FAR CPA Exam Review Course

Welcome back in this far cpa review course, we're going to begin our discussion of an absolutely gigantic topic, a very important topic, a very heavily tested topic. And what I'm talking about is how to account for a company's investments. Let's dive right into it. Generally speaking, a company should divide their investments.

Into three categories, three portfolios let's go over them. The first portfolio is called held to maturity securities. Now, the first thing you have to know for the FAR CPA Exam is what investments get in this category? What investments do we put in this category? Let's go over. It. Held to maturity investments are for investments in debt, securities, only like bonds where management has both management must have both.

The intent and the ability to hold the debt until maturity that's held to maturity securities investments in debt, securities only like bonds, mortgage notes, where management has both the intent and the ability to hold the debt until maturity. Now, besides knowing what investments you put in this portfolio, I think there's two big things that you want to remember about this category.

First held to maturity investments will be carried on a company's balance sheet at amortized cost. And if you're not sure what amortized cost is, let me assure you. It's the method everybody had in college, where you advertise discounts and premiums on bonds. As part of the interest adjustment. We're not going to get into those calculations in this far cpa review course.

We're going to save that. For our class later where we go through bonds. So we'll hold off on the actual calculations. But as I say, it is the method everybody has seen before where you amortize discounts and premiums on bonds as part of the interest adjustment, but all invest held to maturity investments will always be carried on a company's balance sheet at amortized cost.

Now, the second point I want to talk about is how do we classify these investments? In other words, with these investments, be classified as a current asset. Or a non-current asset. I always tell my students, you know, you may not think that classification is a big deal, but the FAR CPA Exam thinks it's important.

So how do you classify these investments? Well, I think this will make sense to you. The only way to classify held to maturity investments is by looking at the maturity date. My point is if the debt matures more than 12 months from the balance sheet date, It's a non-current investment. If the investment matures less than 12 months from the balance sheet date, it's a current investment.

The only way to classify these investments is to go by the maturity date. If the debt matures more than 12 months from the balance sheet date, it is a non-current investment, but if the debt matures less than 12 months from the balance sheet date, it's a current investment. Let's go to the second category.

The second portfolio is called trading securities. Now again, first, let's be clear on what investments go in. This category. Trading securities are for investments in equity or debt, securities stocks, or bonds. Make sure that's clear. A lot of students aren't sure about that. Trading securities are for investments in equity or debt, securities, stocks, or bonds that are held for the purpose.

These investments are held for the purpose of selling in the near term. Oh, those are trading securities investments in stocks or bonds that are held for the purpose of selling in the near term. Now I say, besides making sure you're clear about what investments go in this portfolio. I think there's three big things that you have to remember about this portfolio.

Let's start with classification because it's easy trading securities will always be carried on a company's balance sheet. As a current asset, always trading securities always will be carried on a company's balance sheet. As a current asset point. Number two, trading securities will be carried on the company's balance sheet at their fair market value.

This is fair value accounting. What I'm saying is with trading securities, we're going to write them up to fair value or down to fair value. It's fair value accounting because trading securities. It must be carried on the company's balance sheet at fair market value. Now, I think you see what's going to happen.

If I write trading securities up to fair value, I end up with an unrealized holding gain. If I write to it trading securities down to fair value, I end up with an unrealized holding loss and that leads to point number three, any unrealized holding gains or losses, and he unrealized holding gains or loss.

From the trading portfolio belong on the income statement. These gains and losses are included in earnings. That's the third point and he unrealized holding gains or losses from the trading portfolio do belong on the income statement. These gains and losses are included in earnings. That is the third point.

And you have to remember that. Let's go to the third category. And perhaps before I do that, let me make sure you know, why we're calling these gains and losses on realized why am I calling these gains and losses unrealized, gains and losses because we haven't sold anything. These are just gains and losses on paper, but even though they were unrealized gains and losses, they do belong on the income statement because it is the trading portfolio.

