CPA Exam Study Guide: FAR Comprehensive Accounting Principles and FAR Review

Final FAR Exam Comprehensive Study Notes: Financial Accounting and Reporting

Statement of Cash Flows and Operating Activities

• Financing Activities:     * Includes the payment for Treasury Stock (T-stock), even if paid in cash.     * Includes the issuance of stock, payment of dividends, and other distributions to owners.     * Includes receipt of donor-restricted resources to be used for long-term (LT) purposes.     * Includes the issuance of debt and the repayment or settlement of debt obligations.     * Redemption: Specifically refers to settling or clearing debt by paying the principal amount and interest.     * Cash outflow for the principal portion of finance lease payments.

• Operating Activities:     * Adjustments to Net Income (Indirect Method): Non-cash expenses included in Net Income (NI) are added back to determine net cash flow.     * Patent Amortization: Treated as a non-cash addition to NI.     * Non-cash Expenses to Add Back: Amortization, Depletion, and Bad Debt (BD) expense.     * Equity in Income of Investee: If using the equity method ($20\% - 50\%$ ownership), this is a non-cash item to be subtracted from NI.     * Unrealized Gains/Losses: Unrealized trading securities gains/losses are included in operating; however, unrealized gains/losses on Available-for-Sale (AFS) debt securities are excluded from the main operating section as they are recorded in Other Comprehensive Income (OCI).     * Trading Debt Securities: Realized gains/losses from these are most likely considered cash flows from operating activities.     * Payments Included: Payments to suppliers for inventory, employees for services, other suppliers for goods/services, governments for taxes (including duties, fines, fees), and lenders for interest.     * Interest Paid: Specifically categorized as an operating cash outflow.

• Investing Activities:     * Includes cash proceeds from the sale of land or equipment (gain/loss hits operating, but the full cash proceeds hit investing).     * Includes AFS securities proceeds.     * Includes cash payments for Property, Plant, and Equipment (PP&E), intangible assets, and other long-lived assets.     * Includes cash advances and loans made to other parties (and the receipts from their repayment).

• Supplemental Disclosures:     * Any significant non-cash investing and financing activities that affect assets or liabilities but not cash flows must be disclosed separately (e.g., issuing common stock in exchange for land, converting preferred stock to common, or acquiring assets through a finance lease).     * Cash paid for interest and cash paid for income taxes must be disclosed when using the indirect method.

• Accrual Basis Formula for Net Income Missing Dividends:     * $\text{Dividends Paid} = \text{Beginning Retained Earnings} + \text{Net Income} - \text{Ending Retained Earnings}$

• Specific Calculation for Taxes Paid:     * $\text{Taxes Paid} = \text{Beginning Tax Payable} + \text{Tax Expense} - \text{Ending Tax Payable}$

Efficiency and Profitability Ratios

• Efficiency Ratios:     * Accounts Receivable (AR) Turnover: $\frac{\text{Net Credit Sales}}{\text{Average AR}}$     * Inventory Turnover: $\frac{\text{COGS}}{\text{Average Inventory}}$     * Asset Turnover: $\frac{\text{Sales}}{\text{Average Assets}}$     * Cash Conversion Cycle: $\text{Average Collection Period} + \text{Day's Sale in Inventory} - \text{Average Payables Period}$     * Operating Cycle: $\text{Days' Sales in Inventory} + \text{Days' Sales in Receivables}$

• Profitability Ratios:     * Gross Profit Margin: $\frac{\text{Sales} - \text{COGS}}{\text{Sales}}$     * Operating Margin: $\frac{\text{Operating Income}}{\text{Sales}}$     * Net Profit Margin: $\frac{\text{Net Income}}{\text{Sales}}$     * Return on Assets (ROA): $\frac{\text{Net Income}}{\text{Average Total Assets}}$     * Return on Equity (ROE): $\frac{\text{Net Income}}{\text{Average Equity}}$     * DuPont Formula: $\text{ROE} = (\frac{\text{Net Income}}{\text{Sales}}) \times (\frac{\text{Sales}}{\text{Assets}}) \times (\frac{\text{Assets}}{\text{Equity}})$

