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The Mysterious Case of the Disappearing AICPA Released Questions
Several years ago, the AICPA unexpectedly released a set of 140 CPA Exam questions to the public and then removed them a month later.
I call them “The Disappearing AICPA Questions.”
Spooky.
The AICPA only released the correct answer, not the explanations.
(If you want the answer explanations, we have them in our CPA Test Bank as part of NINJA MCQ (8,200+ CPA Exam Questions & 340+ CPA Simulations)… we can't post them here, or bad men will steal them.)
They're worth a quick look … 10-15 minutes of your time.
(Yeah, BEC doesn't “exist” any longer, but the questions have mostly moved to BAR).
Study them … skim them … ignore them … your choice.
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AUD CPA Exam Questions
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Auditing and Attestation CPA Exam Questions
AUD-1. Which of the following statements is correct concerning both an engagement to compile and an engagement to review a nonissuer's financial statements?
A. The accountant expresses no assurance on the financial statements.
B. The accountant should obtain a written management representation letter.
C. The accountant need not obtain an understanding of internal control.
D. The accountant must be independent in fact and appearance.
The correct answer is (C).
An auditor is required to obtain an understanding of Internal Control in Audit Engagements, but not in either review or compilation engagements.
An accountant expresses limited assurance on a review of a non-issuer's financial statements, stating that the accountant is not aware of any material modifications that should be made to the financial statements for them to be in accordance with the applicable financial reporting framework. However, no assurance is provided in an engagement to compile a non-issuer's financial statements.
An accountant is required to obtain a management representation letter in a review of a non-issuer's financial statements. However, the same is not required for the compilation of financial statements.
Independence is required for a review of a non-issuer's financial statements, whereas independence is not required for the compilation of financial statements. However, if the accountant is not independent, he/she needs to indicate a lack of independence in the Compilation Report.
AUD-2. A compilation of financial statements in accordance with Statements on Standards for Accounting and Review Services is limited to presenting
A. Accounting data that conforms with a special purpose framework other than GAAP.
B. Unaudited financial statements that omit substantially all required GAAP disclosures.
C. Information in the form of financial statements that is the representation of management.
D. Supplementary financial information that has been subjected to inquiry and analytical procedures.
The correct answer is (C).
A compilation engagement is limited to taking information provided by management and presenting it in the form of financial statements. The accountant uses accounting expertise to organize the data, but does not verify its accuracy, perform procedures, or provide any assurance.
The key point is that the financial statements remain entirely management’s representations. The accountant is simply assisting with the presentation, not validating the underlying information.
AUD-3. According to rules issued under the Sarbanes-Oxley Act, which of the following nonaudit services is an accounting firm permitted to provide for an issuer audit client without impairing the accounting firm's independence?
A. Providing an expert opinion in order to advocate the client's interest in litigation.
B. Providing an expert opinion in order to advocate the client's position in a regulatory investigation.
C. Providing factual accounts in testimony explaining positions taken during the performance of any services provided to the client.
D. Providing legal services to the client in a foreign jurisdiction.
The correct answer is (C).
When evaluating nonaudit services for an issuer audit client, focus on whether the service places the auditor in an advocacy or legal role. Independence is impaired if the firm is acting in a way that supports or defends the client’s position.
There is an important distinction between advocating for the client and explaining work already performed.
Providing an expert opinion to support the client in a dispute or investigation crosses into advocacy, which is not allowed. However, simply giving factual testimony about procedures performed or conclusions reached during prior services does not place the auditor in an advocacy role. The auditor is not taking a position; they are just explaining the work.
That type of neutral, factual explanation is permitted and does not impair independence.
AUD-4. Before accepting an audit engagement, a CPA should evaluate whether conditions exist that raise questions as to the integrity of management. Which of the following conditions most likely would raise such questions?
A. There are significant differences between the entity's forecasted financial statements and the financial statements to be audited.
B. The CPA will not be permitted to have access to sensitive information regarding the salaries of senior management.
C. There have been substantial inventory write-offs just before the year-end in each of the past four years.
D. The CPA becomes aware of the existence of related party transactions while reading the draft financial statements.
The correct answer is (B).
Before accepting an audit engagement, a CPA firm should make an assessment of the client’s auditability. This includes assessing the availability and adequacy of accounting records, the integrity of management, and the management's attitude towards the internal control environment. Management integrity sets the tone of the organization and is the foundation for all other components of internal control.
If the CPA is not allowed to have access to sensitive information regarding the salaries of senior management, it would raise serious concerns about management’s integrity.
Variances in forecasts, inventory write-offs, and related party transactions would require further investigation. However, this does not necessarily raise direct concerns about management’s integrity.
AUD-5. Which of the following factors most likely would cause a CPA not to accept a new audit engagement?
A. Management's reputation for failing to provide schedules to prior auditors on a timely basis.
B. The CPA's inability to review the predecessor auditor's working papers.
C. Management's unwillingness to make all financial records available to the CPA.
D. The CPA's lack of understanding of the entity's operations and industry.
The correct answer is (C).
Prior to accepting an audit engagement, the auditor should, amongst other pre-engagement activities, make an assessment of the client’s auditability. This would include whether the financial reporting framework is acceptable, whether accounting records will be available, and adequate, and also assessing the integrity and attitude of the management. In case the prospective client is unwilling to make all financial records available to the CPA, he/she may choose not to accept the new audit engagement.
The following would not cause a CPA to reject a new engagement:
- Management's reputation for failing to provide schedules to prior auditors on a timely basis.
- The auditor is required to communicate with the predecessor auditor before accepting a new audit engagement. It is not mandatory to review the predecessor’s audit work papers before such acceptance.
Lack of understanding of the prospective client’s operations and industry is not a prerequisite to accepting a new audit engagement. It can be obtained on a timely basis before the commencement of the audit procedures.
AUD-6. Which of the following factors most likely would cause an accountant not to accept an engagement to compile the financial statements of a nonissuer?
A. A lack of segregation of duties in the entity's accounting and payroll departments.
B. Indications that reports of asset misappropriation are not investigated by management.
C. The entity's intention to omit from the financial statements substantially all of the disclosures required by GAAP.
D. Management's acknowledgment that the financial statements will be included in a written personal financial plan.
The correct answer is (B).
If the accountant becomes aware of potential fraud, such as asset misappropriation, that is not being addressed by management, it raises serious concerns about the integrity of the entity’s financial reporting. This could impair the accountant's ability to perform the engagement with reasonable assurance that the financial statements are free from material misstatements. If management is ignoring fraud, the accountant may not feel comfortable accepting the engagement due to the increased risk of being associated with misleading financial statements.
Therefore, indications that reports of asset misappropriation are not investigated by management is the most likely reason for the accountant to decline the engagement, as it indicates a potential risk of fraud and management’s failure to address it, which could impair the accountant's ability to compile reliable financial statements.
A lack of segregation of duties can be a weakness in internal controls, but it is not necessarily a reason to decline a compilation engagement. In a compilation, the accountant is not required to assess or provide assurance on internal controls. Therefore, this issue alone wouldn’t automatically prevent the accountant from accepting the engagement.
GAAP allows financial statements to omit disclosures as long as this omission is clearly indicated in the accountant's compilation report and the omission is not intended to mislead users. If the client chooses to omit required disclosures, the accountant can still perform the compilation as long as they disclose this omission in their report. Therefore, this is not necessarily a reason to decline the engagement.
Management's acknowledgment that the financial statements will be included in a written personal financial plan simply describes the intended use of the financial statements and does not imply any issue that would prevent the accountant from accepting the compilation engagement. The accountant would simply need to ensure that the report clearly reflects the intended purpose of the financial statements.
AUD-7. Which of the following statements would most likely appear in an auditor's engagement letter?
A. Management is responsible for reporting to us any inadequate provisions for the safeguarding of assets.
B. We will identify internal controls relevant to specific assertions that may prevent or detect material misstatements.
C. Management agrees to correct all deficiencies in internal control activities identified by us.
D. Management is responsible for making all financial records and related information available to us.
The correct answer is (D).
The agreed-upon “written” terms of the audit engagement should include the following management responsibilities:
- Preparation & fair presentation of Financial Statements
- Design, implementation, and maintenance of Internal Control over Financial Reporting
- Providing written representations to the auditor
The other three statements are not likely to be included in the engagement letter.
AUD-8. Which of the following activities is not an element of a CPA firm's quality control system to be considered in establishing quality control policies and procedures?
A. Deciding whether to accept or continue a client relationship.
B. Selecting personnel for advancement who have the necessary qualifications.
C. Assessing a client's ability to establish effective internal controls.
D. Monitoring the effectiveness of professional development activities.
The correct answer is (C).
A system of quality control in a CPA firm is there to meet its responsibilities to offer professional services that conform to professional standards.
Elements of a system of quality control include the following:
- Tone at the top (leadership responsibilities for the quality within the firm)
- Ethical requirements (independence)
- Acceptance & continuance of client relationships and specific engagements (deciding whether to accept or continue a client relationship)
- Human Resources: selecting personnel for advancement who have the necessary qualifications
- Monitoring: monitoring the effectiveness of professional development activities
- Engagement performance
Assessing a client's ability to establish effective internal controls is not one of the elements of a CPA firm's quality control system.
AUD-9. The purpose of establishing quality control policies and procedures for deciding whether to accept or continue a client relationship is to
A. Provide reasonable assurance that personnel are adequately trained to fulfill their responsibilities.
B. Minimize the likelihood of associating with clients whose management lacks integrity.
C. Document the matters that are required to be communicated to the audit committee.
D. Enhance the auditor's understanding of the client's business and its industry.
The correct answer is (B).
A system of quality control is in a CPA firm to meet its responsibilities to offer professional services that conform to professional standards. The primary reason quality control policies are used in a CPA firm is to minimize the likelihood of associating with clients whose management lacks integrity.
Quality control policies and procedures within the CPA firm would not provide reasonable assurance that the personnel is adequately trained to fulfill their responsibilities in order to decide to accept or continue a client relationship, document the matters that are required to be communicated to the audit committee, or enhance the auditor's understanding of the client's business and its industry.
AUD-10. Which of the following is an element of a CPA firm's quality control policies and procedures applicable to the firm's accounting and auditing practice?
A. Engagement performance.
B. Risk analysis.
C. Safeguarding of assets.
D. Information processing.
The correct answer is (A).
Elements of a System of Quality Control include the following:
- Tone at the top (leadership responsibilities for quality within the firm)
- Ethical Requirements (independence)
- Acceptance & continuance of client relationships and specific engagements
- Human Resources
- Monitoring
- Engagement performance
AUD-11. Which of the following is an element of a CPA firm's quality control policies and procedures applicable to the firm's auditing practice?
A. Acceptance of a client relationship.
B. Professional skepticism of management.
C. Computer information processing.
D. Efficiency of organizational structures.
The correct answer is (A).
Elements of a System of Quality Control include
- Tone at the top (leadership responsibilities for quality within the firm)
- Ethical Requirements (independence)
- Acceptance & continuance of client relationships & specific engagements
- Human Resources
- Monitoring
- Engagement performance
AUD-12. Which of the following procedures would an auditor most likely perform before the balance sheet?
A. Confirm with client's lawyer that all litigation probable of assertion has been disclosed to the auditor.
B. Obtain an understanding of the client's internal control activities.
C. Determine whether there are any liens or encumbrances on assets that have been pledged as collateral.
D. Consider the client's plans and ability to meet imminent purchase commitments and cash flow obligations.
The correct answer is (B).
In an audit, understanding internal control is part of the risk assessment process, which occurs early in the engagement. This includes evaluating control activities to determine where material misstatements could occur and how the auditor should design further procedures.
This work is performed before the balance sheet date because it drives the overall audit strategy, specifically the nature, timing, and extent of testing. Without this understanding, the auditor cannot properly plan the audit.
AUD-13. Which of the following factors most likely would be considered an inherent limitation to an entity's internal control?
A. The ineffectiveness of the entity's audit committee.
B. Collusion of employees in circumventing internal controls.
C. The lack of resources to monitor internal controls.
D. The complexity of the entity's electronic order processing system.
The correct answer is (B).
Internal control only provides reasonable assurance that entity-specific objectives will be achieved. Inherent limitations that can result in the breakdown of internal control include:
- Competence – Human errors, such as mistakes or misjudgments, by the company personnel.
- Obsolescence – Change in the operating environment may result in existing internal control becoming obsolete, requiring a modification in internal control to suit the new operating environment.
- Collusion – Though there may be segregation of duties, collusion between personnel may circumvent internal control.
- Override by management – Management has the ability to override internal control.
Cost constraints: The cost of internal control should not exceed the benefits expected to be derived.
AUD-14. Which of the following factors most likely would heighten an auditor's concern about the risk of fraudulent financial reporting?
A. The audit committee's approval of the initial selection of accounting principles.
B. A lack of competition in the entity's industry, accompanied by increasing profit margins.
C. Management's disclosure of unresolved litigation and contingent liabilities.
D. Year-end adjustments by the entity that significantly affect financial results.
The correct answer is (D).
Year-end adjustments by the entity that significantly affect financial results will most certainly heighten an auditor's concern about the risk of fraudulent financial reporting because these adjustments were not made in the normal course of business.
The audit committee's approval of the initial selection of accounting principles is a good sign and not indicative of fraud.
A lack of competition in the entity's industry, accompanied by increasing profit margins and management's disclosure of unresolved litigation and contingent liabilities, is all justified and not indicative of fraud.
AUD-15. Which of the following characteristics most likely would heighten an auditor's concern about the risk of material misstatements arising from fraudulent financial reporting?
A. Management displays a significant disregard for regulatory authorities.
B. There is a lack of turnover of employees in the accounting department.
C. Monthly bank reconciliations usually include several deposits in transit.
D. Equipment is usually sold at a loss before being fully depreciated.
The correct answer is (A).
Significant disregard for regulatory policies would increase the compliance risk that management is not complying with all the laws and regulations. It would also heighten the risk of material misstatements arising from fraudulent financial reporting.
- Lack of turnover in the accounts department is not indicative either of fraud or of risk of material misstatement.
- Monthly bank reconciliations usually include several deposits in transit and are a normal business occurrence and not indicative of fraud or of risk of material misstatement. Reconciliations are likely to have large in-transit transactions.
- Equipment is usually sold at a loss before being fully depreciated, which is not indicative of fraud or of risk of material misstatement, as equipment sold at a loss is a normal business occurrence.
AUD-16. Which of the following circumstances most likely would cause an auditor to suspect that there are material misstatements in an entity's financial statements?
A. There are unusual discrepancies between the entity's records and confirmation replies.
B. Management enforces strict budgetary controls over the entity's departmental supervisors.
C. Cash transactions are electronically processed and recorded, leaving no paper audit trail.
D. The monthly bank reconciliation ordinarily includes several large outstanding checks.
The correct answer is (A).
Unusual discrepancies between the entity's records and confirmation replies from external parties would indicate misstatements on financial statements, either due to fraud or error.
Strict budgetary controls over the entity's departmental supervisors would reduce the risk of material misstatement. Electronically processed transactions will not have a paper trail. However, this doesn’t imply misstatements in financial statements. The monthly bank reconciliation ordinarily includes several large outstanding checks that will also not indicate misstatements in financial statements.
AUD-17. Which of the following factors most likely would heighten an auditor's concern about the risk of material misstatement arising from the misappropriation of assets?
A. There is a potential for bias in the preparation of accounting estimates.
B. The entity's fixed assets lack ownership identification.
C. Management recently adopted new accounting principles.
D. The entity recently experienced rapid growth in revenue.
The correct answer is (B).
If an entity’s fixed assets lack ownership identification, it would increase the risk of a material misstatement arising from the misappropriation of assets.
Bias in the preparation of accounting estimates, adoption of new accounting principles, and rapid revenue growth would heighten the risk of material misstatements arising from financial reporting and not from misappropriation of assets.
