 Key Topics (LO 1-5) Concern for the Public Interest • Public Accounting as a Recognized Profession: o Public accounting is recognized as a profession because it involves a commitment to the public interest. o Professionals in this field have the right to sign audit reports and tax returns, provided they meet education, examination, and experience requirements. o Responsibilities include adherence to professional standards, a code of conduct, and continuing education. • EC vs. CPI Professionals: o EC Professionals (Expert Competitor):  Defined by high skill and expertise in their field.  Example: Professional athletes, expert consultants. o CPI Professionals (Concern for Public Interest):  Defined by their responsibility to the public, specialized knowledge, formal education, standards, a code of ethics, and licensing.  Example: Medicine, architecture, public accounting. Know and describe the structure/components of the AICPA Code of Professional Conduct (high level) The Code is organized in four major sections, as presented in Illustration 2.1. A preface applicable to all AICPA members. Part 1, which includes ethical rules for members in public practice (usually CPAs in CPA firms). Part 2, which includes ethical rules for members in business (such as a CFO, a controller, or an accountant working in industry or government). Part 3, which includes ethical rules for other members (e.g., non-CPA members of the AICPA). Step 1: Identify Threats The CPA identifies a self-interest threat to exercising due professional care when performing the audit. The firm understands there may be an incentive to cut corners when doing audit work in order to make a profit in performing the engagement. Adverse interest threat. The threat that a member will not act with objectivity because the member’s interests are opposed to the client’s interests. Advocacy threat. The threat that a member will promote a client’s interests or position to the point that his or her objectivity or independence is compromised. Familiarity threat. The threat that, due to a long or close relationship with a client, a member will become too sympathetic to the client’s interests or too accepting of the client’s work or product. Management participation threat. The threat that a member will take on the role of client management or otherwise assume management responsibilities, such may occur during an engagement to provide nonattest services. Self-interest threat. The threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, a client or persons associated with the client. Self-review threat. The threat that a member will not appropriately evaluate the results of a previous judgment made or service performed or supervised by the member or an individual in the member’s firm and that the member will rely on that service in forming a judgment as part of another service. Undue influence threat. The threat that a member will subordinate his or her judgment to an individual associated with a client or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member. Subordination of judgment Definition: It occurs when a professional's personal or external pressures lead them to make decisions that are not based solely on their expertise or ethical standards. o Not Material: No action needed. o Material Misrepresentation: Discuss with supervisor. o Unresolved: Escalate to higher management. Step 2: Evaluate the Significance of Threats Assess each threat individually and together to determine their overall impact. Apply the conceptual framework (check LO-3 review on p. 2- 1. Identify Threats: Recognize potential self-interest threats, such as incentives to cut corners for profit. 2. Evaluate Significance: Assess the seriousness of the threat and determine the need for safeguards. 3. Identify and Apply Safeguards: Implement measures such as setting clear expectations for professional standards and having work reviewed by a second audit partner. a. Safeguards Created by the Profession: Rules and regulations affecting CPAs. b. Safeguards Implemented by the Client: Measures taken by the client (e.g., reassignment of personnel). c. Safeguards Implemented by the Firm: Independent reviews, rotation of personnel, etc. 4. Evaluate Effectiveness: Confirm that the safeguards are effective in addressing the threat and decide if the engagement can proceed. 5. Document: Record the identified threats, applied safeguards, and the rationale for their effectiveness in a memo for the audit engagement file. Auditor independence (fundamental audit concept, study entire LO 5) 1. Independence in Fact: o Definition: Acting with integrity, objectivity, and without subordinating public trust for personal gain. 2. Independence in Appearance: o Definition: Avoiding situations that could be perceived as conflicts of interest, even if they do not affect actual independence. Covered Members • Definition: Individuals who can influence attest decisions or outcomes. This includes: o Members of the engagement team o Partners and managers with significant responsibilities o Professionals who perform significant nonattest services for the client o Partners in the same office as the engagement partner Family Members 1. Immediate Family: o Definition: Spouse, spousal equivalent, or dependents. o Restrictions: Must not hold key positions or have significant financial interests in an attest client. 