• Liquidity and Solvency Ratios:     * Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$     * Quick (Acid-Test) Ratio: $\frac{\text{Cash and Equivalents} + \text{Marketable Securities} + \text{Net Receivables}}{\text{Current Liabilities}}$     * Debt-to-Equity: $\frac{\text{Total Liabilities}}{\text{Total Equity}}$     * Times Interest Earned: $\frac{\text{EBIT}}{\text{Interest Expense}}$

Bonds and Debt Accounting

• Bond Pricing Rules:     * Issued at a Discount: Stated Rate (SR) < Market Rate (MR). Price is below $100$ (e.g., 97).     * Issued at a Premium: Stated Rate (SR) > Market Rate (MR). Price is above $100$ (e.g., 105).     * Issued at Par: Stated Rate (SR) = Market Rate (MR). Price is exactly $100$.

• Bond Vocabulary:     * Face Amount (Par): The legal amount of the debt repaid at maturity (\text{# of bonds} \times \text{face per bond}).     * Issue Price: The price investors paid for the bond itself ($\text{Face} \times \text{Issue \%}$).     * Carrying Value (CV) / Net Carrying Amount (NCA): $\text{Face} + \text{Unamortized Premium} - \text{Unamortized Discount} - \text{Unamortized Issue Costs}$.

• Interest Expense vs. Interest Paid:     * Interest Expense (Effective Interest Method): $\text{Beginning CV} \times \text{Effective Interest Rate (Yield)}$.     * Cash Interest Paid: $\text{Face Amount} \times \text{Stated (Coupon) Rate}$.     * Amortization Amount: The difference between Interest Expense and Interest Paid.

• Early Debt Extinguishment:     * Step 1: Compute Reacquisition Price (RP): $\text{Face} \times \text{Call \%}$.     * Step 2: Compute Net Carrying Amount (NCA).     * Step 3: Calculate Gain/Loss: $\text{Reacquisition Price} - \text{Net Carrying Amount}$.         * If $RP > NCA = \text{Loss}$.         * If $RP < NCA = \text{Gain}$.

• Debt Issue Costs:     * Deducted from the face amount on the balance sheet (contra-liability).     * Amortized to interest expense over the life of the debt using the effective interest method.     * Examples include underwriting, registration, legal, and printing fees.

• Troubled Debt Restructuring (TDR):     * Debtor Thinking: Use the sum of future payments (undiscounted) to determine the gain.     * Creditor Thinking: Use the Present Value (PV) of expected future cash flows using the original market rate to determine the impairment loss.

Leases (ASC 842)

• Finance Lease Classification (OWNES Criteria): Success in meeting any one of these five classifies an agreement as a finance lease:     1. Ownership transfer at the end of the term.     2. Written purchase option that is reasonably certain to be exercised.     3. Near major part: Lease term is $≥ 75\%$ of the asset's economic life.     4. Equal to substantially all: PV of lease payments $≥ 90\%$ of the asset's Fair Value (FV).     5. Specialized asset: No alternative use to the lessor at the end of the term.

• Initial Recognition (Lessee):     * Recorded on the commencement date.     * ROU Asset: $\text{Lease Liability} + \text{Initial Direct Costs} + \text{Prepayments} - \text{Lease Incentives Received}$.     * Lease Liability: PV of remaining rental payments, exercise price of purchase options (if certain), and probable residual value guarantees.

• Expense Recognition:     * Operating Lease: Single straight-line lease expense reported in operating income.     * Finance Lease: Two separate expenses: Amortization of the ROU asset (straight-line) and Interest Expense on the liability (front-loaded).