AUD-18. If the objective of an auditor's test of details is to detect the overstatement of sales, the auditor should trace transactions from the
A. Sales journal to the shipping documents.
B. Shipping documents to the cash receipts journal.
C. Cash receipts journal to the customer's purchase orders.
D. Customer's purchase orders to the sales journal.
The correct answer is (A).
When auditing sales, existence is generally a more relevant assertion than others because the risk that sales would be overstated is high. If account books reflect overstated sales, either on account of recording nonexistent sales or recording sales for an amount greater than the actual amount, such cases will not have the required supporting documentation and can be identified by scrutinizing the source documents for the entries in the accounting records. These transactions would be in the sales journal; however, they might not have appropriate support, such as the shipping documents.
AUD-19. When assessing an internal auditor's objectivity, an independent auditor should
A. Perform tests of controls to determine whether significant internal control activities are properly maintained.
B. Analyze the risk factors that relate to misstatements arising from the misappropriation of assets.
C. Review the internal auditor's reports to verify that the conclusions reached are consistent with the procedures performed.
D. Consider the policies that prohibit the internal auditor from auditing areas where relatives are employed in key management positions.
The correct answer is (D).
Objectivity is the ability to perform tasks without bias and conflict of interest. For internal auditors to be objective, it’s important that their responsibilities are free from conflicting responsibilities. If there are policies in place that prohibit internal auditors from auditing areas where relatives are employed, it would keep the objectivity of the auditor in check. As such, considering the policies that prohibit the internal auditor from auditing areas where relatives are employed in key management positions will help the independent auditor assess the objectivity of the internal auditor.
Performing tests of controls to determine whether significant internal control activities are properly maintained will help the auditor assess control risk.
Analyzing the risk factors that relate to misstatements arising from the misappropriation of assets will help the auditor assess fraud risk.
Reviewing the internal auditor's reports to verify that the conclusions reached are consistent with the procedures performed and will help the auditor assess the competence of the internal auditor, but not objectivity.
AUD-20. Which of the following procedures would a CPA most likely include in planning a financial statement audit?
A. Determine the extent of involvement of the client's internal auditors.
B. Ask the client's lawyer if contingencies have been recorded in conformity with GAAP.
C. Obtain a written representation letter from the client's management.
D. Scan the client's journals and ledgers to identify any unusual transactions.
The correct answer is (A).
While planning a financial statement audit, a CPA would consider in which areas and to what extent the work of the internal audit function can be used in obtaining audit evidence, as well as whether internal auditors can be used to provide direct assistance to the CPA.
Asking the client's lawyer if contingencies have been recorded in conformity with GAAP, obtaining a written representation letter from the client's management, and scanning the client's journals and ledgers to identify any unusual transactions are procedures performed during the fieldwork stage of audit and not during planning.
➡️ Free AUD Notes – Ethics & Professional Responsibilities
AUD-21. In selecting an appropriate sample for a substantive test, the auditor most likely would stratify the population if the
A. Auditor suspects that management fraud has occurred during the year.
B. Desired assessed level of control risk is less than the prior year.
C. Technique to be used is attribute sampling.
D. Auditor plans to give greater representation to large recorded amounts.
The correct answer is (D).
In substantive testing, stratification is used to improve the efficiency and effectiveness of sampling by grouping items based on characteristics, most commonly dollar amount.
When an account includes a wide range of balances, a small number of large items often make up a significant portion of the total. By separating these larger amounts into their own group, the auditor ensures they receive more attention in the sample.
This approach reduces sampling risk, particularly the risk of missing a material misstatement, and can allow for a smaller overall sample size while still achieving appropriate assurance.
In practice, stratification is most relevant in variable sampling, where the focus is on dollar misstatements rather than simply whether a control was followed.
AUD-22. Which of the following sampling methods would an auditor use to estimate a numerical measurement of a population, such as the dollar value of inventory?
A. Variable sampling.
B. Discovery sampling.
C. Attribute sampling.
D. Random-number sampling.
The correct answer is (A).
During substantive testing, variable sampling is used, which refers to examining a sample of items from a population to determine if the individual account balance stated in dollar terms or other numerical values is materially correct.
Attribute sampling and discovery sampling are used in a test of controls to determine what percentage of them contain a particular attribute. It cannot be used to estimate a numerical measurement of the population. Random number sampling also does not provide a numerical value. Numbered documents or transactions are selected through the use of random number tables or computer software.
AUD-23. An auditor is selecting prenumbered purchase orders for testing an entity's internal control activities related to their proper approval before office equipment is ordered. The auditor is matching random numbers with the purchase order numbers to determine which purchase orders to inspect. If a random number matches a voided purchase order, the auditor ordinarily would replace the voided purchase order with another if the voided purchase order
A. Represents office equipment ordered and never received.
B. Has been properly voided in the normal course of business.
C. Represents office equipment ordered and canceled before being processed by the vendor.
D. Has been electronically deleted from the purchase order file.
The correct answer is (B).
When an item is included in a sample on which an audit procedure cannot be performed, as in the case of a properly voided purchase order in the normal course of business, an auditor should replace the purchase order with another one.
However, when a purchase order represents office equipment ordered, and was never received or has been electronically deleted from the purchase order file, or represents office equipment ordered and canceled before being processed by the vendor, the auditor should investigate further and should not choose a replacement item.
AUD-24. In assessing the tolerable rate of deviations of a test of controls that was performed using statistical sampling, an auditor should consider that
A. Deviations from pertinent controls do not affect the risk of material misstatement in the accounting records.
B. Deviations from pertinent controls at a given rate ordinarily result in misstatements at a lower rate.
C. When the degree of assurance desired in a sample is high, the auditor should allow for a high level of sampling risk.
D. Increasing the number of items selected for the test of controls usually increases the tolerable rate of deviations.
The correct answer is (B).
Deviations from pertinent controls at a given rate ordinarily result in misstatements at a lower rate as deviations from control need not necessarily imply that accounts are misstated. Deviations from control do not imply misstated financial statements but increase the risk. As such, normally, control deviations would lead to misstatements at a lower rate.
Deviations from pertinent controls do affect the risk of material misstatement in the accounting records, but normally, material misstatements are at a lower rate than deviations in control.
When the degree of assurance desired in a sample is high, the auditor should allow for a low level of sampling risk and not a high level.
There is an inverse relationship between the tolerable rate of deviations and the sample size, i.e., as the tolerable rate of deviations increases, the sample size decreases. As such, increasing the number of items selected for the test of controls usually implies a decrease in the tolerable rate of deviations.
AUD-25. An auditor is using statistical sampling in testing whether cash disbursements were properly authorized. The sample results indicate that the sample rate of deviation plus the allowance for sampling risk exceeds the tolerable rate. Under these circumstances, the auditor most likely would reduce the
A. Planned reliance on the prescribed control.
B. Assessed level of control risk.
C. Planned reliance on substantive tests.
D. Tolerable rate of deviations.
The correct answer is (A).
If the auditor determines that the sample rate of deviation plus the allowance for sampling risk exceeds the tolerable rate, the auditor would conclude that the controls are not operating effectively and would increase the assessed level of control risk. This would mean that the auditor is not relying on internal controls and would reduce his/her planned reliance on prescribed controls.
AUD-26. An auditor decides to use the blank form of positive accounts receivable confirmation. The auditor should be aware that the blank form may be ineffective because
A. All accounts do not have an equal opportunity to be selected for confirmation.
B. Accounts unconfirmed may have already been written off as uncollectible.
C. Few responses may occur because more effort is required of recipients.
D. Accounts actually confirmed may not be representative of the population.
The correct answer is (C).
The auditor uses the blank form of positive confirmation requests that do not state the amount (or other information) on the confirmation request and that ask the confirming party to fill in the amount or furnish other information. However, the use of this type of “blank” confirmation request may result in lower response rates because the additional effort is required from the confirming parties to provide the requested information.
AUD-27. Confirmation of accounts receivable that have been categorized initially by an auditor as “exceptions” most likely could be due to
A. Customers who have credit or zero balances with the client.
B. Responses that were mailed rather than faxed to the auditor.
C. Accounts receivable that have been classified as uncollectible.
D. Payments mailed to the client that have not been recorded.
The correct answer is (D).
An exception is a response that indicates a difference between the information requested to be confirmed, or contained in the entity’s records, and the information provided by the confirming party. As such, if payments are mailed to the client that have not been recorded, there would be a difference between the recorded balance and the actual balance, leading to an exception.
AUD-28. Which of the following procedures does a CPA usually perform when reviewing the financial statements of a nonissuer?
A. Make inquiries of management concerning restrictions on the availability of cash balances.
B. Communicate deficiencies in the design of internal control to the entity's audit committee.
C. Examine trend analysis to determine the appropriateness of the CPA's assessment of detection risk.
D. Evaluate management's plans for dealing with negative trends and financial difficulties.
The correct answer is (A).
A CPA would make inquiries of management concerning restrictions on the availability of cash balances when reviewing the financial statements of a non-issuer. An accountant performs inquiries, analytical procedures, and obtains a management representation letter during a review of a non-issuer’s financial statements as per the Statement on Standards for Accounting and Review Services.
Communicating deficiencies in the design of internal control to the entity's audit committee, risk assessment, and evaluating management's plans for dealing with negative trends and financial difficulties is done during an audit.
AUD-29. Which of the following procedures would an accountant least likely perform during an engagement to review the financial statements of a nonissuer?
A. Make inquiries of management about actions taken at board of directors' meetings.
B. Study the relationships of financial statement elements expected to conform to predictable patterns.
C. Identify internal control activities that are likely to prevent or detect material misstatements.
D. Compare the financial statements with anticipated results in budgets and forecasts.
The correct answer is (C).
Identification of internal control activities that are likely to prevent or detect material misstatements is done during the audit of financial statements.
An accountant performs inquiries, analytical procedures, and obtains a management representation letter during a review of a non-issuer’s financial statements as per the Statement on Standards for Accounting and Review Services.
Studying the relationships of financial statement elements expected to conform to predictable patterns and comparing the financial statements with anticipated results in budgets and forecasts are analytical procedures.
AUD-30. In performing substantive tests regarding the granting of stock options to senior management of an issuer, an auditor most likely would
A. Confirm with those members of management as to whether they are actually option holders.
B. Verify the existence of option holders in the issuer's payroll and human resources records.
C. Trace the authorization for the options granted to the board of directors' approval.
D. Review the public records of the SEC to determine whether the options were properly reported.
The correct answer is (C).
The substantive procedure that is most likely when an auditor is performing tests concerning the granting of stock options is to trace the authorization for the options granted to the board of directors' approval. The issuance of stock options is ordinarily a decision made by the board of directors. As such, in performing tests concerning the granting of stock options, the auditor should inspect the minutes of the meeting of the board of directors for corresponding authorization from the board.
AUD-31. In searching for unrecorded liabilities, an auditor most likely would examine the
A. Cutoff bank statement for deposits recorded in the books, but not by the bank.
B. Details of accounts receivable confirmations that are classified as “exceptions”.
C. Files of purchase requisitions for items ordered just before the year end.
D. Receiving reports for items received before year-end, but not yet recorded.
The correct answer is (D).
The requirement is to identify the procedure, among the given choices, that an auditor is most likely to perform in searching for unrecorded liabilities.
Receiving reports for items received before year-end, but not yet recorded, would help the auditor identify unrecorded liabilities.
Items received could create a liability to pay for a purchase or to refund a customer for a return.
AUD-32. An audit client has a valid reason for requesting that a certain account receivable that the auditor has selected for confirmation not be confirmed. Under these circumstances, the auditor should
A. Verify the account balance by inspecting the client's bank statements and cash receipt records.
B. Select at random a different account for confirmation that is approximately the same size.
C. Request the client's management to document the matter in the management representation letter.
D. Explain to the client that the request will most likely cause the auditor to disclaim an opinion.
The correct answer is (A).
An auditor performs alternative procedures to verify account balances that cannot be confirmed. Such procedures help determine if a satisfactory basis for the decision arrived at on omitted audit procedures is obtained. Alternative procedures, such as verifying the client's bank statements and cash receipt records for subsequent collection, would give the auditor comfort about the existence of accounts receivable.
AUD-33. Which of the following procedures would an auditor most likely perform to obtain evidence about the occurrence of subsequent events?
A. Verify inventory pledged under loan agreements by confirming the details with financial institutions.
B. Inquire about the current status of transactions that were recorded on the basis of preliminary data.
C. Compare the financial statements being reported on with those of the prior year.
D. Trace information from shipping documents to sales invoices and sales journal transactions.
The correct answer is (B).
Subsequent events are events that occur after the balance sheet date. Inquiries made of management about the current status of transactions that were recorded on the basis of preliminary data will help an auditor determine if any events have occurred after year-end that impact such data.
AUD-34. Which of the following procedures would an auditor generally perform regarding subsequent events?
A. Inspect inventory items that were ordered before the year-end but arrived after the year-end.
B. Test internal control activities that were previously reported to management as inadequate.
C. Review the client's cutoff bank statements for several months after the year-end.
D. Compare the latest available interim financial statements with the statements being audited.
The correct answer is (D).
Subsequent events are events that occur after the balance sheet date. Such changes affect the interim report for the following year. By comparing the latest available interim financial information with the financial statements being reported upon, an auditor may identify the occurrence of subsequent events.
AUD-35. An auditor of a nonissuer may not issue a qualified opinion when
A. The auditor lacks independence with respect to the entity.
B. Management prevents the auditor from observing the entity's inventory.
C. The entity omits the statement of cash flows from its financial statements.
D. The auditor's report refers to the work of an actuary.
When an auditor lacks independence with respect to the audited entity, that auditor is barred from giving an opinion (not even a qualified opinion). The auditor should disclaim an opinion on account of a lack of independence.
Scope limitation, which prevents the auditor from observing the entity's inventory, could give either a qualified opinion or a disclaimer.
Omitting the statement of cash flows from its financial statements could result in either a qualified opinion or an adverse opinion.
Referring to the work of an actuary can be in any kind of a report – standard, qualified, adverse, or disclaimer.
AUD-36. Mills, CPA, was engaged by a group of royalty recipients to apply agreed-upon procedures to financial data supplied by Modern Co. regarding Modern's written assertion about its compliance with contractual requirements to pay royalties. Mills' report on these agreed-upon procedures should
A. Disclaimer of opinion about the fair presentation of Modern's financial statements.
B. List of the procedures performed (or reference thereto) and Mills' findings.
C. Opinion about the effectiveness of Modern's internal control activities concerning royalty payments.
D. Acknowledgment that the sufficiency of the procedures is solely Mills' responsibility.
The correct answer is (B).
The sample statement, which is included in Mill’s report on agreed-upon procedures, is:
“We have performed the procedures enumerated below, which were agreed to by the audit committee and management of Modern Co., solely to assist you in evaluating the accompanying Statement of Investment Performance Statistics of XYZ fund for the year ended December 31, 20X0”.
As such, the report on agreed-upon procedures should contain the statement about the list of procedures performed (or referenced) and Mill's findings.
It is the responsibility of the practitioner to issue a report with a list of findings. The accountant never expresses an opinion.
The sufficiency of procedures is the sole responsibility of the parties specified in the report, not of the practitioner. The statement that should be part of the report on agreed-upon procedures should be: “The sufficiency of these procedures is the sole responsibility of those parties specified in this report”.
AUD-37. A CPA was engaged to calculate the rate of return on a specified investment according to an agreed-upon formula and verify that the resultant percentage agrees to the percentage in an identified schedule. The CPA's report on these agreed-upon procedures should contain
A. An opinion about the fairness of the agreed-upon procedures.
B. A separate paragraph describing the effectiveness of the internal controls.
C. A disclaimer of responsibility for the sufficiency of those procedures.
D. A disclaimer of opinion on the fair presentation of the financial statements.
The correct answer is (C).
