FAR CPA Prep F5

What is the Fair Value Option?

is an election that allows a company to measure certain financial assets or liabilities at fair value, with unrealized gains and losses reported in net income each period.

On statement of stockholders equity how is losses reported

Net cumulative loss. If we want to find a loss in a specific period subtract PY losses to find the loss in the specific period. Remember cumulative

Entities should report marketable debt securities classified as trading at:

Fair value, with holding gains and losses included in earnings.

Under the fair value method, how are dividends normally recorded?

The portion of the dividends received this year that were not in excess of the investor's share of investee's undistributed earnings since the date of investment is dividend revenue.

What happens if dividends received exceed the investor's share of investee earnings under the fair value method?

The excess is treated as a return of capital (liquidating dividend), which reduces the investment account rather than being recognized as income.

"Dividends exceed investee earnings" means what?

Part income, part return of capital.

Example:

Share of investee earnings = $800

Dividends received = $1,000

Treatment:

$800 = dividend revenue

$200 = return of capital (reduce investment account)

What does the fair value option apply to?

The fair value option applies to financial assets (e.g., debt and equity securities) and liabilities (e.g., notes payable).

What is excluded from the fair value option?

investments in subsidiaries, pension benefit assets/liabilities and assets and liabilities recognized under leases.

How are trading securities classified?

Bought for short-term profit

Intent:

Sell soon

Active buying/selling

Usually within months

Measurement:

Fair value

Unrealized gains/losses → Net Income

How are held to maturity securities classified?

Purpose:

Buy and keep until bond matures

Requirements:

Must be debt securities only

Must have positive intent AND ability to hold to maturity

Measurement:

Amortized cost

No fair value adjustments

(ex: 10 year bonds, held for full 10 years)

How are available for sale securities classified?

Middle ground

Intent:

Not short-term trading

Not holding to maturity

May sell when convenient

Measurement:

Fair value

Unrealized gains/losses → OCI

When interest rates increase this signals a bond will

be sold at a discount

where do the unrealized gains and losses from changes in FV go for trading securities (equity securities as well) go

Net income

Where do unrealized gains and losses from changes in FV for AFS debt securities go

OCI, net of tax

When trading securities are adjusted to FV, what happens to the carrying value?

The carrying value goes to the FV

interest income and fv adj for trading securities, AFA, HTM

Investment	Interest income	Fair value changes
Trading debt	Income statement	Income statement
Available-for-sale debt	Income statement	OCI
Held-to-maturity debt	Income statement	No fair value adjustment

What happens to the unrealized gains and losses on AFS when the security is changes to a trading security?

once it is transferred into the trading category, those unrealized amounts will need to be recognized in earnings.

What is CECL (Current Expected Credit Losses) on debt securities?

A credit-related loss occurs when the investor expects to collect less than originally promised because the issuer's financial condition has weakened or default risk has increased.

If a company holds our HTM debt security, and their financial position has weakened, how would the CECL model apply to Held-to-Maturity (HTM) debt security?

HTM bonds stay recorded at amortized cost, but companies must estimate expected credit losses and record an allowance (contra-asset). This allowance reduces the bond's net value on the balance sheet, while the related credit loss expense reduces earnings.

If a company holds our AFS debt security, and their financial position has weakened, How does CECL apply to Available-for-Sale (AFS) debt security?

For AFS debt securities, normal unrealized gains/losses go to OCI, but credit-related losses are recognized in earnings under CECL. Credit loss is limited to the difference between amortized cost and fair value. NOT NET OF TAX

Does CECL apply to Trading debt securities?

- Measured at fair value

- Unrealized gains/losses already flow through earnings

- Market price already reflects credit risk

- No separate CECL allowance needed, so NO

Why:

Credit deterioration is already embedded in fair value changes

How does CECL differ across debt security classifications?

- HTM → CECL through allowance in earnings, NO FV

dr. credit loss exp cr. allowance for credit losses

- AFS → AFS splits losses; Credit loss through earnings, non-credit loss through OCI

Trading → No CECL, all FV changes in net income

Memory trick:

HTM = Allowance

AFS = Split treatment

Trading = Already marked to market

When is a loss recorded for Held to maturity securities

When amortized cost is above present value of expected future cash flows

How to find interest income without market int rate

Amortization = Cash payment - Interest income

For AFS securities

1. Compare FV to amortized cost. if FV > then no credit loss even if amortized cost is > than PV

2. If FV < amortized cost, then compare AC - PV is credit loss btu cannnot exceed the total FV decline(fv - amort)

3. Take total g/l and take out your credit loss and the remainder goes to OCI

What is the FV method?

>20% no significant influence

-Dividends (income, does not reduce investments)

• cash , div rev

- FV adjustments are adjusted to market value each period

- Reduce or increase Investment accounts and same with unrealized holding gain/loss for FF Adj

• unrealized loss, invest in x

Does the 2/1 stock split, double the investment account?