2. Close Relatives: o Definition: Parents, nondependent children, siblings, or step-relatives. o Restrictions: Cannot hold key positions or have significant influence over the client. Chapter 3 Key Topics (LO 1-6) Factors related to client acceptance (1. Integrity of management; 2. Competence issues; 3. Independence issues; 4. Special circumstances and unusual risks) 1. Integrity of Management • Reputation: Consider reputation of client, management, directors, and key stakeholders. • Previous Audits: Investigate reasons for switching audit firms (if applicable). • Risk Attitude: Assess management's approach to risk exposure. • Internal Controls: Evaluate management's commitment to implementing and maintaining adequate internal controls. • Accounting Rules: Examine the appropriateness of management’s interpretation of accounting rules. • Access to Information: Determine management’s willingness to provide auditors full access to personnel, records, and information needed for the audit. 2. Competence issues • The firm has the required expertise or access to specialists to fulfill the client’s needs. positive • The firm lacks the necessary expertise to provide the full scope of services or does not have access to specialists to meet client requirements. Negative 3. Independence Issues Review of Independence Threats: • The firm must assess threats to independence and implement safeguards to mitigate or eliminate them. Decline/Resign if Threats are Insurmountable: • If independence threats cannot be addressed, the firm should decline a prospective audit or resign from an existing client. No Independence Issues: • No threats to independence exist, or they can be resolved before accepting the client. Unresolvable Independence Issues: • Independence or conflict of interest issues exist that cannot be resolved before client acceptance. 4. Special Circumstance and unusual risk: No Special Circumstances: • Minimal regulatory reporting requirements. • Financially stable and profitable client with no concerns about debt covenants. • No scope limitations on the audit. • Strong accounting system with effective internal controls. Special Circumstances and Unusual Risks: • Significant regulatory reporting requirements with close monitoring by regulators. • Client faces profitability issues, weak cash flows, and is near violating debt covenants. • Client expresses concerns about the scope of audit work. • Ineffective accounting system with few internal controls. risk assessment phase: gaining an understanding of the client, identifying risk factors, setting a materiality level, and developing an audit strategy audit risk: the risk that an auditor expresses an inappropriate audit opinion when the financial statements are materially misstated risk response phase: performing tests of controls and detailed substantive procedures of transactions and accounts, concentrating effort where the risk of material misstatement is greatest reporting phase evaluation: of the results of the detailed testing considering the auditor’s understanding of the client and forming an opinion on the fair presentation of the client’s financial statements Materiality (fundamental audit concept, study entire LO 3) Materiality: the ability of information to influence the judgment made by a reasonable user based on the financial statements. o Qualitative Factors: These are aspects of the client's financial information that could affect user decisions beyond the magnitude of the numbers, such as the nature of certain transactions (e.g., fraud, changes in accounting methods). o Quantitative Factors: These involve the size of the numbers in the financial statements, like the dollar amount of an account balance. Setting Materiality:  Auditors use professional judgment to determine materiality, typically by applying a percentage to a relevant financial benchmark (e.g., total assets, total revenue, income before taxes). o The chosen benchmark and percentage vary depending on the client and the industry, and materiality is adjusted as needed throughout the audit • Performance Materiality: Auditors set a lower threshold than the overall materiality for individual account balances or transactions to reduce the risk that undetected misstatements could aggregate to a material amount. Professional skepticism Professional skepticism is an attitude that auditors must maintain throughout the audit process. It involves a questioning mind and a critical assessment of audit evidence. Auditors are required to remain independent and not take management's representations at face value without corroborating evidence. • Biases Affecting Professional Skepticism: o Availability Bias: Overemphasis on information that is readily available. o Confirmation Bias: Favoring evidence that supports existing