The sufficiency of procedures is the sole responsibility of the parties specified in the report, not of the practitioner. The statement that should be part of the report on the agreed-upon procedures should be: “The sufficiency of these procedures is the sole responsibility of those parties specified in this report”. The CPA would disclaim responsibility for the sufficiency of those procedures
It is the responsibility of the practitioner to issue a report with the list of findings. The accountant never expresses an opinion on either financial statements or internal controls.
AUD-38. During an engagement to compile the financial statements of a nonissuer, an accountant becomes aware that management had stated land at appraised value and that, if GAAP had been followed, both the land account and stockholders' equity would have been decreased by $1 million, a material amount. The accountant decides to modify the standard compilation report because management will not revise the financial statements. Under these circumstances, the accountant should
A. Issue either an adverse opinion or a qualified opinion, depending on materiality, because of the departure from GAAP.
B. Add a separate paragraph to the accountant's report that restricts the distribution of the financial statements to “internal use only.”
C. Add a separate paragraph to the accountant's report that discloses the departure from GAAP and its effects on the financial statements.
D. Add a separate paragraph to the accountant's report that explains the underlying purpose of recording assets at historical cost.
The correct answer is (C).
Overstatement of land account and stockholders' equity is a departure from GAAP. In the compilation engagements, when an auditor comes across a departure from GAAP, the auditor should discuss the departure and its effect on financial statements in a separate paragraph in the compilation report.
AUD-39. An accountant has been engaged to compile a nonissuer's financial statements that contain several misapplications of accounting principles and unreasonable accounting estimates. Management is unwilling to revise the financial statements, and the accountant believes that modification of the standard compilation report is not adequate to communicate the deficiencies. Under these circumstances, the accountant should
A. Disclaim an opinion on the financial statements and advise the board of directors that the financial statements should not be relied upon.
B. Inform management that the engagement can proceed only if distribution of the accountant's compilation report is restricted to internal use.
C. Determine the effects of the deficiencies and add a separate paragraph to the compilation report that describes the deficiencies and their effects.
D. Withdraw from the compilation engagement and provide no further services concerning these financial statements.
The correct answer is (D).
There are times when there exists a scope limitation or the omissions in the financial statements are misleading and management is unwilling to revise the financial statements, and the accountant believes that modification of the standard compilation report is not adequate to communicate the deficiencies. In such cases, the accountant is required to withdraw from the engagement and provide no further services relating to the financial statements.
AUD-40. Which of the following matters is included in a typical comfort letter?
A. Negative assurance on whether unaudited condensed financial information complies in form with the accounting requirements of the SEC.
B. An opinion on whether any fraud risk factors indicate significant incentive and opportunity relating to fraudulent financial reporting.
C. Positive assurance on whether there has been any change in capital stock or long-term debt since the date of the audited financial statements.
D. An opinion on whether the entity's internal control components are operating as designed in achieving their stated objectives.
The correct answer is (A).
A comfort letter is issued by auditors to underwriters in connection with a securities offering. The key feature of a comfort letter is that it provides negative assurance, not an opinion.
Negative assurance means the auditors state that nothing came to their attention that would indicate a problem, rather than affirmatively concluding that something is correct.
One of the standard items included is negative assurance on whether unaudited condensed financial information (such as interim financial statements) complies in form with the applicable reporting requirements. Because the information is unaudited, the auditors do not express an opinion.
AUD-41. Which of the following is an essential element of the audit trail in an electronic data interchange (EDI) system?
A. An integrated test facility that verifies the accuracy of data.
B. A heuristic program that accesses remote locations.
C. Hardware security modules that store sensitive data.
D. Computer activity logs that indicate failed transactions.
The correct answer is (D).
In an EDI environment, transactions are processed electronically with little to no manual intervention. Because of this, the audit trail must provide a clear, chronological record of system activity so transactions can be traced, verified, and reconstructed if needed.
A key part of that audit trail is the ability to capture failed transactions. Logs that record rejected messages, transmission errors, or processing failures allow auditors and management to:
- Identify where breakdowns occurred
- Reconcile discrepancies between trading partners
- Provide evidence in the event of disputes or audits
Without this level of logging, there is no reliable way to investigate errors or confirm the completeness and accuracy of processing.
AUD-42. An issuer's board of directors would ordinarily participate in each of the following activities, except
A. Establishing long-term strategy and objectives to which their information technology system should be aligned.
B. Supervising and monitoring the quality control testing upon the installation of a new information technology system.
C. Ensuring that suitable information technology resources and skills are available to meet the company's strategic objectives.
D. Maintaining awareness of current technology used by the organization to assure its efficiency and effectiveness for financial reporting.
The correct answer is (B).
The board of directors functions at the governance level, not in day-to-day operations. Their responsibility is to set strategic direction, oversee management, and ensure that key systems, including IT, support the organization’s objectives and financial reporting.
This includes evaluating whether the organization has appropriate IT resources, understanding how technology affects operations and reporting, and maintaining oversight of management’s performance in these areas.
Direct involvement in detailed quality control testing during a system implementation goes beyond governance. That level of hands on execution falls within management’s role, typically handled by IT personnel, project teams, or internal audit.
BAR CPA Exam Questions
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Note: These were originally BEC questions, but now reside in BAR.
Business Analysis and Reporting CPA Exam Questions
BAR-1. A 20% target contribution margin is set for Duct, which is a new product with the following unit costs:
| Manufacturing costs | Variable | $12 |
| Fixed | 8 | |
| Selling & admin. Costs | Variable | $3 |
| Fixed | 5 |
What is Duct's target selling price?
A. $18.00
B. $18.75
C. $25.00
D. $33.60
The correct answer is (B)
Contribution = Selling Price – Variable Costs.
In this example, the variable costs = $12 + $3 = $15.
Taking the selling price to be $x, the desired contribution = 20% of x = 0.2x
0.2x = x – 15
Or, x = 15/0.8 = $18.75
BAR-2. Below are data from the income statement of Brown, Inc:
| Beginning inventory, finished goods | $16,000 |
| Ending inventory, finished goods | 21,000 |
| Cost of goods sold | 43,000 |
| Gross margin from sales | 39,000 |
| Operating expenses – marketing and selling | 20,000 |
| Net income | 19,000 |
What was Brown's cost of goods manufactured?
A. $37,000
B. $38,000
C. $48,000
D. $50,000
The correct answer is (C).
Cost of Goods Manufactured is a term used in management accounting to account for the costs incurred to manufacture or produce a product to get it ready for the final sale. The Cost of Goods Manufactured can be derived using the following format:
| Cost of Goods Manufactured | XXX |
| Add: Beginning Inventory of Finished Goods | XXX |
| Less: Ending Inventory of Finished Goods | (XXX) |
| Cost of Goods Sold | XXX |
The cost of goods manufactured = Cost of goods sold – Beginning Inventory of Finished Goods + Ending Inventory of Finished Goods
= 43,000 – 16,000 + 21,000 = $48,000.
BAR-3. The expected selling price for a new product is $19.00. Management's goal is to obtain a 20% contribution margin on all sales. If the new product has variable selling and distribution costs of $3.00 per unit, what is the product's target variable manufacturing cost?
A. $12.20
B. $12.80
C. $15.80
D. $18.20
The correct answer is (A).
The contribution margin of a product = Selling Price – Variable Costs
- In the given scenario, the contribution margin = 20% of $19 = $3.8
- 3.8 = 19 – Target variable manufacturing cost – 3
- Target variable manufacturing cost = 19 – 3 – 3.8 = $12.20
BAR-4. Smith Legal Services has offered to represent a plaintiff in a lawsuit for a retainer of $20,000 plus 40% of any award over $20,000. Smith expects to incur out-of-pocket expenditures of $15,000 in litigating the suit. Possible court awards with their associated probabilities are:
| Award | Probability |
| $100,000 | 0.7 |
| $0 | 0.3 |
What is the expected value to Smith of the lawsuit?
A. $25,900
B. $27,400
C. $33,000
D. $37,000
The correct answer is (B).
When evaluating expected value, focus on the net payoff in each possible outcome and weight those results by their probabilities.
If the award is $100,000, Smith earns the retainer plus a contingency fee on the excess over $20,000:
Fee = 20,000 + 0.40 × (100,000 − 20,000)
Fee = 20,000 + 0.40 × 80,000
Fee = 20,000 + 32,000 = 52,000
After subtracting litigation costs:
Net = 52,000 − 15,000 = 37,000
If the award is $0, Smith still keeps the retainer:
Fee = 20,000
Net = 20,000 − 15,000 = 5,000
Now compute the expected value:
Expected value = (0.7 × 37,000) + (0.3 × 5,000)
Expected value = 25,900 + 1,500 = 27,400
BAR-5. Grant Co.'s sales budget shows the following projections for the year ending December 31:
| Quarter | Units |
| First | 30,000 |
| Second | 40,000 |
| Third | 22,500 |
| Fourth | 27,500 |
| Total | 120,000 |
Inventory at the beginning of the year was budgeted at 9,000 units. The quantity of finished goods inventory at the end of each quarter is to equal 30% of the next quarter's budgeted sales of units. What amount should the production budget show for units to be produced during the first quarter?
A. 36,000
B. 33,000
C. 24,000
D. 12,000
The correct answer is (B).
A period’s production budget can be calculated using this equation:
Beginning Inventory of Finished Goods + Production – Sales = Ending Inventory of Finished Goods
The question states that the ending inventory of FG in the 1st quarter = 30% of sales in 2nd quarter:
- The equation: 9,000 + Production – 30,000 = 30% of 40,000
- 9,000 + Production – 30,000 = 12,000
- Production = 12,000 + 30,000 – 9,000 = 33,000 units
BAR-6. What term is used to represent unavoidable past costs that cannot be changed no matter what action is taken?
A. Prime costs
B. Sunk costs
C. Opportunity costs
D. Incremental costs
The correct answer is (B).
Sunk Costs are historical costs incurred as a result of past decisions; they are not relevant in current decision-making. Sunk costs are never used when making rational business decisions. Rather, they serve as a learning experience in making future decisions.
BAR-7. Spark Co. buys cell phones for $125 each and sells them for $200 each. Spark pays a sales commission of $25 per phone sold, and the monthly fixed costs are $3,000. Assuming Spark desired a profit of 10% of sales, how many units must Spark sell?
A. 600
B. 400
C. 200
D. 100
The correct answer is (D).
Let the number of units to be sold by Spark be x units.
The equation can be formed as follows:
- Profit = Selling Price – Cost Price – Sales Commission – Fixed Costs
- 10% of 200x = 200x – 125x – 25x – 3,000
- 20x = 75x – 25x – 3,000
- 20x = 50x – 3,000
- x = 3,000/30 = 100
As such, the number of units to be sold to get the desired profit = 100 units
BAR-8. A company that produces a single product using a continuous process had no work in process on April 1. During the month of April, 10,000 units were started, and 9,000 completed units were transferred. The ending work-in-process inventory was complete as to materials and 50% complete as to conversion. The cost of direct materials was $114,000, and the cost of direct labor amounted to $38,000. Manufacturing overhead is assigned at the rate of 50% of direct materials. For the purpose of determining the cost of goods manufactured in April, what is the cost per equivalent whole unit?
A. $23.22
B. $21.40
C. $20.90
D. $15.40
The correct answer is (B).
When a product undergoes multiple processes, the cost flow is calculated by taking into account the physical flow of the units. The concept of equivalent units comes into play, and the stage of completion of each cost element is inspected to compute the final cost.
| Particulars | Materials | Particulars | Labor | Particulars | Overheads |
|---|---|---|---|---|---|
| Beginning Inventory | – | Beginning Inventory | – | Beginning Inventory | – |
| Completed in April | 9,000 | Completed in April | 9,000 | Completed in April | 9,000 |
| Ending Inventory (100%) | 1,000 | Ending Inventory (50%) | 500 | Ending Inventory (50%) | 500 |
| Equivalent Units | 10,000 | Equivalent Units | 9,500 | Equivalent Units | 9,500 |
| Particulars | Materials | Labor | Overheads |
|---|---|---|---|
| Total Cost | 1,14,000 | 38,000 | 57,000 (50% of direct materials) |
| Equivalent Units | 10,000 | 9,500 | 9,500 |
| Cost per unit | 11.4 | 4 | 6 |
The total cost of units produced in April = 11.4 + 6 + 4 = $21.4.
BAR-9. Star Co. is a retail store specializing in contemporary furniture. The following information is taken from Star's June budget:
| Sales | $540,000 |
| Cost of goods sold | 300,000 |
| Merchandise inventory–June 1 | 150,000 |
| Merchandise inventory–June 30 | 180,000 |
| Accounts payable for purchases–June 1 | 85,000 |
| Accounts payable for purchases–June 30 | 75,000 |
What amount should Star budget for cash disbursements for June purchases?
A. $260,000
B. $280,000
C. $320,000
D. $340,000
The correct answer is (D).
Step 1: Calculate Purchases
- Opening Inventory + Purchases – Ending Inventory = COGS
- Purchases = COGS + Ending Inventory – Opening Inventory
- Purchases = $300,000 + $180,000 – $150,000 = $330,000
Step 2: Calculate Planned Disbursements
- Opening Payables + Purchases – Closing Payables = Planned Disbursements
- $85,000 + $330,000 – $75,000 = $340,000
- Planned Disbursements = $340,000
BAR-10. Which of the following is a major difference between the just-in-time (JIT) and traditional approaches to manufacturing?
A. The JIT approach usually involves a large number of suppliers while traditional approaches usually involve only a small number of suppliers.
B. The JIT approach requires centralized purchasing while traditional approaches encourage purchasing decisions by production employees.
C. The JIT approach uses a push-through system while traditional approaches use a pull-through system.
D. The JIT approach operates with low inventory levels while traditional approaches may operate with high inventory levels.
The correct answer is (D)
JIT is a production strategy based on the philosophy that unused inventory is a waste of resources (i.e., does not add value). It reduces in-process inventories and associated carrying costs, resulting in improved returns. JIT focuses on continuous improvement and improves quality and efficiency in the manufacturing process.
Since the quantity of materials is kept to a minimum and is ordered as and when required, the JIT is characterized by significantly lower inventory levels when compared to the traditional approach. Consequently, the number of orders in a JIT approach is higher.
BAR-11. Match Co. manufactures a product with the following costs per unit, based on a maximum plant capacity of 400,000 units per year:
| Direct materials | $60 |
| Direct labor | 10 |
| Variable overhead | 40 |
| Fixed overhead | 30 |
| Total | $140 |
Match has a ready market for all 400,000 units at a selling price of $200 each. Selling costs in this market consist of $10 per unit shipping and a fixed licensing fee of $50,000 per year. Reno Co. wishes to buy 5,000 of these units on a special order. There would be no shipping costs on this special order. What is the lowest price per unit at which Match should be willing to sell the 5,000 units to Reno?
A. $110
B. $140
C. $190
D. $200
The correct answer is (C).
When a firm needs to determine the price for a special order, it is required to consider the relevant costs incurred to manufacture that order. Relevant Costs are those costs that are incurred specifically and exclusively for an order. In other words, if that order wasn’t received, those costs would not have been incurred.
The fixed overheads and licensing fees are irrelevant since they would have been incurred irrespective of the order. However, the variable costs will be incurred to manufacture the 5,000 units needed by Reno Co.
| Direct materials | $60 |
| Direct labor | 10 |
| Variable overhead | 40 |
| Total | $110 |
It is noteworthy that the firm is currently operating at its maximum capacity (and has no spare capacity). Moreover, it also has a ready market for the 400,000 units produced. If Match Co. accepts the order of 5,000 units, it means that it will have to forego the contribution that it could have earned by selling those 5,000 units in its pre-existing market. This gives rise to an opportunity cost, which will be added to the selling price to be quoted to Reno.