The 2-for-1 stock split does not double the investment account. The number of shares is doubled and the cost per share is halved, which results in no change to the dollar amount of the investment account.

How are EQUITY securities recorded?

Fair value through net income (FV-NI) no matter on intent of holding or selling, they will result in an aggregate income statement impact

Which risk is a required disclosure for most financial instruments?

Concentration of credit risk - the risk that the other party to the instrument will not perform - must be disclosed.

NOT REQUIRED - Disclosure of market risk - the risk of loss from changes in market prices - is encouraged, but not required.

Disclosure of information about significant concentrations of credit risk is required for:

All financial instruments.

Where in its financial statements should a company disclose information about its concentration of credit risks?

The notes to the financial statements.

must disclose

When we have a sale of an AFS security we

Remove the previously recognized unrealized gain/loss from OCI (write off)

What is the equity method?

20-50% or significant influence

-Dividends reduce investment account

• div = cash , invest in x (decreases investment)

• invest + NI - div - dep

- No FV adj

- Investor share of investee income

- Dr. Investment Cr. Equity in Earnings

Under the equity method, why are fair value/book value differences at ACQUISITION important?

Because the investor must adjust its share of investee earnings for excess purchase price allocated to specific assets (inventory, equipment, buildings, etc.). The higher fair value basis creates additional future expense recognition.

How does inventory fair value exceeding carrying value affect equity method earnings at acquisition?

Inventory fair value excess decreases equity income because when the inventory is sold, the higher fair value basis increases COGS, reducing the investor's share of earnings. Reduced by share of ownership % then spread out over useful life if applicable

How does land fair value exceeding carrying value affect equity method earnings?

No immediate effect, because land is not depreciated or amortized. The excess remains in the investment account until the land is sold or impaired.

If a company has between 20-50% ownership interest, but the question states it has no significant influence, is the equity method still used?

No, and conversely if we own 10-19% and have significant influence then we use the equity method. The key is whether significant influence exists.

If a company owns >50% ownership, what method is used?

This signals control and would require a consolidation

At the point at which the investor's carrying amount of the investment is reduced to zero due to investee losses, the application of the equity method is

suspended. The investor can resume applying the equity method once the investee has returned to profitability and any net losses allocated to the investor during the suspension period are covered by the investor's share of the investee's net income.

If we receive a stock dividend, how does this affect our investment under the equity method?

don’t increase investsment acct, dont increase div inc.

do nothing; momentum entry

Liquidating dividends when received are accounted for as

A reduction in the investment account because it is the return of the original investment regardless if FV method or Equity method

Under the equity method of accounting, investment income is equal to the

Net income - preferred dividends x ownership %, investor's proportional share of the investee's net income. CSH Dividends are not deducted from this total

How is preferred stock view'd

Preferred stock usually:

No voting rights

No operational influence

Passive investment

SO FV method applies even if it is 75%, it cannot exert significant influence so dividends will be under dividend income

• cash, div rev/inc

In a business combination, the valuation of goodwill is a calculation:

Of the residual paid above the fair value of the identifiable net assets.

Any goodwill created in an investment accounted for under the equity method is

It is neither amortized nor tested for impairment

Consolidated financial statements eliminate all

intercompany receivables, payables, advances, sales, purchases, interest, dividends, and profits.

eliminating JE (CAR IN BIG)

Debit: subs cs, apic, end re (fv @ aquition date) ( bb+ni-div), BS adj (changes in FV), intercompany transactions, goodwill

credit: investment in sub, NCI

In consolidated financial statements, how are intercompany receivables and payables reported?

They are eliminated completely because the consolidated entity cannot owe money to itself.

How are intercompany sales treated in consolidation?

Eliminated 100% (Sales ↓, COGS ↓) because the group cannot sell to itself.

What happens if all intercompany inventory is sold to outsiders by year-end?

Only eliminate Sales and COGS; no inventory or profit adjustment needed.

What happens if intercompany inventory remains at year-end?

We have unrealized profit, the inventory hasnt been sold yet. So we have to remove this until it is realized

Dr. COGS

Cr. Inventory

Unrealized profit =Ending inventory × gross profit %

Why do we increase COGS and decrease inventory when eliminating unrealized profit in intercompany inventory?

Because the inventory is recorded at a marked-up internal price, it overstates both inventory and profit. Increasing COGS removes the premature profit, and decreasing inventory brings it back to original cost—so profit is only recognized when sold to an outside party.

If a parent sells a machine to its subsidiary, how do we treat this sale for consolidation purposes?

Treat it as if the sale never happened and record the equipment at original cost and continue accumulated deprecation as if the sale never occurred

How to calculate consolidated stockholders equity?