beliefs. o Overconfidence Bias: Overestimating one's judgment abilities. o Anchoring Bias: Relying too heavily on initial information. o Automation Bias: Over-reliance on automated systems without sufficient critical assessment. Describe audit risk and its individual components Audit risk is the risk that an auditor will issue an incorrect opinion on the financial statements, such as stating that the financial statements are free from material misstatement when they are not. This risk can never be entirely eliminated but can be reduced to an acceptable level. • Components of Audit Risk: o Risk of Material Misstatement (RMM): The risk that financial statements are materially misstated before the audit. It consists of:  Inherent Risk (IR): The susceptibility of an assertion to misstatement before considering any controls.  Control Risk (CR): The risk that internal controls will not prevent or detect material misstatement. o Detection Risk (DR): The risk that audit procedures will fail to detect a material misstatement. Understand the audit risk model o The audit risk model illustrates that audit risk (AR) is a function of RMM (IR and CR) and DR: AR = IR × CR × DR If the RMM is high (due to high inherent risk, control risk, or both), the auditor will aim to reduce detection risk to maintain an acceptable overall audit risk level. Here's why: • High RMM implies that there is a greater chance of material misstatements in the financial statements. • To compensate for this higher risk, the auditor must reduce detection risk by performing more extensive, detailed, or rigorous audit procedures (e.g., larger sample sizes, more substantive testing, additional review). • Lowering detection risk helps ensure that material misstatements are caught, despite the higher risk of them occurring. Audit strategy (first section, p. 3-23) Audit Strategy Overview Purpose of Audit Strategy: • The audit strategy provides the foundation for developing a detailed audit plan. • It includes decisions about the nature, extent, and timing of audit procedures. • It is developed after determining materiality and assessing audit risk. Key Components of an Audit Strategy 1. Nature of an Audit Procedure: o What Type of Procedure?  Tests of Controls: These evaluate the effectiveness of controls in preventing or detecting material misstatements at the account or assertion level.  Substantive Procedures: These aim to detect material misstatements at the account or assertion level, verifying the accuracy of account balances and transactions. 2. Extent of an Audit Procedure: o How Much Testing?  Refers to the amount of audit testing, often involving sampling techniques.  Sample Size: Determined by detection risk. Lower detection risk requires larger sample sizes; higher detection risk allows for smaller sample sizes. 3. Timing of an Audit Procedure: o When to Perform Procedures?  Depends on the effectiveness of the client’s internal controls.  Timing decisions impact when tests are conducted (e.g., interim vs. year-end). Audit Phases Timeline • Risk Assessment Phase (Second and third quarters of the client’s accounting year): o Involves gaining an understanding of the client and its environment, identifying inherent risks. • Risk Response Phase (Latter part of the third quarter into the fourth quarter): o Includes interim testing and year-end substantive procedures. • Reporting Phase (After the audit work is completed): o The audit report is issued. Audit Strategies 1. Reliance on Controls Approach: o Steps: 1. Identify Inherent Risks: Determine if there are internal controls to mitigate these risks. 2. Evaluate Control Existence: Does the control exist? 3. Test Control Effectiveness: If effective, rely more on controls and less on substantive procedures. o Result:  When controls are effective, auditors can perform fewer, less extensive substantive procedures, potentially at an interim date rather than at year-end.  Auditors can focus on higher-risk accounts and assertions during year-end. 2. Substantive Approach: o Steps: 1. Identify Inherent Risks: Determine if controls exist. 2. Evaluate Control Existence: If no controls exist or if controls are ineffective, control risk is high. 3. Perform Extensive Substantive Procedures: Rely less on controls and more on detailed substantive testing, especially at year-end. o Result:  Auditors perform more extensive procedures with larger sample sizes due to higher risk of material misstatement (RMM). 3. Blended Approach: o Combination: Auditors may use a mix of both reliance on controls and substantive approaches, depending on the risk assessment. Understand when an auditor would be able to rely on controls vs. taking a more substantive approach Fraud risk assessment process Key Concepts: 1. Fraud vs. Error: o Error: Unintentional misstatement in the financial statements. o Fraud: Intentional deception leading to a misstatement in the financial statements, which can be harder to detect. 2. Types of Fraud: o Fraudulent Financial Reporting: Misstatements or omissions intended to deceive users of financial statements. o Misappropriation of Assets: Theft or misuse of a company’s assets by employees. 