Opportunity Cost = Contribution foregone = Selling price – Variable Costs – Shipping Costs
= 200 – 110 – 10
= $80
Selling price for 5,000 units to Reno = Variable Costs + Opportunity Cost
= 110 + 80 = $190
BAR-12. Dawn Corp. uses a standard cost system. During the year, both the labor rate variance and the labor efficiency variance were unfavorable. Dawn wrote the variances off directly to cost of goods sold. If Dawn had allocated the variances to work in process, finished goods, and cost of goods sold instead, what would have been the effects on current ratio and net income?
| Current | Net |
| ratio | income |
A. Increases Increases
B. Increases Decreases
C. Decreases Increases
D. Decreases Decreases
The correct answer is (A).
An unfavorable labor rate and efficiency variance is indicative of the fact that the actual labor cost has turned out to be in excess of the standard cost anticipated by the management. As such, this additional cost was allocated to the cost of goods sold (COGS).
If such a cost was, instead, allocated to work in progress, finished goods, and COGS, the following implications would have arisen:
- The closing inventory of finished goods and WIP goods would have been higher (due to more costs allocated).
- The COGS would have been lower and consequently, the net gross margin on goods sold during the period would have been higher.
Current ratio = Current assets / Current liabilities. Since the value of inventory goes up, so do the current assets, which, thereby, results in an increased current ratio.
Further, since the gross margin is higher due to the reallocation, it would also cause the net income to increase.
➡️ Free BAR Notes – Strategic Planning & Budgeting
BAR-13. The essence of responsibility accounting is
A. Developing performance reports emphasizing costs and revenues that managers can control.
B. Allocating service department costs to production departments so that production department managers know all costs for which they are responsible.
C. Determining who is to blame for unfavorable variances.
D. Investigating all variances, regardless of their status as favorable or unfavorable.
The correct answer is (A).
Responsibility accounting systems recognize various decision centers (or responsibility centers) throughout an organization and trace to the individual managers who are primarily responsible for the costs in question. Generally, the manager in question is not held responsible for their own salary or other factors beyond their control. Controllable costs for responsibility accounting purposes are those costs that are directly influenced by a given manager within a given period.
BAR-14. A company sells flat-screen TVs for $200 per unit. The players have a unit variable cost of $160. The company estimates that it will sell one home entertainment system for every four TVs sold. Home entertainment systems have a unit variable cost of $460 and sell for $600 per unit. The company's fixed costs are $90,000. Assuming that the sales mix estimate is correct, how many TVs need to be sold for the company to break even?
A. 300
B. 500
C. 1,200
D. 1,500
The correct answer is (C).
The break-even point is the point at which the company makes enough sales to recover its fixed costs. The break-even point can be calculated as Total Fixed Costs/Contribution per unit.
In this example, the company sells two products, and as a result, the recovery of the fixed costs depends on the contribution of both products. As such, we need to consider the joint contribution as per the given sales mix.
| TVs | Home Entertainment System | |
|---|---|---|
| Selling Price | 200 | 600 |
| Variable Cost | 160 | 460 |
| Contribution (SP-VC) | 40 | 140 |
| Units in 1 sales mix | 4 | 1 |
Average Unit Contribution Margin = (40 x 4) + (140 x 1) / (4 + 1) = 300/5 = $60
Therefore, the breakeven point = 90,000/60
= 90,000/60 = 1,500
This shows that it would be necessary for the company to sell 1,500 sales mix units to achieve a contribution of $90,000. This would help recover the fixed costs. The number of individual products to be sold is as follows:
TVs: 1500 x 4/5 = 1,200 units
Home Entertainment System = 1500 x 1/5 = 300 units
BAR-15. Skytop Co., a nonprofit entity, is considering acquiring a machine for $80,000 that will produce uniform cash inflows of $25,000 for four years. Skytop evaluates capital projects using discounted cash flows at a cost of capital of 10% per year. Based upon the following table, what action should Skytop take regarding the acquisition of the machine, and why?
| Future value of $1 for 4 years at 10% | $1.464 |
| Present value of $1 for 4 years at 10% | $0.683 |
| Future value of $1 ordinary annuity for 4 years at 10% | $4.641 |
| $4.641 Present value of $1 ordinary annuity for 4 years at 10% | $3.170 |
| Acquire: | Reason: |
A. Yes Net cash flow is $20,000
B. Yes Net future value is $36,025
C. No Net present value is ($750)
D. No Net present value is ($8,750)
The correct answer is (C).
In order to evaluate decisions like these, Skytop Co. should compute the Net Present Value of the machine. The NPV = Present Value of all inflows – Present Value of all outflows.
In this example, the machine yields an annual cash flow of $25,000 every year for the next 4 years. As such, the PV of such cash flows = 25,000 x Present value of $1 ordinary annuity for 4 years at 10%
= 25,000 x 3.170 = $79,250
The NPV = 80,000 – 79,250 = ($750)
In such a scenario, it is recommended that the machine not be acquired.
BAR-16. Which of the following statements that relate to capital budgeting is true?
A. The impact of taxes on capital budgeting will not make a difference in the decision to purchase new equipment.
B. Accelerated methods of depreciation provide tax shields that are advantageous from a present-value point of view.
C. The depreciation method used for financial accounting reporting and not the depreciation method used for tax purposes should be used in capital budgeting decisions.
D. If the depreciable life of a project is shorter than the expected useful life of the project, then the anticipated after-tax cash flows should be evaluated over the depreciable life.
The correct answer is (B).
Depreciation tax savings or shield is the amount of tax that is saved by an entity due to claiming depreciation as an expense while calculating its taxable income. These savings can be calculated by applying the current tax rate to the amount of depreciation. These shields are responsible for an increase in the value of the annual cash flows.
Under accelerated methods of depreciation, a larger charge is made to the depreciation of a capital asset in the initial years to match the larger revenues generated due to the usage of that asset.
When such a method is followed, it results in increased depreciation in the earlier years, leading to higher depreciation tax shields and higher annual cash flows.
Higher cash flows, in turn, increase the present value of the inflows of the capital project of an entity.
BAR-17. Roger Co. implemented activity-based costing in the current year. To select the appropriate driver for Cost Pool A, Roger performed regression analyses for two independent variables, Driver 1 and Driver 2, using monthly operating data. The monthly levels of Cost Pool A were the dependent variables in both regressions. The output results from the regression analyses were as follows:
| Driver 1 | Driver 2 | |
| R squared | 0.46 | 0.80 |
| Intercept | $551.00 | $970.00 |
| X variable (slope) | $ 0.55 | $ 0.33 |
At the budgeted production level for next month, the levels of Driver 1 and Driver 2 are expected to be 5,880 and 7,000, respectively. Based on this information, what is the budgeted amount for Cost Pool A for next month?
A. $2,624
B. $3,280
C. $3,464
D. $3,785
The correct answer is (B).
As per the given information, the following regression equations can be formed:
For Driver 1: Budgeted cost = $551 + ($0.55 x units)
For Driver 2: Budgeted cost = $970 + ($0.33 x units)
| Particulars | Driver 1 | Driver 2 |
|---|---|---|
| Variable | 0.55 | 0.33 |
| Units produced | 5,880 | 7,000 |
| Total | 3,234 | 2,310 |
| Add: Intercept | 551 | 970 |
| Total budgeted cost | $3,785 | $3,280 |
It is also seen that Driver no. 2 has a higher R2 which means that this model is better at explaining the variability of the response data. In other words, this model fits the data better than the other model.
As such, the budgeted cost would be the cost for driver 2, i.e., $3,280.
BAR-18. Gamma Co., a manufacturer of medical products, had a 10% return on assets and an asset turnover of 4:1. What was Gamma's profit margin on sales?
A. 40.0%
B. 10.0%
C. 4.0%
D. 2.5%
The correct answer is (D).
- Asset turnover = Sales / Total Assets = 4
- Total Assets = Sales/4
We can substitute this in the equation of return on assets to get the required profit margin on sales.
- Return on Assets = Profit / Total Assets = 10%
- Or, profit/(sales/4) = 10%
- Profit/Sales = 10% / 4
= 2.5%
BAR-19. What is the process by which products and services of a business entity are measured and evaluated relative to the best possible levels of performance?
A. Measuring the performance gap
B. Standard measurement
C. Benchmarking
D. Variance management
The correct answer is (C).
Benchmarking is the process of examining an exemplary process similar in nature to a process being considered for improvement. The exemplary process under observation typically exists at a different company. Alternatively, the exemplary process may exist in a single unit of a large organization.
The exemplary process is identified and examined to determine the criteria for excellence. Benchmarking implies assigning quantifiable measures of best practices. Contrast benchmarking with current-use assessment: current-use assessment traces every aspect of the process to customer (internal or external) needs. Benchmarking might be considered as partly leveraging other entities’ current-use assessment work.
BAR-20. The following information pertains to Baxter Co:
| Inventory at beginning of year | $200,000 |
| Inventory at year end | $300,000 |
| Cost of goods sold during the year | $500,000 |
What was Baxter's inventory turnover for the year?
A. 1.0
B. 1.5
C. 2.0
D. 2.5
The correct answer is (C).
Inventory Turnover = Cost of Goods Sold / Average Inventory [= (beginning + ending)/2]
= 500,000 / [(200,000+300,000)/2]
= 500,000 / 250,000
= 2
BAR-21. How would the following ratios or measures be affected if a company-issued additional capital stock for cash?
| Total debt to total assets | Working capital |
A. Increase Increase
B. Increase Decrease
C. Decrease Increase
D. Decrease Decrease
The correct answer is (C).
When a company issues additional capital stock for cash, it affects the following two items of the balance sheet:
- Cash (a part of current assets) increases
- Increase in stockholders’ equity
It is evident then that there is no effect of such a transaction on the total debt or on the current liabilities.
Total debt to total assets = Total debt / Total assets.
Since the total assets increases due to an influx of cash, this ratio decreases.
Working capital = Current assets – Current liabilities.
Since the current assets increased due to an increase in cash, the working capital also increases.
BAR-22. Darv Co. had a current ratio of 3-to-1 and a quick ratio of 1-to-1. Current liabilities were $322,000. What was the total amount for inventory and prepaid expenses?
A. $322,000
B. $644,000
C. $966,000
D. $1,288,000
The correct answer is (B).
Current Ratio = Current Assets / Current Liabilities
As per the question, 3 = Current Assets / 322,000
As such, Current Assets = 322,000 x 3 = $966,000
Further, Quick Ratio = [Current Assets – (Inventory + Prepaid Expenses)] / Current Liabilities
1 = [966,000 – (Inventory + Prepaid Expenses)] / 322,000
Therefore, Inventory + Prepaid Expenses = 966,000 – 322,000
= $644,000
BAR-23. Carter Co. had the following items on its balance sheet at the end of the current year:
| Cash and cash equivalents | $ 200,000 |
| Short-term investments | 100,000 |
| Accounts receivable | 400,000 |
| Inventories | 600,000 |
| Patent–10 years | 300,000 |
| Equipment | 1,000,000 |
| Accumulated depreciation | 200,000 |
The amount of current liabilities at the end of the current year was $640,000. What is Carter's working capital at the end of the current year?
A. $60,000
B. $560,000
C. $660,000
D. $960,000
The correct answer is (C).
Working Capital = Current Assets – Current Liabilities
Of the given assets in the question, the following do not qualify either as current assets or current liabilities:
- Patent–10 years
- Equipment
- Accumulated depreciation
The current assets can be calculated as follows:
| Amount ($) | |
|---|---|
| Cash and cash equivalents | 200,000 |
| Short-term investments | 100,000 |
| Accounts receivable | 400,000 |
| Inventories | 600,000 |
| Total current assets | 1,300,000 |
As such, working capital = 1,300,000 – 640,000 = $660,000.
BAR-24. Swift Co. has identified three operating segments that may require separate disclosure in Swift's general purpose financial statements for the year ended December 31, year 2. Information for year 2 follows:
|
Segment (in thousands) |
|
Reported revenue | A
$ 42 | B
$ 121 | C
$ 14 | Total
$ 177 |
| Reported profit(loss) | $ 12 | $ 65 | $ (3) | $ 74 |
| Assets | $ 470 | $ 800 | $ 80 | $ 1,350 |
Which of Swift's segments are required to be separately disclosed in its December 31, year 2, financial statements?
A. A and B only.
B. A and C only.
C. B and C only.
D. A, B, and C.
The correct answer is (A).
An enterprise should separately report information about an operating segment that meets any of the following quantitative thresholds:
- Its reported revenue, including both sales to external customers and intersegment sales or transfers, is 10 percent or more of the combined revenue, internal and external, of all operating segments.
- The absolute amount of its reported profit or loss is 10 percent or more of the greater, in absolute amount, of either the combined reported profit of all operating segments that did not report a loss or the combined reported loss of all operating segments that did report a loss.
- Its assets are 10 percent or more of the combined assets of all operating segments
| Particulars | Total | Threshold | A | B | C |
| Revenues | 177 | 17.7 | 42 | 121 | 14 |
| Combined reported profit of segments that did not report a loss (12+65) | 77 | 7.7 | 12 | 65 | 3 |
| Assets | 1,350 | 135 | 470 | 800 | 80 |
As is evident from the above table, the segment ‘C’ does not cross the threshold in any of the criteria. As such, it is not a reportable segment.
BAR-25. Toft Co. had 120,000 shares of common stock outstanding at January 1. On April 1, it issued 40,000 additional shares of common stock. Outstanding all year were 10,000 shares of nonconvertible preferred stock on which a dividend of $5 per share was declared during the year. Net income for the year was $480,000. What should Toft report as earnings per share for the year?
A. $2.69
B. $2.87
C. $3.00
D. $3.20
The correct answer is (B).
Earnings per share can be calculated as:
Earnings available for distribution to common stockholders / Weighted Average Outstanding Common Shares
Earnings available for distribution to common stockholders = Net Income – Dividends to preferred stockholders
= 480,000 – (10,000 x 5)
= $430,000
Weighted Average Outstanding Common Shares = 120,000 + (40,000 x 9/12) = 150,000 shares
EPS = 430,000 / 150,000 = $2.87 per share
BAR-26. Mentor Co., a U.S. corporation, owned 100% of a Swiss corporation. The Swiss franc is the functional currency. The remeasurement of Mentor's financial statements resulted in a $25,000 gain at year end. The translation of the financial statements resulted in a $40,000 gain at year end. What amount should Mentor recognize as foreign currency gain in its income statement?
A. $0
B. $25,000
C. $40,000
D. $65,000
The correct answer is (B).
When the company executes a transaction in a currency other than the one in which the books are maintained, the transaction is remeasured to the functional currency. This remeasurement gain or loss is recognized in the income statement. If the company maintains its books in a foreign currency, but issues its financial statements using a different currency, all transactions are translated to the reporting currency. This translation gain or loss is recognized in the other comprehensive income. A remeasurement gain of $25,000 will be recognized in the income statement. A translation gain of $40,000 will only be recognized in the other comprehensive income.
BAR-27. Which of the following financial instruments may be considered a derivative financial instrument?
A. Option contract.
B. Municipal bond.
C. Bank certificate of deposit.
D. Money market fund.
The correct answer is (A).
An option contract is a derivative contract between two parties for a future transaction on an asset at a specified (i.e., reference) price any time during a specified period in the future. The buyer of the option has the right, but not the obligation, to engage in that transaction, while the seller assumes the corresponding obligation to fulfill the transaction. The price of an option results from the difference between the reference price and the value of the underlying asset (usually stocks, bonds, a currency, or a futures contract) plus a premium based on the time remaining until the expiration of the option.
BAR-28. Brill Co. made the following expenditures relating to Product X:
| Labor and material costs incurred in producing a prototype | $100,000 |
| Cost of testing the prototype | $40,000 |
| Legal costs to file a patent | $5,000 |
Production of Product X commenced when the patent was granted. What amount of the above costs should be expensed as research and development costs?
A. $40,000
B. $100,000
C. $140,000
D. $145,000
The correct answer is (C).
Research activities are those aimed at the discovery of knowledge that will be useful in developing or significantly improving products or processes. Development activities are those concerned with translating research findings and other knowledge into plans or designs for new or significantly improved products or processes. Out of the items given, the legal costs to file a patent is not included in R&D expenses. As such, the research and development costs = 100,000 + 40,000 = $140,000.