Parent's equity + Noncontrolling interest (NCI)

For sharing of income between parent and subsidiary, how is that treated?

Ownership % determines how much income you take, and Timing determines when you start consolidating. For example if control takes place in July then the previous 6 months might be treated as the equity method

if you own 80% of sub, you report 100% of subs revs /exp on consolidated fs.

• at the bottom on the IS you allocate the net income based on % owned, so 80% to parent and 20% nci

In consolidated financial statements, what dividends are reported?

Only dividends paid to external parties. This includes:

100% of parent dividends

NCI’s share of subsidiary dividends (Exclude any portion paid within the group)

What dividends are reported in the consolidated statement of retained earnings?

Only parent dividends, because this statement reflects changes in parent retained earnings only (exclude all subsidiary dividends, including NCI portion).

NCI dividends only reduce the Noncontrolling Interest (NCI) equity account, that is why it is not included in consolidated RE

In a consolidated f/s, how should the non-controlling interest be shown

The consolidated balance sheet presents the noncontrolling interest as a separate component within the equity section but separate from the parent company's equity. So Classified as equity and presented separately from the equity of Quality.

In the acquisition method for consolidation what happens

(1) 100% of the net assets acquired are recorded at fair value, with the excess recorded to goodwill; and

(2) when the company prepares consolidated financial statements, the subsidiary's entire equity (including common stock, APIC, and retained earnings) is eliminated.

The purchase by the member of a consolidated group of stock of another member of the consolidated group is treated as a

treasury stock transaction.

What do the AR and Inventory differences show in the consolidated balances?

A/R difference = who owes who

Inventory difference = fake profit

Why do we debit COGS when trying to get rid of unrealized profits

Because how is profit decreased? By increasing COGS. Having ending inventory at a markup cost at year end allows for unrealized profit that should not be there and a sales transaction that should not be there either

Profit from intercompany sale goes to TWO places:

Inventory (unsold) → EI sub

COGS (sold) → sub COGS

From a consolidated perspective how is the purchase of bonds treated

As an extinguishment, so if the sub or parent bought the bonds at a higher price then it was issued then it is treated as a loss (think treasury stock). Price paid - carrying value

At date of acquisition, the consolidated equity will be equal to the

parent company's equity plus the fair value of any noncontrolling interest. The subsidiary company's equity accounts are eliminated.

What is reported as common stock on the consolidated balance sheet?

Parents common stock, 100% of a purchased subsidiary's shareholders' equity (including common stock) as of the date of acquisition is eliminated in consolidation.

Consolidated retained earnings =

Parent's retained earnings ONLY. ALWAYS. No exceptions

How are consolidated balances of assets recorded

Parents assets at BV + Subs assets at FV

Bonus method for partnerships

Comparing total BV of old partners and new partners investment to FV of the share of new partners investment and excess over % is bonus

(A) New partner overpays → bonus to OLD partners

New partner pays more than their share of book value

Old partners get the extra

(B) New partner underpays → bonus to NEW partner

New partner pays less than their fair share

Old partners give up capital

When a partnership becomes incorporated what happens

Assets and Liabilities are brought to FV on BS and then A = L + SE (C/S + APIC)

The partners original capital disappears when incorporated

When a partner contributes property WITH a liability, their capital =

FV of asset − liability assumed by the partnership

When property other than cash is invested in a partnership, at what amount should the noncash property be credited to the contributing partner's capital account?

Fair value at the date of contribution.

When a new partner is admitted:

Ownership % → determines what they SHOULD have

Investment → determines what they ACTUALLY have

Difference → bonus

Old ratio → who absorbs it

What should land and equipment (assets) be valued at in a partnership

FV

Drawings reduce the partner's

capital account, not their share of net income. Net income allocation happens before drawings.

How to calculate the capital account after drawings

Partners capital + share of NI - drawings

Under the goodwill method that REQUIRES EQUAL INITIAL CAPITAL BALANCES

Under the partnership agreement, the partners start with equal initial capital balances. Because they did not contribute the same amounts, the partner that contributed less gets goodwill allocated to them using a two-step process:

1: Implied Value of Partnership = Partner who paid the most & their contribution x # of partners & their contribution

2: Goodwill: Implied Value - Total Actual Contributions

Under the goodwill method with new partner admission with ownership position and what should be recorded as total goodwill to original partners (no equal initial balances)

Implied Total capital = New Partner Investment / ownership %

Implied total capital - total capital = goodwill

How to figure out capital account change during year when partners receive int and divide profits and losses evenly

Start with

1: Beg Capital x Int received % = Total Interest credited

2: Profit - Int = Gain or Loss

3: Gain or loss / # of partners = allocated gain or loss

4. Beg Capital Balance + Int % credited to them = Total cap

5: Total Cap - allocated gain or loss =New account balance

What happens if salary allocations exceed partnership net income?