Inventory Valuation and Cost Flow

• Subsequent Measurement:     * LIFO or Retail Method: Measured at Lower of Cost or Market (LCM).         * Market Definition: Replacement cost, constrained by a Ceiling ($NRV$) and a Floor ($NRV - \text{Normal Profit Margin}$).     * All Other Methods (FIFO, Weighted Average): Measured at Lower of Cost or Net Realizable Value (LCNRV).         * NRV Formula: $\text{Estimated Selling Price} - \text{Reasonably Predictable Costs of Completion, Disposal, and Transportation}$.

• Cost Flow Methods:     * FIFO (First-In, First-Out): Oldest costs are sold first. Ending Inventory (EI) consists of newest costs. Results in higher NI and higher EI during inflation.     * LIFO (Last-In, First-Out): Newest costs are sold first. EI consists of oldest costs. Results in lower NI and lower taxes during inflation. Not allowed under IFRS.     * Weighted Average (Periodic): Cost per unit is calculated at the end of the period.     * Moving Average (Perpetual): New unit cost is computed after every purchase.     * Dollar-Value LIFO: Uses a price index to value inventory layers. $\text{Price Index} = \frac{\text{Ending Inventory at Current-Year Cost}}{\text{Ending Inventory at Base-Year Cost}}$.

• Inventory Errors:     * If Ending Inventory Year 1 is Overstated: COGS is Understated $→$ NI is Overstated.     * Year 2 Reversal: Year 1 EI is Year 2 Beginning Inventory (BI). If BI is Overstated $→$ COGS is Overstated $→$ NI is Understated.

Income Statement and Comprehensive Income

• Income Statement Structure (Multi-Step):     1. Net Sales     2. Cost of Goods Sold (COGS)     3. Gross Profit     4. Operating Expenses (General \& Admin, Selling)     5. Operating Income     6. Other Income and Expenses (Interest, Gains/Losses)     7. Income Before Tax     8. Income Tax Expense     9. Income from Continuing Operations (Net of Tax)     10. Discontinued Operations (Net of Tax)     11. Net Income

• Other Comprehensive Income (OCI) - PUFER:     * Pension adjustments (actuarial gains/losses, prior service costs).     * Unrealized gains/losses on Available-for-Sale (AFS) debt securities.     * Foreign currency translation adjustments (CTA).     * Effective portion of cash flow hedges.     * Revaluation surplus (IFRS only).     * OCI items are closed to Accumulated Other Comprehensive Income (AOCI) in the Equity section of the Balance Sheet.

Asset Retirement Obligations (ARO)

• Recognition: Recognized at PV of expected cash flows when a legal obligation for retirement is incurred (due to acquisition, construction, or normal operation).
• ARO Rollforward Formula:     * $\text{Beginning ARO} + \text{New Obligations (at PV)} + \text{Accretion Expense} - \text{Settlement Payments} = \text{Ending ARO}$
• Capitalization: The initial ARO is also added to the carrying amount of the long-lived asset (ARC - Asset Retirement Cost) and depreciated over the asset's useful life.

Business Combinations and Consolidations

• Goodwill Calculation:     * $\text{Goodwill} = \text{Fair Value (FV) of Consideration Transferred} + \text{FV of Noncontrolling Interest (NCI)} + \text{FV of previously held equity} - \text{FV of identifiable net assets acquired}$.

• Acquisition Method Costs:     * Direct Acquisition Costs (Legal, Consulting, Finder's Fees): Expensed as incurred.     * Stock Issuance Costs (Registration, SEC fees): Reduce Additional Paid-In Capital (APIC).

• Elimination Rules:     * Intraentity Revenue/COGS: $\text{Consolidated Revenue} = \text{Parent's} + \text{Sub's} - \text{Intraentity Sales}$.     * Intraentity Debt: Eliminated and treated as an extinguishment of debt (recognize G/L based on purchase price vs. carrying value).     * Downstream (Parent to Sub): Gains/losses remain $100\%$ with the parent.     * Upstream (Sub to Parent): Gains/losses are split between Parent and NCI.