BAR-29. Aln Co. incurred the following expenses during the current period:
| Routine on-going efforts to improve an existing product | $50,000 |
| Trouble-shooting in connection with breakdowns during commercial production | $75,000 |
| Routine testing of products during commercial production for quality control purposes | $100,000 |
What is the total amount of research and development expenses incurred by Aln during the current period?
A. $0
B. $75,000
C. $125,000
D. $175,000
The correct answer is (A).
Research activities are those aimed at the discovery of knowledge that will be useful in developing or significantly improving products or processes. Development activities are those concerned with translating research findings and other knowledge into plans or designs for new or significantly improved products or processes.
None of the expenses incurred by Aln Co. qualify as research and development expenses.
Source: AICPA
FAR CPA Exam Questions
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Financial Accounting and Reporting CPA Exam Questions
FAR-1. Accrual accounting involves accruals and deferrals. Which of the following best describes accruals and deferrals?
A. Accruals are concerned with expected future cash receipts and payments, while deferrals are concerned with past cash receipts and payments.
B. Accruals are concerned with past cash receipts and payments, while deferrals are concerned with expected future cash receipts and payments.
C. Both accruals and deferrals are concerned with expected future cash receipts and payments.
D. Both accruals and deferrals are concerned with past cash receipts and payments.
The correct answer is (A).
Under accrual accounting, revenues are recognized when earned, and expenses are recognized when incurred, regardless of when cash moves. To align income and expenses with the correct period, adjusting entries are classified as either accruals or deferrals.
Accruals arise when revenue or expense has already been earned or incurred, but the related cash has not yet been received or paid. The economic activity has occurred, and the cash flow will happen later.
Deferrals occur when cash has already been received or paid, but the related revenue or expense has not yet been earned or incurred. The cash flow happens first, and recognition is deferred.
Because the cash flow has already occurred, deferrals are tied to past cash receipts or payments.
FAR-2. During the current year, Cooley Co. had an unrealized gain of $100,000 on a debt investment classified as available-for-sale. Cooley's corporate tax rate is 25%. What amount of the gain should be included in Cooley's net income and other comprehensive income at the end of the current year?
| Net income: | Other comprehensive income: |
A. $100,000 $0
B. $75,000 $25,000
C. $25,000 $75,000
D. $0 $75,000
The correct answer is (D).
Unrealized Gains and Losses on Certain Investments in debt securities, including the following, are reported exclusively as other comprehensive income:
- Unrealized holding gains and losses on available-for-sale (AFS) debt securities.
- Unrealized holding gains and losses that result from a debt security being transferred into the AFS category from the HTM category.
- Subsequent decreases or increases in the fair value of AFS debt securities previously written down as impaired.
- A change in the market value of a futures contract that qualifies as a hedge of an asset reported at fair value.
Such gains and losses are not classified as net income unless the securities are sold off.
FAR-3. During the year, Verity Co. purchased $200,000 of Otra Co. bonds at par and $50,000 of U.S. Treasury bills. Verity classified the Otra bonds as available-for-sale securities and the Treasury bills as cash equivalents. In Verity's statement of cash flows, what amount should it report as net cash used in investing activities?
A. $0
B. $150,000
C. $200,000
D. $250,000
The correct answer is (C).
All cash outflows arising from purchases of noncurrent assets are classified under the Investing Activities section of the cash flow statement. As such, the $200,000 investment in bonds is meant to be reported under investing activities. However, the treasury bills of $50,000 purchased by Verity Co. are not classified by the company as an investment, i.e. as a noncurrent asset. Rather, it has been classified as a cash equivalent. As such, it would be excluded from being shown under investing activities.
FAR-4. Ace Co. issued 1,000 shares of its $10 par value common stock for $15 per share in cash. How should this transaction be reported in Ace's statement of cash flows for the year of issuance?
A. $15,000 cash inflow from financing activities.
B. $10,000 cash inflow from financing activities and $5,000 adjustment to arrive at cash flows from operating activities.
C. $15,000 cash flow from investing activities.
D. $10,000 cash flow from investing activities and $5,000 adjustment to arrive at cash flows from operating activities.
The correct answer is (A).
The Financing Activities section of a cash flow statement includes transactions whereby cash is obtained from or returned to owners and lenders and also includes the net change in overdrafts for the period.
Because the entire amount of $15,000 has been collected by Ace Co. from the owners (stockholders) of the company, it would be classified under Stockholders’ Equity in the balance sheet, the entire amount categorically falls under the Financing Activities section.
FAR-5. Strut Co. has a payable to its parent, Plane Co. In which of the following balance sheets should this payable be reported separately?
| Strut's balance sheet | Plane's consolidated balance sheet | |
| A. | Yes | Yes |
| B. | Yes | No |
| C. | No | Yes |
| D. | No | No |
The correct answer is (B).
In case the financial statements of two separate entities are consolidated, the intercompany receivables, payables, security holdings, capital, revenues, cost of goods sold, interest, dividends, etc., are eliminated. This is the reason that the payable from Strut to Plan does not reflect on the< consolidated balance sheet.
However, the said payable is bound to be reported on the separate balance sheets of both Strut and Plane.
FAR-6. The primary purpose of a not-for-profit organization's statement of activities is to provide relevant information to its
A. Resource providers.
B. Managers.
C. Beneficiaries.
D. State regulatory body.
The correct answer is (A).
SFAC 4 established the objectives of general-purpose external financial reporting by non-profit organizations. Those objectives, together with the objectives set forth in FASB Concepts Statement No. 8, serve as the foundation of the conceptual framework that the FASB developed for financial accounting and reporting. The framework clearly provides that organizations that do not operate for-profits are obliged to provide relevant information to their resource providers through their financial statements. While the information is also used by regulatory bodies, managers, and beneficiaries/constituents of the entity, the primary user of such statements is the resource providers.
FAR-7. Financial statements prepared by a voluntary health and welfare nongovernmental not-for-profit organization must report expenses by the following classification(s):
| Functional | Natural | |
| A. | Yes | Yes |
| B. | Yes | No |
| C. | No | Yes |
| D. | No | No |
The correct answer is (A).
All nongovernmental not-for-profit organizations are mandated to disclose the expenses incurred by them during a fiscal year as per their functional as well as natural classifications. This rule, as mandated by FASB, results in the statement of functional expenses being presented like a matrix where each expense is reported by its function and then by the nature or type of the expense.
FAR-8. Zokro, a nongovernmental not-for-profit organization, uses the indirect method to prepare its statement of cash flows. In determining its net cash provided (used) by operating activities, Sokro must add back which of the following to the change in net assets?
A. Purchase of equipment.
B. Payment on long-term debt.
C. Depreciation.
D. Decrease in accounts payable.
The correct answer is (C).
The statement of cash flows for nongovernmental not-for-profit organizations is similar to that of a for-profit organization reporting, as per US GAAP. As such, depreciation is always added back to the change in net assets. The primary reason for this is that deprecation is a non-cash item that affects the net income for a period. While considering the cash flow for an organization, it is necessary that only those items that are taken into account have a bearing on the cash and cash equivalents balance of the entity.
FAR-9. Box, a nongovernmental not-for-profit organization, had the following transactions during the year:
| Proceeds from sale of investments | $80,000 |
| Purchase of property, plant and equipment | $10,000 |
| Proceeds from long-term debt | $100,000 |
| Loss on sale of investment | $5,000 |
What amount should be reported as net cash provided by financing activities in Box's statement of cash flows?
A. $70,000
B. $75,000
C. $80,000
D. $100,000
The correct answer is (D).
The statement of cash flows for nongovernmental not-for-profit organizations is similar to that of a for-profit organization reporting, as per US GAAP. The Financing Activities section of a cash flow statement includes transactions where cash is obtained from or returned to owners and lenders and also includes a net change in overdrafts for the period.
Out of the items presented in the question, only the proceeds from long-term debt qualify as a financing activity. All others can be classified under investing activity.
FAR-10. Sussman Co. prepared cash-basis financial statements for the month ended January 31. A summary of Sussman's January activities follows:
| Credit sales of $5,600. |
| Collections of $1,900 relating to January credit sales. |
| Accrued salaries of $1,200. |
By what amount will Sussman's cash-basis income for the month ended January 31 increase as a result of restating these activities to the accrual basis of accounting?
A. $2,500
B. $3,700
C. $4,400
D. $4,900
The correct answer is (A).
| Income under Cash Basis: | |
| Income (Cash Collection from A/R) | $1,900 |
| Expenses | $0 |
| Profit | $1,900 |
| Income under Accrual Basis: | |
| Income (Credit Sales) | $5,600 |
| Expenses (Accrued Salaries) | $1,200 |
| Profit | $4,400 |
Increase in income as a result of changing to Accrual Basis from Cash Basis = $4,400 – $1,900 = $2,500.
FAR-11. Bailey Co. changed the accounting for insurance expense from the cash basis to the accrual basis in the current year. In January of the prior year, Bailey recorded insurance expense of $240,000 for the cash purchase of a four-year insurance policy. How should Bailey report the insurance transaction in the current year's financial statements?
A. As a $180,000 debit to prepaid insurance.
B. As a $60,000 debit to insurance expense.
C. As a $60,000 debit to insurance expense, a $120,000 debit to prepaid asset, and $180,000 credit to retained earnings.
D. As a $180,000 debit to insurance expense, a $120,000 credit to prepaid asset, and $60,000 credit to retained earnings.
The correct answer is (C).
$240,000 expended for insurance purposes in the prior year was meant to be a four-year policy, so the per year expense amounts to $60,000.
The following chain of reporting should occur if the accrual basis is followed:
- Expense paid for a future fiscal year should be reported as a prepaid asset. In this case, the insurance expense of $240,000 was paid last year and at the end of the current year, $120,000 ($60,000 x 2 years) remains to be recognized in the year of expense. As such, $120,000 should be treated as a prepaid asset.
- Last year, the entire expense of $240,000 must have been reported in the ‘Income Statment’. Consequently, the retained earnings would have been debited by $240,000. However, as per the accrual basis, $180,000 out of such an expense should have been reported as a prepaid asset and the rest should have been reported as an expense. Therefore, retained earnings were debited by an excess of $180,000. In the current year, $180,000 should be credited to retained earnings.
FAR-12. Rune Co.'s checkbook balance on December 31, was $10,000. On that date, Rune held the following items in its safe:
$4,000 check payable to Rune, postdated January 3, and not included in the December 31 checkbook balance, in collection of a sale made in December.
$1,000 check payable to Rune, deposited December 15 and included in the December 31 checkbook balance, but returned by the bank on December 30 stamped “NSF”. The check was redeposited on January 2, and cleared on January 9.
What amount should Rune report as cash in its December 31, balance sheet?
A. $9,000
B. $10,000
C. $13,000
D. $14,000
The correct answer is (A).
A $4,000 check payable to Rune is post-dated in January, i.e. in the next fiscal year. The effect of such a check would not reflect in the checkbook balance until January 3. The revenue for the said check is accounted for in the books as a credit sale already.
A $1,000 check payable to Rune has been returned in the current fiscal year. As a result of this, the checkbook balance would decrease by $1,000 as of December 31st.
The cash balance to be reported = 10,000 – 1,000 = $9,000.
FAR-13. Mast Co. converted from the FIFO method for inventory valuation to the LIFO method for financial statement and tax purposes. During a period of inflation, would Mast's ending inventory and income tax payable using LIFO be higher or lower than FIFO?
| Ending inventory | Income tax payable | |
| A. | Lower | Lower |
| B. | Higher | Higher |
| C. | Lower | Higher |
| D. | Higher | Lower |
The correct answer is (A).
In a Last-In-First-Out or LIFO system of inventory management, the most recent purchases are sold first. Because of this, inventory in hand consists of the earliest purchases.
During a period of inflation, the recent purchases made by the company will be at a higher price than the earlier purchases. Since recent purchases are sold on a priority over the older ones, the ending stock of inventory would comprise the items purchased at a lower price. This means the ending inventory would be lower.
Further, since the higher-priced items are sold first, the net income also decreases which leads to lower income tax payable.
FAR-14. Stone Co. had the following consignment transactions during December year 1:
| Inventory shipped on consignment to Omega Co. | $36,000 |
| Freight paid by Stone | $1,800 |
| Inventory received on consignment from Gamma Co. | $24,000 |
| Freight paid by Gamma | $1,000 |
No sales of consigned goods were made through December 31, year 1. What amount of consigned inventory should be included in Stone's December 31, year 1, balance sheet?
A. $24,000
B. $25,000
C. $36,000
D. $37,800
The correct answer is (D).
In consignment sales, the title of the goods remains with the consignor (seller) until goods are sold by the consignee (agent). Because of this, the title passes directly to the third-party buyer at the point of sale. Further, costs incurred by the consignor in transferring goods to the consignee is considered inventory costs.
Even though Stone has passed on goods to Omega, the title remains with Stone and they would be accounted for in its books. The freight paid by Stone would also be added to inventory costs.
The amount of consigned inventory in Stone’s books = 36,000 + 1,800 = $37,800.
FAR-15. Cobb, Inc.'s inventory at May 1 consisted of 200 units at a total cost of $1,250. Cobb uses the periodic inventory method. Purchases for the month were as follows:
| Date | No. of Units | Unit cost | Total Cost |
| May 4 | 20 | $5.80 | $116.00 |
| May 17 | 80 | $5.50 | $440.00 |
Cobb sold 10 units on May 14 for $120. What is Cobb's weighted average cost of goods sold for May?
A. $60.20
B. $62.10
C. $62.50
D. $65.00
The correct answer is (A).
Average inventory methods assume that the cost of goods sold and the ending inventory should be based on the average cost of the inventory available for sale during the period. A weighted average is generally used with a periodic inventory system, while a moving average requires the use of a perpetual inventory system.
Under the periodic system, use the Weighted Average Method as follows:
- Cost of units calculated at the end of the period based upon the weighted average price paid (including freight, etc.)
- Weighted Average price = Cost of goods available for sale / No. of units available for sale
| Particulars | Units | Total Cost |
| Opening | 200 | 1,250 |
| May-04 | 20 | 116 |
| May-17 | 80 | 440 |
| Total | 300 | 1,806 |
The weighted average cost per unit = 1,806 / 300 = $6.02 per unit
The cost of goods sold = 10 units x $6.02 = $60.20
FAR-16. Ultra Co. uses a periodic inventory system. The following are inventory transactions for the month of January:
| 1/1 | Beginning inventory | 20,000 units at $13 |
| 1/20 | Purchase | 30,000 units at $15 |
| 1/23 | Purchase | 40,000 units at $17 |
| 1/31 | Sales at $20 per unit | 50,000 units |
Ultra uses the LIFO method to determine the value of its inventory. What amount should Ultra report as cost of goods sold on its income statement for the month of January?
A. $710,000
B. $750,000
C. $830,000
D. $1,000,000
The correct answer is (C).
In a Last-In-First-Out or LIFO system of inventory management, the most recent purchases are sold first. As such, inventory in hand consists of the earliest purchases.
The cost of the goods sold on 1/31 can be calculated as follows:
| Particulars | Units | Rate | Total Cost |
| Purchases on 1/23 | 40,000 | $17 | $680,000 |
| Purchases on 1/20 | 10,000 | $15 | $150,000 |
| Total | 50,000 | $830,000 |
FAR-17. Pine Co. purchased land for $450,000 as a factory site. An existing building on the site was razed before construction began. Additional information is as follows:
| Cost of razing old building | $60,000 |
| Title insurance and legal fees to purchase land | $30,000 |
| Architect's fees | $95,000 |
| New building construction cost | $1,850,000 |
What amount should Pine capitalize as the cost of the completed factory building?
A. $2,005,000
B. $1,975,000
C. $1,945,000
D. $1,910,000
The correct answer is (C).