The excess becomes a residual loss, allocated by the P/L ratio. Final share = Salary− share of the loss (distribution).

When Mill retired from the partnership of Mill, Yale, and Lear, the final settlement of Mill's interest exceeded Mill's capital balance. Under the bonus method, the excess:

Reduced the capital balances of Yale and Lear.

When liquidating a partnership you are

turning everything into cash, paying liabilities, clearing partner loans, then distributing what is left based on final capital balances.

If an asset sells for a gain/loss, you have to allocate that loss to their capital accounts to get how much will be distributed to them because of the liquidating partnership

Bonus method vs. Goodwill method — what's the key difference in partnership accounting?

Bonus method: reallocates capital between partners (decrease or increase), no change in total assets

Goodwill method: records goodwill, changes total assets and total capital

Admission vs. Withdrawal — what number do you start with?

Admission: start with investment

Withdrawal (goodwill): start with extra cash paid over capital → Then divide by ownership % to scale up

Under the indirect method on the statement of cash flows, what is a supplemental disclosure

a supplemental disclosure of cash paid for interest and income taxes is required. Tam will report total cash paid for interest and income taxes

Statement of Cash Flows — when net cash from operating, investing, and financing is given, do you include individual items (like proceeds from sale of land)?

No. Use only the net cash amounts (CFO, CFI, CFF).Individual items (e.g., proceeds, gains) are already included — do not add them again.

Statement of Cash Flows — how are purchases of cash equivalents (e.g., 3-month T-bills) reported?

Not reported. Cash is used to buy another form of cash (cash equivalent), so total cash & cash equivalents doesn’t change → no cash flow to report.

Financial statements should not report an amount of

cash flow per share.

The primary purpose of a statement of cash flows is to provide relevant information about:

The cash receipts and cash disbursements of an enterprise during a period.

Operating Activities (Indirect Method) — what is it and what's included?

Converts net income → cash from operations

Start with Net Income

Add:

- Non-cash expenses (depreciation, amortization, bond discount, impairment)

- Losses

Subtract:

Gains (Only subtract gains if the related cash flow is in INVESTING, if already in operating do not adjust)

Working Capital (AR,AP, Prepaids, DTL, accrued int payable):

Increase in assets → subtract

Decrease in assets → add

Increase in liabilities → add

Decrease in liabilities → subtract

Rule: If it affects net income but not cash → adjust here

What supplementnal disclosures are required

- Income Taxes paid

- Interest paid

- noncash investing and financing activities is required under both the direct and indirect methods. (issuing stock for assets, converting bonds to stock, issuing bonds for assets, etc.)

Investing Activities — what is it and what's included?

Cash flows from long-term assets

Add (inflow):

Sale of PPE or investments (full proceeds including gain)

Collection of loans

Subtract (outflow):

Purchase of PPE or investments (purchase C/S, bonds payable, stock of other companies)

Making loans

Rule: Cash coming in = add

Cash going out = subtract

Financing Activities — what is it and when do you add or subtract?

Debt and equity

Add (inflow):

Issuing stock, bonds

Issuing debt

borrowings

Subtract (outflow):

Repaying debt

Repurchasing stock (TS)

Paying dividends

Rule: Cash from investors/lenders = add

Cash paid to them = subtract

Cash Flow Statement (Indirect) — how do you calculate cash paid for interest (supplemental disclosure)?

Start with total cash interest paid, then:

Subtract capitalized interest (investing activity) and was included in cash paid but it is tied to a building or asset and therefore was capitalized to the asset itself

Ignore accrued interest (not yet paid)

Ignore non-cash interest (e.g., zero-coupon bonds)

Rule: Only include actual cash paid for operating interest → remove anything not operating or not cash

Stock issuances are categorized as

cash inflows from financing activities. The amount of cash the company receives is equal to the number of shares issued multiplied by the issuance price per share. TOTAL PROCEEDS IN INVESTING

Dividends received are treated like

income → Operating

current portion of income tax expense

Taxable income × tax rate

Common examples of DTA vs DTL

DTL (pay less now, more later):

- Accelerated tax depreciation (Tax > Book expense)

DTA (pay more now, less later):

- Accrued expenses not yet deductible (Book > Tax expense)

- Warranty, loss accruals

Steps to solve for deferred tax (given book → taxable reconciliation)

- Ignore permanent differences

- Identify temporary differences only

Classify each:

Taxable income ↑ → DTA

Taxable income ↓ → DTL

Net all temporary differences

Multiply net amount × tax rate → Result = net DTA or DTL

Only certain items are shown net of tax (intraperiod tax allocation)

Splitting total tax expense across different sections of the income statement

Discontinued operations

Income from continuing operations

Other comprehensive income items

Accounting changes (like retrospective changes)

Under current generally accepted accounting principles, which approach is used to determine income tax expense?

Asset and liability approach.