Long-Lived Assets and Depreciation

• Depreciable Base: $\text{Historical Cost} - \text{Salvage Value}$. (Note: DDB ignores salvage value until the final year).

• Depreciation Methods:     * Straight-Line: $\frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$.     * Digits-of-the-Years (SYD): Accelerated method using the formula $\frac{\text{Remaining Life}}{\text{Sum of Digits}} \times (\text{Cost} - \text{Salvage})$.     * Double-Declining Balance (DDB): $\text{Beginning-of-period CV} \times (\frac{2}{\text{Useful Life}})$.

• Two-Step Impairment Test (Finite-Lived Assets):     1. Recoverability Test: If $\text{Carrying Amount} > \text{Sum of Undiscounted Future Cash Flows}$, impairment exists.     2. Measurement of Loss: $\text{Impairment Loss} = \text{Carrying Amount} - \text{Fair Value}$. Loss is never reversed for assets used in operations.

Revenue Recognition (ASC 606)

• Five Steps:     1. Identify the contract with the customer.     2. Identify performance obligations.     3. Determine the transaction price.     4. Allocate transaction price to performance obligations based on stand-alone selling prices.     5. Recognize revenue when (or as) obligations are satisfied.

• Variable Consideration: Estimated using either the Expected Value method (probability-weighted) or the Most Likely Amount method. Recognition is constrained to ensure no significant reversal occurs later.

• Construction Progress Recognition (Input Method):     * $\text{Progress \%} = \frac{\text{Total Costs Incurred to Date}}{\text{Total Estimated Costs}}$     * $\text{Cumulative GP} = (\text{Total Contract Price} - \text{Total Estimated Costs}) \times \text{Progress \%}$     * $\text{Current Year GP} = \text{Cumulative GP} - \text{Prior Profit Recognition}$.

Government and Not-for-Profit (NFP)

• Governmental Funds (Modified Accrual - GRASP CDP): General, Special Revenue, Debt Service, Capital Projects, Permanent. Focus on current financial resources. Use "Budgetary," "Activity," and "Encumbrance" accounting.
• Proprietary and Fiduciary Funds (Full Accrual): Enterprise and Internal Service (Proprietary). Pension, Investment, Private-purpose, and Custodial (Fiduciary). Focus on economic resources.
• Not-for-Profit Net Assets: Classified into "With Donor Restrictions" (time or purpose) and "Without Donor Restrictions." Expenses always decrease net assets without donor restrictions.
• NFP Financial Statements:     1. Statement of Financial Position (Balance Sheet).     2. Statement of Activities (Income Statement).     3. Statement of Cash Flows.

SEC Reporting and Forms

• Form 10-K: Annual report, must be audited. Due within $60 - 90$ days (depending on filer status).
• Form 10-Q: Quarterly report, must be reviewed (not audited). Due within $40 - 45$ days.
• Form 8-K: Current report for material events (e.g., bankruptcy, change in control). Due within $4$ business days.
• Significant Accounting Policies: Typically disclosed in the initial note or a summary section preceding notes. Includes depreciation methods, inventory pricing, and revenue recognition basis.

Questions & Discussion

• Q: How are bank overdrafts handled?

• A: They are reported as current liabilities unless the entity has other funds in the same bank to offset the overdraft.

• Q: What is the criteria for a cash equivalent?

• A: Short-term, highly liquid investments with an original maturity to the holder of 3 months or less.

• Q: Are NSF (nonsufficient funds) checks considered cash?

• A: No, they should be treated as receivables.

• Q: How are gain contingencies handled?

• A: Recognized only when realized; however, they may be disclosed if the failed appeal probability is high.

• Q: When are loss contingencies accrued?

• A: When the loss is both Probable and Reasonably Estimable. If a range exists and no amount is better than another, accrue the minimum amount in the range.