Fixed assets such as buildings, machinery and equipment, and furniture and fixtures, are to be recorded at their acquisition cost. Building costs generally include cash price to purchase, building permits, architect fees, engineering fees, and interest. Machinery and equipment costs typically include transportation, insurance while in-transit, special foundations, installation, and test runs.
- Building cost includes
- Purchase price and construction costs
- Alterations and improvement costs
- Architect fees
- Repair charges neglected by the previous owner, now incurred (‘deferred maintenance’)
- Capitalized interest (during construction period before occupancy begins)
Out of the given list of items, the following items qualify to be capitalized as building in the books of the entity:
- Architect's fees: $95,000
- New building construction cost: $1,850,000
- Total: $1,945,000
The cost of razing the old building and legal fees to purchase the land would be capitalized along with the land.
FAR-18. Smile, Inc. purchased a computer on May 1, for $12,000 with an estimated salvage value of $1,500 and a 3-year life. What is the depreciation expense for the year ended December 31, using the double-declining method of depreciation?
A. $8,000
B. $7,000
C. $5,333
D. $4,667
The correct answer is (C).
Under the double-declining method of depreciation, a rate of depreciation twice the straight-line rate is applied to the book value (BV) of the asset to obtain the depreciation expense for the period. The BV is the declining balance (historical cost less accumulated depreciation) of the asset and is also known as the depreciable base. Depreciation is charged in this manner as long as the amount does not depreciate the asset to a value less than the salvage value. No more depreciation is provided once the book value equals the salvage value.
Depreciation rate = 2 x (1/useful life of the asset)
In this particular question, the rate of depreciation = 2 x (1/3) = 2/3.
The depreciation expense for the year ended December 31 = 12,000 x 2/3 = $8,000.
Since the computer was purchased in the middle of the year, the depreciation would be applied proportionately, i.e. for the period from May to December.
Proportionate depreciation = 8,000 x 8/12 = $5,333.
FAR-19. Hall Co. purchased a machine on January 1 at a cost of $140,000. The machine had an estimated useful life of eight years and a salvage value of $60,000. Hall chose to depreciate the machine using the double-declining balance method. What was the carrying amount of the machine in Hall's balance sheet at the end of its second year of operations?
A. $60,000
B. $61,250
C. $78,750
D. $80,000
The correct answer is (C).
Under the double-declining method of depreciation, a rate of depreciation twice the straight-line rate is applied to the book value (BV) of the asset to obtain the depreciation expense for the period. The BV is the declining balance (historical cost less accumulated depreciation) of the asset and is also known as the depreciable base. Depreciation is charged in this manner as long as the amount does not depreciate the asset to a value less than the salvage value. No more depreciation is provided once the book value equals the salvage value.
Depreciation rate = 2 x (1/useful life of the asset).
In this question, the rate of depreciation = 2 x (1/8) = 1/4
| Particulars | $ |
| Historical Cost | 140,000 |
| Depreciation – 1st year | 35,000 |
| Carrying Value at year-end | 105,000 |
| Depreciation – 2nd year | 26,250 |
| Carrying Value at year-end | 78,750 |
FAR-20. Dodd Co.'s debt securities at December 31 included available-for-sale securities with a cost basis of $24,000 and a fair value of $30,000. Dodd's income tax rate was 20%. What amount of unrealized gain or loss should Dodd recognize in its income statement at December 31?
A. $6,000 loss.
B. $0
C. $4,800 gain.
D. $6,000 gain.
The correct answer is (B).
Unrealized gains and losses on certain investments in debt securities including the following are reported exclusively as other comprehensive income:
Unrealized holding gains and losses on available-for-sale (AFS) debt securities
- Unrealized holding gains and losses that result from a debt security being transferred into the AFS category from the HTM category
- Subsequent decreases or increases in the fair value of AFS debt securities previously written down as impaired
- A change in the market value of a futures contract that qualifies as a hedge of an asset reported at fair value
- Such gains and losses are not classified as net income unless the securities are sold off
Going by the above principle, the unrealized gain on the debt securities held by Dodd Co. shouldn’t be recognized in its income statement on December 31, but will be classified in other comprehensive income.
FAR-21. Goll Co. has a 25% interest in the common stock of Rose Co. and an 18% interest in the common stock of Jave Co. Neither investment gives Goll the ability to exercise significant influence over either company's operating and financial policies. Which of the two investments should Goll account for using the equity method?
A. Both Rose and Jave.
B. Rose only.
C. Jave only.
D. Neither Rose nor Jave.
The correct answer is (D).
The equity method is based upon the premise that the investor owns a large enough proportion of voting shares of the investee to allow the investor to exert significant influence over the policies of the investee, particularly operating and financial policies.
Since neither of the investments gives Goll the ability to exercise significant influence over either company’s operating and financial policies, they both would not be accounted for using the equity method.
FAR-22. Bay Co. incurred legal fees in defending its patent rights. These legal fees should be capitalized when the outcome of the litigation is
| Successful | Unsuccessful | |
| A. | Yes | Yes |
| B. | Yes | No |
| C. | No | No |
| D. | No | Yes |
The correct answer is (B).
A patent represents a special right to a particular product or process that has value to the holder of the right. Only the external acquisition costs, which include items such as legal costs associated with obtaining a patent on a new product, are capitalized. Research and development costs incurred to internally develop a patent are expensed as incurred.
- The cost of a competing patent acquired to protect an existing patent and the cost of a successful legal defense of an existing patent should also be capitalized.
- The cost of an unsuccessful defense, along with any amounts previously capitalized for the patent, is expensed in the period in which an unfavorable court decision is rendered.
FAR-23. Corbet Co. purchased a copyright near the beginning of the current year from an author for $20,000. The legal life of the copyright is equivalent to the life of the author plus 50 years. Corbet expects to sell the book for five years. What amount should Corbet report as amortization expense related to the copyright at the end of the current year?
A. $0
B. $400
C. $500
D. $4,000
The correct answer is (D).
A copyright is an exclusive right granted by the federal government, giving the owner protection against the illegal reproduction by others of the owner’s written works, designs, or literary productions. It is amortized over the shorter of its useful and legal life.
Although the copyright period is for the life of the author plus 50 years, the cost of a copyright should be amortized over its useful life, i.e. over 5 years.
➡️ Free FAR Notes – Fundamentals of Accounting & Conceptual Framework
FAR-24. The following information pertains to Dash Co.'s utility bills:
| Period covered | Amount | Date paid |
| April 16 – May 15 | $5,000 | June 1 |
| May 16 – June 15 | $6,000 | July 1 |
| June 16 – July 15 | $8,000 | August 1 |
What is the amount that Dash should report as a liability in its June 30 balance sheet?
A. $6,000
B. $7,000
C. $10,000
D. $14,000
The correct answer is (C).
Liabilities are obligations, based on past transactions, to convey assets or perform services in the future. An accrued expense is an expense incurred, but not yet paid in cash. An example of an accrued expense would be salaries incurred for the last week of the accounting period that are not payable until the subsequent accounting period. In this question, the following expenses have been incurred up until June but were not paid in cash in the same period:
- $6,000 for the period May 16 – June 15
- Half of the expenses ($4,000) for the period June 16 – July 15 relate to June (June 16 to June 30).
The liabilities to be reported in the balance sheet as on June 30 = 6,000 + 4,000 = $10,000.
FAR-25. Under state law, Boca Co. may reimburse the state directly for actual unemployment claims or it may pay 3% of eligible gross wages. Boca believes that actual unemployment claims will be 2% of eligible gross wages, and has chosen to reimburse the state. Eligible gross wages are defined as the first $15,000 of gross wages paid to each employee. Boca had four employees, each of whom earned $20,000 during the year. What amount should Boca report as accrued liability for unemployment claims in its year-end balance sheet?
A. $1,200
B. $1,600
C. $1,800
D. $2,400
The correct answer is (A).
An accrued expense is an expense incurred, but not yet paid in cash. An example of an accrued expense is salaries incurred for the last week of the accounting period that are not payable until the subsequent accounting period.
The liability accrued for the year-end = 2% of gross wages to all the employees.
= 2% of (15,000 x 4)
= 2% of 60,000 = $1,200
FAR-26. On July 1, year 7, Dean Co. issued, at a premium, bonds with a due date of July 1, year 12. Dean incorrectly used the straight-line method instead of the effective interest method to amortize the premium. How were the following amounts affected by the error at June 30, year 12?
| Bond carrying amount | Retained earnings | |
| A. | Overstated | Understated |
| B. | Understated | Overstated |
| C. | Overstated | No effect |
| D. | No effect | No effect |
The correct answer is (D).
Dean Co. used the straight-line method instead of the effective interest method to amortize the premium. Under the straight-line method, the premium is amortized equally over the life of the bond, but under the effective interest method, the amortization is less in the initial periods and more in the later periods. However, under both methods, the entire premium would have been amortized by June 30, Year 12. There would be no effect because of this error as on June 30, Year 12 on Bond Carrying Value.
Interest Expense = Interest Paid – Premium Amortization. Under the straight-line method, the premium is amortized equally over the life of the Bond. As such, interest expense would be the same over the life of the bond, but under the effective interest method, amortization is less in the initial periods leading to higher interest expense in the initial periods and less in the later periods. However, under both methods, the entire premium would have been amortized by June 30, Year 12, and the total interest expense charged under both methods would be the same overall. There would be no effect because of this error as on June 30, Year 12 on Retained Earnings.
FAR-27. On July 1, Alto Co. split its common stock 5 for 1 when the fair value was $100 per share. Prior to the split, Alto had 10,000 shares of $10 par value common stock issued and outstanding. After the split, the par value of the stock
A. Remained at $10.
B. Was reduced to $8.
C. Was reduced to $5.
D. Was reduced to $2.
The correct answer is (D).
Stock splits are when a company increases the number of shares outstanding and proportionately decreases the par or stated value of the stock. There is no change in the dollar amount of capital stock, additional paid-in capital, retained earnings, or total stockholders’ equity. Stock splits are issued mainly to reduce the unit market price per share of the stock in order to obtain a wider distribution.
The par value of the shares of Alto Co. was $10 prior to the split of 5 for 1. The revised par value = 10/5 = $2 per share.
FAR-28. Elan Co. has two employees. Each employee receives two weeks of paid vacation each year. Vacation rights accumulate. One employee, whose weekly salary is $600, took a two-week vacation during the year, but the other employee, who earns $800 per week, took no vacation during the year. In its year-end financial statements, what amount should Elan report as vacation liability and expense?
| Answer | Liability | Expense |
|---|---|---|
| A. | $1,600 | $1,200 |
| B. | $1,600 | $2,800 |
| C. | $0 | $1,200 |
| D. | $0 | $2,800 |
The correct answer is (B).
Expenses are outflows or other uses of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations during a period. Expenses represent actual or expected cash outflows (or equivalents).
Vacation rights are an expense that is incurred by Elan Co. every fiscal year (due to accumulation rights), even though they aren’t paid in cash if the employee does not take a vacation. As such, the vacation expense = 2 x weekly salary.
= 2 x (600 + 800)
= 2 x 1,400 = $2,800
Liabilities are obligations, based on past transactions, to convey assets or perform services in the future. An accrued expense is an expense incurred, but not yet paid in cash.
Out of the incurred expense, vacations of $1,200 (2 x $600) were exercised by one of the employees. As such, the accrued liability to be recognized = 2 x 800 = $1,600.
FAR-29. Holt Co. discovered that in the prior year, it failed to report $40,000 of depreciation related to a newly constructed building. The depreciation was computed correctly for tax purposes. The tax rate for the current year was 20%. How should Holt report the correction of error in the current year?
A. As an increase in accumulated depreciation of $32,000.
B. As an increase in accumulated depreciation of $40,000.
C. As an increase in depreciation expense of $32,000.
D. As an increase of depreciation expense of $40,000.
The correct answer is (B).
Errors in financial statements result from mathematical mistakes, mistakes in the application of accounting principles, or the oversight or misuse of facts that existed at the time the financial statements were prepared. Any error in the financial statements of a prior period discovered subsequent to their issuance should be reported as a prior period adjustment by restating the prior period financial statements.
Holt Co. failed to report a depreciation expense in the previous year. If this hadn’t been omitted, the Depreciation Expense and Accumulated Depreciation would have been higher by $40,000 and consequently Income Tax Expense and Income Tax Payable would have been lower by $8,000 ($40,000 x 20%).
This has been demonstrated below:
Journal Entry that should have been recorded in the Prior Year:
| Depreciation Expense | $40,000 | |
| Accumulated Depreciation | $40,000 | |
| Income Tax Payable | $8,000 | |
| Income Tax Expense | $8,000 |
Journal Entry was not passed in the Prior Year
Correcting Journal Entry
| Retained Earnings | $32,000 | |
| Income Tax Payable | $8,000 | |
| Accumulated Depreciation | $40,000 |
As such, correction of such an error would entail crediting the accumulated depreciation account by $40,000.
FAR-30. Mill Co. reported pretax income of $152,500 for the year ended December 31. During the year-end audit, the external auditors discovered the following errors:
| Ending inventory
$30,000 overstated |
| Depreciation expense
$64,000 understated |
What amount should Mill report as the correct pretax income for the year ended December 31?
A. $58,500
B. $118,500
C. $186,500
D. $246,500
The correct answer is (A).
Correcting the overstatement of ending inventory would mean a decrease in the gross margin and consequently a decrease in the pre-tax income of the entity.
Correction of the understated depreciation expense would cause the total expenses of the year to increase, causing a decrease in the pre-tax income.
The correct pre-tax income for the year ended December 31 = 152,500 – 30,000 – 64,000
= $58,500
FAR-31. Arno Co. did not record a credit purchase of merchandise made prior to year end. However, the merchandise was correctly included in the year-end physical inventory. What effect did the omission of reporting the purchase of merchandise have on Arno's balance sheet at year end?
| Assets | Liabilities | |
| A. | No effect | No effect |
| B. | No effect | Understated |
| C. | Understated | No effect |
| D. | Understated | Understated |
The correct answer is (B).
The two accounts that would have been affected due to the credit purchase of the merchandise are:
- A credit to accounts payable (causing an increase in the current liabilities).
- A debit to inventory (causing an increase in the current assets).
As stated, the merchandise was correctly included in the year-end inventory. The only omission was the credit to accounts payable, leading to an understatement of liabilities.
FAR-32. Prior to the issuance of its December 31 financial statements, Stark Co. was named as a defendant in a lawsuit arising from an event that occurred in October. Stark's legal counsel believes that it is reasonably possible that there will be an unfavorable outcome and that damages will range from $100,000 to $150,000. Which amount(s) should Stark accrue and/or disclose in its December 31 financial statements?
| Accrue contingent liability | Disclose contingent liability | |
| A. | $100,000 | $100,000 – $150,000 |
| B. | $100,000 | $150,000 |
| C. | $0 | $100,000 – $150,000 |
| D. | $0 | $150,000 |
The correct answer is (C).
Contingent liabilities arise from events or circumstances occurring before the balance sheet date, the resolution of which is contingent upon a future event or circumstance. ‘Reasonably possible’ means the likelihood of the future event is more than remote but less than probable. Where the loss is considered reasonably possible, no accrual should be made, but the nature of the contingency should be disclosed with the range of possible losses, i.e., $100,000 – $150,000.
FAR-33. Dari, Inc. guaranteed the debt of a related party. In December, Dari learned that it is probable it will be required to pay between $150,000 and $200,000 within the next six months in satisfaction of its guarantee, but no amount within that range is more likely. What amount of contingent liability should Dari accrue in its December 31 balance sheet?
A. $200,000
B. $175,000
C. $150,000
D. $0
The correct answer is (C).
A contingent liability comes from a condition that exists at the balance sheet date, but its final outcome depends on a future event. The key issue is uncertainty about whether the liability actually exists, not uncertainty about the exact amount.
When a loss is considered probable and can be reasonably estimated, it must be recorded in the financial statements. If the estimate falls within a range and no amount is more likely than another, the rule is to record the lowest amount in that range and disclose the potential for additional loss.