3. Indicators of Fraud (Red Flags): o Discrepancies between financial growth and related nonfinancial measures. o High turnover of key employees. o Overly dominant management. o Inadequate internal controls. o Significant adjusting entries at the end of a period. 4. Fraud Risk Factors: o Pressure: Incentives or pressures that motivate fraud (e.g., financial difficulties, market expectations). o Opportunity: Situations that allow fraud to be committed (e.g., ineffective controls, complex transactions). o Rationalization: Justifications or attitudes that make fraud acceptable (e.g., focus on profit maximization, poor ethical standards). 5. Professional Skepticism: o Auditors must apply professional skepticism throughout the audit, particularly in areas involving significant management judgment and the potential for fraud. o Skepticism may be hindered by biases, such as a desire to maintain client relationships or reduce audit costs. o Auditors should ensure proper documentation and monitoring to maintain skepticism. 6. Fraud Risk Assessment Process: o Brainstorming: Audit team members discuss the susceptibility of financial statements to fraud, considering factors such as management’s involvement and unusual transactions. o Inquiries: Auditors inquire of management, the audit committee, and other relevant parties about knowledge of fraud and internal controls in place to prevent and detect fraud. o Documentation: Auditors must document the fraud risk assessment, including details of the brainstorming session and any significant risks identified. Chapter 4 Key Topics (LO 1, 3-6) Understanding the client Understanding the Entity Key Points: • Entity-Level Risk: Affects multiple accounts/assertions. • Transaction-Level Risk: Affects single class/account/assertion. • Understand: Business operations, investments, financial reporting, internal controls. Factors Influencing Inherent Risk (IR): • Customers: Satisfaction impacts revenue and collectibility. • Suppliers: Quality and timeliness affect costs. • Trade: Stability of countries, currencies, and tariffs. • Technology: Adaptation affects risk. • Warranties: Quality and liability implications. • Discounts: Affect profitability. • Reputation: Influences business relationships. • Operations: Centralized vs. decentralized; international presence. • Accounting Standards: Recent changes and personnel competence. • Complexity: Subjectivity and transaction volume. • Payroll: System complexity and benefits. • Financing: Debt reliance and covenant risks. • Capital Structure: Simplicity vs. complexity. Example: Samsung Fire • Affects customer loyalty, revenue, quality, warranties, and reputation. Auditors need extra focus on related accounts. Understanding the Industry and Business Environment Factors: • Demand: Seasonal vs. steady. • Government Policy: Impact of regulations and incentives. • Technology: Risk of obsolescence and inventory valuation. Reputation • Poor Reputation: May lead to customers and suppliers shifting to competitors. • New Industry with Support: New industry with significant government support and incentives. • Competitive Industry: New or established industry with international competition and government support. • Minimal Regulation: Industry with minimal government regulation and no special financial reporting requirements. Legal, Political, and Regulatory Environment • No Government Support: New industry with minimal or no government support. • Intense Competition: New or established industry with intense international competition and little government support. • Heavily Regulated: Industry with special taxes and unique regulations. Demand • Steady Revenue: Non-seasonal demand, minimal impact from trends, low risk of obsolescence. • Seasonal Demand: Sporadic revenue flow, subject to changing trends, and technological obsolescence. Economy • Economic Upturn: Pressure to perform better, focus on overstatement of revenues and understatement of expenses. • Economic Downturn: Management might understate profits to create a low base for future improvement, focus on understatement of revenues and overstatement of expenses. Auditor Procedures to Understand the Client • Inquiry: Asking client personnel and third parties about operations and accounting. • Analytical Procedures: Using financial ratios and trend analysis. • Observation: Observing operations and processes. • Inspection: Reviewing documents, such as board meeting minutes. Compliance with Laws and Regulations • Illegal Acts: o Direct and Material Effect: Impact on financial statements through fines or litigation (e.g., payroll tax evasion). o Material but Indirect Effect: Possible contingent liabilities or disclosures (e.g., health regulation violations). Auditor’s Responsibility • Direct and Material: Responsibility to detect and address illegal acts impacting financial statements. • Material but Indirect: Limited to specific audit procedures; no assurance of detection of all indirect effects. • Discovery of Illegal