Here, the estimated loss falls between $150,000 and $200,000, and the likelihood is probable. Since no single amount is identified as the best estimate, the minimum amount is recorded.
Accrued liability = 150,000
FAR-34. True Co. did not record an accrual for a probable loss from a lawsuit in its financial statements. Which of the following explanations for True's not accruing the probable loss is in accordance with generally accepted accounting principles?
A. No reasonable estimate of the loss can be made.
B. An estimated range for the loss can be made but no amount in the range is more accurate than any other amount.
C. Recognizing an amount in its financial statements would weaken the company's defense of the lawsuit.
D. Accrual was not required because an estimated amount of the loss was disclosed in the notes to the financial statements.
The correct answer is (A).
Contingent liabilities come from conditions that exist at the balance sheet date but depend on a future event for final resolution. The key issue is uncertainty about whether the liability actually exists, not uncertainty about the amount.
When a loss is considered probable and can be reasonably estimated, it must be recorded as an expense and liability. In addition, the nature of the contingency should be disclosed.
If only a range of possible losses can be determined and no single amount is a better estimate than the others, record the minimum amount in the range. Disclosure should also include the potential for additional loss beyond the amount recorded.
If the loss cannot be reasonably estimated, no accrual is recorded. In that case, only disclosure is appropriate.
FAR-35. During year 2, Pipp Co. incurred the following costs to develop and produce a routine, low-risk computer software product:
| Completion of detailed program design | $10,000 |
| Costs incurred for coding and testing to establish technological feasibility | $15,000 |
| Other coding and testing costs incurred after establishment of technological feasibility | $44,000 |
In Pipp's December 31, year 2, balance sheet, what amount should be capitalized as software cost?
A. $10,000
B. $25,000
C. $44,000
D. $59,000
The correct answer is (C).
For software that will be sold to customers, the key cutoff is technological feasibility. Costs incurred before that point are treated as research and development and expensed. Once feasibility is established, subsequent production costs are capitalized until the product is ready for release.
Completion of detailed program design ($10,000) occurs as part of determining feasibility for a routine, low-risk product. This is still before the cutoff, so it is expensed.
Coding and testing to establish feasibility ($15,000) are also pre-feasibility activities. These costs are expensed as well.
The remaining coding and testing costs ($44,000) occur after feasibility has been established. These costs are capitalized.
FAR-36. Which characteristic of information in the statistical tables included in a comprehensive annual financial report differentiates it from information contained in the financial statements?
| Data covering financial trends | Fiscal years | |
| A. | Yes | Yes |
| B. | Yes | No |
| C. | No | Yes |
| D. | No | No |
The correct answer is (A).
When you see a question about the statistical section of a governmental annual report, focus on its purpose: providing long term context rather than just current period reporting.
The statistical section presents trend information over an extended period, typically around 10 years. This allows users to evaluate patterns in financial position, operating results, revenue capacity, and debt over time.
This is fundamentally different from the basic financial statements, which are limited to the current year, with only a prior year comparison. Those statements are designed to show the entity’s current financial position and recent performance, not long-term trends.
Because of this distinction, the statistical tables include multi-year trend data and extend beyond just the current and prior fiscal year. That combination is what makes (A) correct.
FAR-37. The city of Cobb has two trust funds for the benefit of the city's library, trust fund A and trust fund B. Only the earnings from trust fund A can be expended and both the principal and interest from trust fund B can be expended. How should the city of Cobb report each trust fund?
| Trust fund A | Trust fund B | |
| A. | Permanent | Permanent |
| B. | Permanent | Special revenue |
| C. | Special revenue | Permanent |
| D. | Special revenue | Special revenue |
The correct answer is (B).
In governmental accounting, the classification depends on whether the principal must be preserved or can be spent.
Trust fund A allows only the earnings to be spent, while the principal must remain intact. That structure fits a permanent fund, which is used when resources are restricted so that only investment income can be used for a public purpose.
Trust fund B allows both the principal and the earnings to be spent. When all resources are expendable but still restricted for a specific governmental purpose, the activity is reported in a special revenue fund.
FAR-38. The City of Windemere decided to construct several large windmills to generate electrical power. The construction was financed through a general residential property tax levy for the next ten years. Utility revenues are intended to offset all expenses associated with the windmills. The land for the windmills was donated to the city by a local farmer. The land from the farmer should be reported in which fund type?
A. Special revenue.
B. Capital projects.
C. Enterprise.
D. Permanent.
The correct answer is (C).
When a government operates an activity that functions like a private business, the key question is whether the activity is intended to be self-supporting through user fees. Here, the windmills generate electricity and the related revenues are expected to cover operating costs, depreciation, and long-term maintenance.
That fact pattern aligns with a business-type activity. These activities are accounted for using enterprise funds, which follow an economic resources focus and full accrual accounting, similar to private-sector accounting.
The donated land is directly tied to the power generation operation. Because it supports an enterprise activity, it is reported within the enterprise fund. Enterprise funds include capital assets such as land, buildings, and equipment since they measure overall financial position, not just short-term resources.
The fact that initial funding came from property taxes does not change the classification. What matters is the ongoing nature of the activity. Once the operation is designed to recover its costs through charges to users, it is treated as an enterprise activity.
FAR-39. In the statement of activities for a governmental entity, revenues such as charges for building permits, garbage collection, and dog licenses are reported as which of the following?
A. Program revenues in the category “Capital Grants and Contributions.”
B. Program revenues in the category “Charges for Services.”
C. General revenues in the category “Charges for Services.”
D. General revenues in the category “Capital Grants and Contributions.”
The correct answer is (B).
In the government-wide statement of activities, revenues are classified as either program revenues or general revenues. The key distinction is whether the revenue is tied to a specific function or program.
Program revenues are directly associated with a particular activity and reduce the net cost of that function. They fall into three categories:
- Charges for services
- Operating grants and contributions
- Capital grants and contributions
Charges for services include amounts collected from individuals or entities that directly receive a benefit. This covers fees for services and regulatory-type charges such as permits and licenses.
Building permits, garbage collection fees, and dog licenses all involve a direct exchange. The payer receives a specific service or privilege, so these revenues are tied to identifiable government functions.
Because of that, they are reported as program revenues in the category of charges for services, not as general revenues.
FAR-40. The statement of activities in the government-wide financial statements includes which of the
A. Separate columns for governmental activities, business-type activities and discretely presented component units.
B. Separate columns for each major governmental fund.
C. Separate columns for each nonmajor governmental fund.
D. A separate section at the bottom of the statement that shows program and general revenues.
The correct answer is (A).
In the government-wide financial statements, the presentation focuses on the government as a whole using full accrual accounting. These statements separate activities into distinct columns so users can clearly evaluate different types of operations.
Governmental activities and business-type activities are each reported in their own columns, with an additional total column for the primary government. Any discretely presented component units are shown in separate column(s), apart from the primary government, so their financial position and results do not get mixed in.
This same columnar structure applies to the statement of activities. That statement reports expenses by function, then offsets them with related program revenues to arrive at net expense or revenue. General revenues and transfers are reported afterward to determine the overall change in net position.
FAR-41. Best County's capital projects fund had the following receipts during the year:
| Transfer from the general fund | $100,000 |
| Federal capital grant | $75,000 |
| Special assessment for capital improvements | $300,000 |
What amount of revenues should Best County report in its capital projects fund at the end of the year?
A. $75,000
B. $300,000
C. $375,000
D. $475,000
The correct answer is (C).
In a capital projects fund, the focus is on distinguishing between revenues and other financing sources. Only inflows from external sources, such as grants or special assessments, are reported as revenues. Interfund transfers are reported separately.
The federal capital grant represents an external inflow restricted for capital purposes, so it is reported as revenue.
The special assessment for capital improvements is also treated as revenue when it is measurable and available, since it is imposed to finance capital activity.
The transfer from the general fund is not revenue. It is an interfund transfer and is classified as an other financing source.
Total revenues:
75,000 + 300,000 = 375,000
FAR-42. Large City does not use the modified approach to account for roads. At the beginning of the current year, the city spent $800,000 on new roads. The roads have a 20-year useful life. What amount should Large City report as an expense related to the new roads in the statement of activities for the current year?
A. $0
B. $20,000
C. $40,000
D. $800,000
The correct answer is (C).
Because the city is not using the modified approach, infrastructure is accounted for using the depreciation method. That means the $800,000 cost of the roads is capitalized and then allocated over its useful life.
Annual depreciation is calculated as:
800,000 ÷ 20 = 40,000
On the government-wide statement of activities, which uses full accrual accounting, the city reports depreciation expense each year rather than expensing the full cost upfront.
FAR-43. Zarr Town levied property taxes of $500,000, of which 1% is expected to be uncollectible. During the year, Zarr Town collected $450,000. What amount of property tax revenue should Zarr Town report in its government-wide statement of activities for the current year?
A. $0
B. $450,000
C. $495,000
D. $500,000
The correct answer is (C).
Property taxes are recognized as revenue in the period they are levied, adjusted for the portion expected to be uncollectible. This follows accrual accounting used in the government-wide statements.
Net revenue is:
500,000 × 99% = 495,000
The amount actually collected during the year affects cash and receivables, but it does not determine revenue recognition under the accrual basis.
FAR-44. In the current year, Poplar City paid $5,000 interest and $20,000 principal on its outstanding general obligation bonds. The payment was made from a debt service fund using cash transferred earlier the same year from the general fund. How should the city report the expenditures?
| General fund | Debt service fund | Permanent fund | |
| A. | $25,000 | $25,000 | $0 |
| B. | $0 | $25,000 | $20,000 |
| C. | $25,000 | $5,000 | $0 |
| D. | $0 | $25,000 | $0 |
The correct answer is (D).
Debt service funds are used to account for the payment of long-term debt principal and interest. Both components are recorded as expenditures in that fund.
Interest = 5,000
Principal = 20,000
Total expenditures = 25,000
The general fund does not report these payments as expenditures. Instead, the earlier transfer to the debt service fund is reported as an other financing use. The permanent fund is not involved.
REG CPA Exam Questions
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Regulation CPA Exam Questions
REG-1. If a CPA recklessly departs from the standards of due care when conducting an audit, the CPA will be liable to third parties who are unknown to the CPA under the law of
A. Strict liability.
B. Breach of contract.
C. Negligence.
D. Gross negligence.
An accountant must exercise due professional care in the performance of an audit., i.e., that of an ordinary prudent CPA. Due care is exercised through:
- Disclosure of information to the client
- Correction of previously discovered errors and
- Follow GAAP/GAAS standards.
An absence of any of the above is deemed as failure to exercise due care and is subject to liability under common law negligence.
A reckless departure from standards of due care when conducting an audit is gross negligence by a CPA. It is an indication that the CPA made false statements with a reckless disregard for the truth. In such cases, the CPA is liable to all parties (including unknown) who sue on account of common law fraud or gross negligence.
REG-2. Which of the following defenses is likely to be successful in a suit alleging negligence by a CPA?
A. Due care.
B. Ignorance of the law.
C. Lack of intent.
D. Lack of mental capacity.
The correct answer is (A).
In a common lawsuit based on negligence against a CPA, the best defenses available to a CPA are:
- Due Care (CPA followed GAAS).
- Lack of privity (However, this will not work against a client or intended third party).
REG-3. Which of the following pairs of elements must a client prove to hold an accountant liable for common law fraud?
A. Material misrepresentation and breach of contract.
B. Freedom from contributory negligence and loss.
C. Scienter and justifiable reliance.
D. Intent to deceive and privity.
The correct answer is (C).
A common law theory of liability that can be used by any party, including one who is unknown to the auditor, is fraud. Fraud refers to the intent to deceive. To hold an accountant liable for common law fraud, the client must prove:
- Material misstatement or omission in the financial statements.
- Loss (damages) – Plaintiff must have suffered a financial loss as a result of the above.
- Information was relied upon by the plaintiff.
- Reckless misconduct or Intent to deceive – the auditor must have had actual knowledge (Scienter) or constructive knowledge that their opinion was incorrect.
The correct pair of elements is Scienter and justifiable reliance.
REG-4. To which of the following parties will a CPA be liable if the CPA fraudulently issues an unqualified opinion on a corporation's materially misstated financial statements?
| Corporate shareholders | Corporate bondholders | |
| A. | Yes | Yes |
| B. | Yes | No |
| C. | No | Yes |
| D. | No | No |
The correct answer is (A).
According to common law theory, in cases of fraud, any party, including those unforeseen by a CPA, can sue the CPA for fraud or gross negligence. Accordingly, a CPA is liable to a party who has suffered a loss as a result of the fraud, including the Corporate Shareholders and Bondholders.
REG-5. Which of the following transactions correctly illustrates the doctrine of substantial performance?
A. Blair ordered a dozen blue chairs from Kyle, but Kyle delivered a dozen red chairs.
B. Leslie painted an entire room but failed to put the electrical outlet covers back on.
C. A contract required hair styling to be done to Toby's satisfaction, but Toby was, in good faith, dissatisfied with the completed result.
D. A dentist competently completed the extraction of Lee's tooth but mistakenly pulled the wrong one.
The correct answer is (B).
The doctrine of substantial performance essentially states that if in good faith, an attempt is made to perform the terms and conditions of the contract, the performance will be considered complete as long as the performance accomplishes the required purpose. However, there can be a claim of damages for the shortfall. If the defendant is sued by the claimant for non-performance, he can claim substantial performance.
Leslie painting an entire room but failing to put the electrical outlet covers back on is still a substantially complete performance as the main purpose of the contract was to get the room painted, which has been achieved.
Red chairs instead of blue, unsatisfactory performance by a hairstylist, and dentist extracting the wrong tooth does not satisfy the doctrine of substantial performance.
REG-6. Which of the following circumstances generally will cause a discharge of contractual duties by operation of law?
A. Novation.
B. Accord and satisfaction.
C. Anticipatory repudiation.
D. Impossibility of performance.
The correct answer is (D).
Discharge of Contracts by operation of law can happen due to the following reasons:
- Death or incapacity of the party obligated to perform a personal service contract
- Impossibility or Destruction of subject matter
- The illegality of the services to be performed
- Discharge in bankruptcy
REG-7. Brown cosigned Royal's $50,000 note to State Bank. If Royal is later adjudicated mentally incompetent, what would be Brown's liability on the note?
A. Liable to pay State on the due date of the note.
B. Liable to pay State only if State first seeks payment from Royal.
C. Not liable to pay State because Royal's incompetency discharges Royal as a surety.
D. Not liable to pay State unless Brown was a compensated surety.
The correct answer is (A).
Contracts entered into before adjudication of insanity may be voidable by the incompetent person, but once adjudicated insane by a court of law, they are considered void. In such a case, when Royal is adjudicated mentally incompetent, and the contract is void, Brown would be liable to pay the State Bank on the due date of the note.
REG-8. Which of the following statements is correct regarding the Federal Unemployment Tax Act?
A. An employee, who resigns, regardless of cause, is eligible for unemployment benefits.
B. The federal unemployment system is funded by both employer and employee taxes.
C. The Act is intended to assist workers who are permanently out of work and need assistance in supporting themselves.
D. The unemployment insurance system is administered by the states through their employment laws.
The correct answer is (D).
State laws govern eligibility for unemployment benefits and the amount of such benefits. All states require substantial past employment.
Generally, unemployment benefits are provided to workers who are discharged through no fault of their own.
Unemployment benefits are funded by contributions from employers only and are deductible as a business expense for federal income tax purposes.
The amount of benefits varies from state to state. Unemployment benefits are not available to the self-employed
REG-9. A partner in a general partnership is usually not entitled to which of the following?
A. To participate in management.
B. To review accounting records.
C. To enter into a contract with a third party without the consent of the other partners.
D. To be liable only for personal negligence.
The correct answer is (D).
A General Partnership is a partnership where one partner is liable for the negligent acts of another partner or an employee, who does not act under a partner's supervision.
The partner can participate in management, review accounting records, and enter into a contract with a third party without the consent of the other partners. However, the partner is not only liable for his/her own personal negligence but also for the negligence of other partners or employees.
REG-10. Which of the following statements is correct regarding a shareholder’s right to inspect corporate books and records? The right
A. Is absolute.
B. Is conditioned upon the demanding shareholder owning at least $5,000 worth of stock.
C. Requires that the demand to inspect be for a proper purpose.
D. Exists only when fraud or illegality is alleged.
The correct answer is (C).
Shareholders of a corporation have the right to inspect books and records at a reasonable time and place for a reasonable purpose. Some examples of a reasonable purpose would include: obtaining the shareholder list to send a proxy solicitation to replace the existing board of directors or to determine if the books agree with the financial statements issued, etc.
REG-11. Parent gave securities with an adjusted basis of $10,000 and fair market value of $9,000 to a child. Later the child sold the securities for $7,000. What is the child's basis for the securities sold?
A. $10,000
B. $9,000
C. $7,000
D. $0
The correct answer is (B).
Generally, when a taxpayer receives a gift, he/she receives the same basis and holding period as that of the donor. But in exceptional cases, where the FMV on the date of the gift is lower than the rollover basis, the donee’s basis cannot be determined until the time of sale (Dual basis rules).
If the donor’s basis is more than FMV at the gift date, and FMV at the gift date is more than the Sale price, use FMV at the gift date to determine the basis.
The basis of $10,000 is more than the FMV of $9,000, which is more than the sale price of $7,000. As such, the basis would be the FMV of $9,000.
➡️ Free REG Notes – Individual Taxation
REG-12. Lemon owned 2,000 shares of Spectrol Corp. common stock that were purchased in year 1 at $10.50 per share. In year 4, Lemon received a 5% non-taxable dividend of Spectrol common stock. In year 5, the stock split 2-for-1. In the current year Lemon sold 800 shares. What is Lemon's basis in the 800 shares of stock sold?
A. $4,000
B. $8,000
C. $8,400
D. $16,800
The correct answer is (A).
Original Basis of 2000 shares (2000 x $10.5): 21,000.
A stock dividend means a distribution of more shares of the corporation’s stock to the stockholders. The basis of the original stock is allocated to the increased number of stocks. Because there is a 5% stock dividend, the number of shares = 2,000 x 1.05 = 2,100 shares.
After the stock split, the number of shares would be increased. As such, the total number of shares after 2-for-1 stock split would be 2,100 x 2 = 4,200.
Basis for each share = $21,000/4,200 = $5.
Basis for 800 shares sold = 800 x $5 = $4,000.
REG-13. On January 1, the partners' interest in capital, profits, and losses of Studio Partnership were:
| Partners | Percentages |
| Ross | 15% |
| Stone | 35% |
| Taylor | 50% |
On April 9, Stone sold his entire interest to Taylor. For tax purposes, which of the following statements is correct regarding Studio's status as a partnership?
A. Studio terminated as of January 1.
B. Studio terminated as of April 9.
C. Studio terminated as of December 31.
D. Studio did not terminate.
The correct answer is (D).
The transfer of a partner’s interest is a change in the relationship of the partners caused by any partner ceasing to be associated in the carrying on of the business. Under the Revised Uniform Partnership Act (RUPA), a partner’s withdrawal, death, or bankruptcy does not automatically cause the dissolution of the partnership if the remaining partners that own the majority of the partnership can choose to continue the partnership within 90 days of the partner’s withdrawal, death, or bankruptcy. As such, Studio does not terminate.
REG-14. Prime Corp. is an accrual-basis, calendar-year C corporation. Its current-year reported book income before federal income taxes was $300,000, which included $17,000 corporate bond interest income. A $20,000 expense for term life insurance premiums on corporate officers was incurred. Prime was the policy owner and beneficiary. What was Prime's current-year taxable income as reconciled on Prime's Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, of Form 1120, U.S. Corporation Income Tax Return?
A. $320,000
B. $300,000
C. $283,000
D. $280,000
The correct answer is (A).
Owing to the differences in the tax treatment of certain items of income and expenses from US GAAP, a reconciliation of book income to tax income is required of all corporations. These differences, some of which are permanent while others are temporary, are reconciled on Schedule M-1 of Form 1120.
| Reconciliation of book income to taxable income for Prime Corp.: | |
| Total Book Income | $300,000 |
| Add: Premiums paid on key person’s life insurance | $20,000 |
| Total Tax Income | $320,000 |
- Corporate Bond Interest is income for both Book and Tax Purposes.
REG-15. Vital Corp. is an accrual-basis, calendar-year C corporation. Its year 2 reported book income before federal income taxes was $500,000. Included in that amount were the following items:
| Year 1 state franchise tax refund | $50,000 |
| Municipal bond interest income | 7,500 |
What should be the amount of Vital's year 2 taxable income as reconciled on Vital's Schedule M-1 of Form 1120, U.S. Corporation Income Tax Return?
A. $500,000
B. $492,500
C. $450,000
D. $442,500
The correct answer is (B).
Due to the differences in the tax treatment of certain items vs US GAAP, a reconciliation of book income to tax income is required of all corporations. These differences, some of which are permanent while others are temporary, are reconciled on Schedule M-1 of Form 1120.
| Reconciliation of book income to taxable income for Vital Corp.: | |
| Total Book Income | $500,000 |
| Less: Municipal Bond Interest Income | ($7,500) |
| Total Tax Income | $492,500 |
- Interest income from municipal bonds is not considered taxable, and as such, would be deducted from Book Income.
- State franchise tax refund is included in income for both book income and tax purposes.
TCP CPA Exam Questions
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Tax Compliance and Planning CPA Exam Questions
Note: These were originally REG questions, but now reside in TCP.
TCP-1. In the current year, Vinton exchanged unimproved land for an apartment building. The land had a basis of $300,000, and a fair market value (FMV), of $420,000, and was encumbered by a $100,000 mortgage. The apartment building had an FMV of $550,000 and was encumbered by a $230,000 mortgage. Each party assumed the other's mortgage. What is Vinton's basis in the office building?
A. $300,000
B. $320,000
C. $430,000
D. $550,000
The correct answer is (C).
According to Sec. 1031, any gain realized from a qualified like-kind exchange can be tax-deferred and recognized only when the replacement property is ultimately sold. An exception to recognition of gain is when a boot is involved. A boot is a receipt of unlike property, which also now includes personal property and is taxed to the extent of the smaller of (1) the realized gain or (2) the actual boot received.
Vinton’s exchange of unimproved land for an apartment building qualifies as a like-kind exchange since they both are real properties and are in the same asset class. The mortgages exchanged are boot (unlike property) and gain is recognized to the extent of the smaller of (1) the realized gain or (2) the actual boot received. Note that the boot given as assumption of liability can offset the boot received as relief of liability.
Vinton’s recognized gain is calculated as follows:
Calculate Realized Gain
- Realized gain = FMV of new property – Basis of property given up + (Boot received – Boot paid).
- Realized gain = $550,000 – $300,000 + ($100,000 – $230,000) = $120,000.
Calculate Recognized Gain
Recognized Gain is the smaller of
- Realized gain = $120,000 or
- Actual boot received = $0. (As Boot is paid, Debt Assumed > Debt Relief)
Recognized gain = $0
Basis in the replacement property can be calculated as follows:
| Adjusted basis of the relinquished property | $300,000 |
| Add: Excess debt assumed over debt relief | $130,000 |
| Add: Gain recognized on boot | $0 |
| Less: Boot received | $0 |
| Basis in the replacement property | $430,000 |
TCP-2. Decker, a 62-year-old single individual, sold his principal residence for the net amount of $500,000 after all selling expenses. Decker bought the house 15 years ago and occupied it until it was sold. On the date of sale, the house had a cost basis of $200,000. Within six months, Decker purchased a new house for $600,000. What amount of gain should Decker recognize from the sale of the residence?
A. $0
B. $50,000
C. $175,000
D. $300,000
The correct answer is (B).
Generally, a gain on sale of personal property is taxable and the loss is not deductible. An exception to recognition of gain applies to the sale of a personal residence. According to Sec.121 of the IRC, homeowners upon the sale of personal residence can exclude up to $250,000 ($500,000 for married ling jointly) from income if the ownership test and use test is met:
Ownership test: Taxpayer must own the home for at least 2 out of the last 5 years.
Use test: Taxpayer must live in the home and use it as a personal residence for at least 2 out of the last 5 years.
In the above case, Decker satisfies both the ownership test and the use test.
| Sales Price | $500,000 |
| Adjusted Basis | ($200,000) |
| Realized gain | $300,000 |
| Exemption | ($250,000) |
| Recognized Gain | $50,000 |
Since the taxpayer's available exclusion from income is $250,000, only $50,000 of realized gain is taxable.
TCP-3. Vale is a 50% partner in Ball Partnership. Vale's tax basis in Ball on January 2, year 1, was $60,000. Ball did not have unrealized receivables, appreciated inventory, or properties that had been contributed by its partners. On December 31, year 1, Ball made a $10,000 nonliquidating cash distribution to each partner. The Ball Partnership income tax return reported the following items for year 1:
| Tax-exempt interest income | $80,000 |
| Dividend income | 12,000 |
What total amount of gross income from Ball should be included in Vale's year 1 adjusted gross income?
A. $6,000
B. $16,000
C. $36,000
D. $46,000
The correct answer is (A).
A partnership is a pass-through entity that files only an information return on Form 1065. Income is passed through to the partners proportionate to their interest in the partnership, who then report and pay taxes on their respective tax returns.
Tax-exempt interest income of $80,000 will not be part of Vale’s Adjusted Gross Income. As such, the total amount of gross income from Ball that should be included in Vale's year 1 adjusted gross income is 50% of Dividend Income, i.e. 50% of 12,000 = $6,000.
TCP-4. Decker, an individual, owns 100% of Acre, an S corporation. At the beginning of the year, Decker’s basis in Acre was $25,000. Acre had ordinary income during the year in the amount of $10,000 and a long-term capital loss in the amount of $4,000. Decker has no other capital gains or losses during the year. What amount of the long-term capital loss may Decker deduct this year?
A. $0
B. $1,000
C. $3,000
D. $4,000
The correct answer is (C).
S-Corps do not pay income taxes but are required to file annual information returns on Form 1120-S, reporting income and the allocation of that income to the various shareholders.
Because the items will be reported on the tax returns of the shareholders, the shareholders must segregate items that have special treatment on their individual tax returns.
Capital losses are passed through to the individual shareholders who can claim the loss on their tax return, subject to the $3,000 limitation. Excess Capital loss of $1,000 is carried forward to next year.
TCP-5. West is single, has no dependents, and does not itemize. West provides the following information regarding his current year’s return:
| Long-term capital gain | $15,000 |
| Percentage depletion in excess of property's adjusted basis | 9,000 |
| Dividends from publicly-held companies | 10,000 |
What is the amount of West's AMT tax preference items?
A. $9,000
B. $19,000
C. $24,000
D. $34,000
The correct answer is (A).
Certain deductions or income that is exempt from taxation for Regular Tax Purposes must always be added back for computing the Alternate Minimum Taxable Income (AMTI). These include:
- Depreciation on Pre-1987 Real or Personal Property
- Interest on Private Activity Bonds
- Percentage Depletion
Therefore, Percentage Depletion in excess of the Property's Adjusted Basis, i.e., $9,000, is added back as AMT Tax Preference Items.
Long-Term Capital Gain and Dividends from Publicly-Held Companies are included in income for Regular Tax Purposes and are not deducted for AMT purposes, so are not Preferences.
➡️ Free TCP Notes – Individual Taxation & Planning
TCP-6. Press Corp. and Swank Corp. file a consolidated return. The companies had the following items of income and deductions for the current year:
| Press Corp. | Swank Corp. | |
| Income from operations | $80,000 | $40,000 |
| Section 1231 loss | (12,000) | 0 |
| Capital gain(loss) | 4,000 | (3,000) |
What is Press and Swank's consolidated taxable income?
A. $109,000
B. $112,000
C. $121,000
D. $124,000
The correct answer is (A).
An affiliated group is a group of two or more corporations that are related through common ownership, consist of a parent and one or more subsidiaries, and the parent must own at least 80% of the subsidiary's stock. An affiliated group of corporations may elect to file a consolidated tax return instead of filing separately.
| Consolidated Income from Operations | $120,000 |
| Section 1231 Loss | ($12,000) |
| Capital Gain after setoff from Capital Loss ($4,000 – $3,000) | $1,000 |
| Consolidated Taxable Income | $109,000 |
TCP-7. Rigg, Steele, and Urco Corps., all accrual-basis, calendar-year C corporations, have only voting common stock outstanding. Rigg owns 85 percent of Steele and 40 percent of Urco. Steele owns 50 percent of Urco. Which group of corporations qualifies as an affiliated group and may join in the filing of a consolidated federal income tax return?
A. Rigg and Urco.
B. Urco and Steele.
C. Rigg, Steele, and Urco.
D. An affiliated group does not exist.
The correct answer is (C).
Only an affiliated group of corporations can file a consolidated tax return instead of filing separately. An affiliated group is one or more corporations in a group connected through stock ownership and having a common parent that owns at least 80% or more of the voting power and total value of the stock.
Rigg owns 85 percent of Steele. As such, Rigg and Steele satisfy the above 80% criteria and would consolidate. Steele owns 50 percent of Urco & Rigg Owns 40% of Urco. Combined, Rigg and Steele own 90%, which also satisfies the 80% criteria. Because of this, Rigg, Steele, and Urco may join in the filing of a consolidated federal income tax return.
TCP-8. Sunshine Corp., a wholly-owned subsidiary of Pierpoint Corp., purchased land from Pierpoint for its fair market value of $10,000 on January 1 of the previous tax year. Pierpoint's adjusted basis of the land on the date of sale was $8,000. During the current tax year, Sunshine sold the land for $9,000 to an unrelated taxpayer. What gain or loss will be reported on a consolidated tax return filed by Sunshine and Pierpoint for the current tax year?
A. ($1,000)
B. $0
C. $1,000
D. $2,000
The correct answer is (C).
Consolidated tax returns eliminate intercompany profits, interest, and dividends. So the only profit that would be recorded is when Sunshine sold the land for $9,000 to an unrelated taxpayer for which the basis was $8,000, recognizing a gain of $1,000.
TCP-9. Aston and Becker are equal partners in AB Partnership. In the tax year, the ordinary income of the partnership is $20,000, and the partnership has a long-term capital gain of $12,000. Aston's basis in AB was $40,000, and he received distributions of $5,000 during the year. What is Aston's share of AB's ordinary income?
A. $10,000
B. $15,000
C. $16,000
D. $18,500
The correct answer is (A).
A partnership is a pass-through entity that files only an information return on Form 1065. Income is passed through to the partners proportionate to their interest in the partnership, who then report and pay taxes on their respective tax returns.
Aston's share of AB's ordinary income = 50% of $20,000 = $10,000.
TCP-10. Lake Trust, a simple trust, reported the following items of income and expense during the year:
| Dividend income | $2,500 |
| Taxable interest income | 2,000 |
| Capital gains (allocable to corpus) | 5,000 |
| Accounting fees (allocable to income) | (500) |
| Trustee fees (allocable to income) | (750) |
What is Lake's distributable net income?
A. $9,500
B. $8,250
C. $5,000
D. $3,250
The correct answer is (D).
An estate’s Distributable Net Income (DNI) is the maximum amount of distribution that is taxable to the beneficiaries. It is also the maximum amount of distribution deduction available for the estate for a given year. It is calculated as follows:
| Total Income (Dividend Income + Taxable Interest Income + Capital Gains) | $9,500 |
| < Deductions >(Accounting Fees + Trustee Fees) | ($1,250) |
| Adjusted Total Income | $8,250 |
| < Net Capital gains allocated to corpus > | ($5,000) |
| Net Tax-Exempt Income | $0 |
| Distributable Net Income (DNI) | $3,250 |
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