Acts: o Use professional skepticism, document work, discuss with management and governance. o Re-evaluate risk assessments and internal controls. o Consult legal counsel if needed and consider withdrawing from the audit if necessary. Analytical procedures (pp. 4-13 and 4-14; you do not have to memorize ratios) Analytical Procedures Overview • Purpose: Analyze plausible relationships among financial and nonfinancial data. • Phases: o Risk Assessment: Identify unusual fluctuations, aid in risk identification, and enhance understanding of the client and industry. o Risk Response: Gather evidence about account balances. o Audit Conclusion: Assess if financial statements reflect auditors’ knowledge. Types of Analytical Procedures: 1. Comparisons: Compare account balances over time, with budgets, or industry data. 2. Trend Analysis: Compare account balances over time to spot changes and trends. 3. Common-Size Analysis: Compare account balances to a single line item (e.g., total assets, sales revenue). 4. Ratio Analysis: Assess relationships between financial statement accounts. Types of Analyses • Comparisons: Track significant changes by comparing current vs. previous years or budgets. • Trend Analysis: Use base year to compare and understand account changes over time. • Common-Size Analysis: Express account balances as a percentage of a single line item to understand relative contributions. • Ratio Analysis: Evaluate profitability, liquidity, and solvency. Key Ratios 1. Profitability Ratios: o Gross Profit Margin: Indicates markup sufficiency. o Profit Margin: Measures overall profitability. o Return on Assets (ROA): Efficiency in generating profit from assets. o Return on Equity (ROE): Profitability from stockholders' equity. 2. Liquidity Ratios: o Current Ratio: Ability to meet short-term obligations (ratio > 1 is preferable). o Acid-Test Ratio: Ability to meet short-term obligations with liquid assets. o Sustainable Free Cash Flow: Cash left after operations and capital expenditures. o Cash Flow Coverage: Ability to cover debt and dividends. 3. Activity Ratios: o Inventory Turnover in Days: Time to sell inventory (lower is better). o Receivables Turnover in Days: Time to collect receivables (lower is better). o Payables Turnover in Days: Time to pay suppliers (lower is better). o Gross Operating Cycle: Time to purchase, sell, and collect receivables. o Net Operating Cycle: Time to purchase, sell, collect, and pay creditors. 4. Solvency Ratios: o Debt-to-Equity Ratio: Measures long-term viability by comparing debt to equity. o Times-Interest-Earned Ratio: Measures ability to cover interest expenses. Explain common-size analysis Common-Size Analysis (or Vertical Analysis) involves comparing account balances to a single line item, typically to understand how each component of the financial statements contributes to the total. Related parties A related party is an affiliate, principal owner, manager, or other party that is not independent of the entity. Related parties include affiliates of the entity, investments in other entities accounted for by the equity method, and trusts for employee benefit plans that are managed by or under the trusteeship of management. Audit committee (including Public Company Requirements section) Audit committee a committee of the board of directors responsible for oversight of internal controls, financial reporting and disclosure in financial statements, regulatory compliance, and the company’s independent auditors. SOX Requirements for Audit Committees: • Independence: Members must be independent, not executive directors or affiliated with the issuer. • Compensation: Members can't accept consulting or advisory fees beyond normal director compensation. • Financial Expert: At least one member must be a financial expert, proven by education or experience. • Auditor Oversight: Responsible for appointing, compensating, and overseeing auditors. • Direct Reporting: Auditors report directly to the audit committee. • Dispute Resolution: Responsible for resolving disagreements between management and auditors. • Complaint Procedures: Establish procedures for receiving and handling complaints about accounting or internal controls, including anonymous complaints. • Legal Counsel: Authority to engage legal counsel if needed. Information Technology information technology (IT) the use of computers to process, record, and store financial reporting data and other information IT Aspect - Inherent Risk Considerations: • Unauthorized Access: o Risks: Data loss, distortion, public release; errors or fraud in financial statements; unauthorized program modifications; hardware theft or damage. • Installation of New IT System: o Risks: System may not meet client needs; data loss or corruption during transfer; inappropriate data processing; inadequate staff training. • In-House Software Development: o Risks: Errors if not properly reviewed, approved, or tested. • Commercial Software (Off-the-Shelf): o Risks: May need modification, leading to errors; inadequate staff training; potential lack of post-purchase support.