Let's go to the third category, the third portfolio it's called available for sale securities. What investments go in this category? Available for sale securities are for investments in equity or debt, securities stocks, or bonds. Be clear on that investments in equity or debt, securities stocks, or bonds that are not categorized as held to maturity or trading.

So you see how this works, any investment that we do not put in the first two categories just automatically falls to the third and it's on the balance sheet available for sale. And if you need cash, you'll get rid of it. That's how this works now, besides knowing what investments go in this category, because you have to know that I think there are three essential things you have to remember about the available for sale portfolio.

Number one, how do you classify these investments? You know, I can't get off that point. Well, this is a little tricky because available for sale securities could be classified as current or noncurrent. And I'll bet you see why? Because if I, I have debt securities in this portfolio, I have to look at the maturity date.

If the debt matures more than 12 months from the balance sheet date, it is a non-current investment. If the debt matures less than 12 months from the balance sheet date, it is a current investment. I think that makes sense. I could have debt securities in this portfolio, and the only way I'm going to classify those kinds of investments is by looking at the maturity date.

If the debt matures more than 12 months from the balance sheet, date and management, it tends to hold onto the investment. It is a non-current investment. If the debt matures less than 12 months from the balance sheet date, it is a current investment. Now, if we have equity securities stocks in this portfolio, we have to look at management's intentions.

What does management intent if management intends to hold onto the investment? Indefinitely. It is a non-current investment. If management intends to sell off the investment in a short period, it is a current investment. What I'm saying to you is there's nothing to prevent a company from having both a current portfolio and a noncurrent portfolio of available for sale securities.

Now, having said all of that, it's probably non-current but there is nothing to prevent a company. From having both a current and non-current portfolio of available for sale securities. And you have to be aware of that. How do you classify these investments? Point number two, the available for sale portfolio will be carried on the company's balance sheet at its aggregate fair market value.

Let me say that again. The available for sale portfolio will be carried on the company's balance sheet at its aggregate. It's aggregate fair market value. So once again, we're going to use fair value accounting and you know, what's coming. If I'm going to write this portfolio up to fair value we'll then we're going to end up with an unrealized holding gain.

If I write this portfolio down to fair value, well, then we end up with an unrealized holding loss and that leads to 0.3. Any unrealized holding gains or losses, any unrealized holding gains or losses from the available for sale portfolio. Do not go to the income statement. These gains and losses do not go to the income statement.

They don't have, they do not belong on the income statement. No, these gains and losses flow directly to stockholders' equity as an item of other comprehensive income on item of O C I. Say that again, any unrealized holding gains or losses gains or losses from the avail for sale portfolio, do not go to the income statement.

These gains and losses do not flow to the income statement. They go directly to the balance sheet directly to stockholders' equity as an item of OCI items of other comprehensive income. It's a critical point. Now another point, and you have to remember this. If a company has an investment in common stock, listen carefully.

If a company has on investment in common stock, that's being accounted for under the equity method, equity investments are carried separately on the company's balance sheet. In other words, equity investments would certainly not be held to maturity because that's dead only. We know that equity investments are investments in common stock equity securities.

So we know. The equity investments, wouldn't be part of Helda maturity, but equity investments. Wouldn't be part of trading securities. Either equity investments are not part of available for sale securities either because equity investments are carried separately on a company's balance sheet. And in this far cpa review course, we're not going to get into equity investments.

We're going to cover the, the equity method in a future class. We'll get to the equity method. We'll have a separate class on that. We'll hold off on that. in this far cpa review course, but I just wanted to mention that to you, that trading securities wouldn't include investments under the equity method available for sale securities would not include investments in common stock.

Being in California, the equity method, equity investments are carried separately on the company's balance sheet. We'll deal with that later, but let's do a problem where we account for trading securities. If you look in your viewers guide, you'll see the problem we get to December 31 year one. And we're looking at our trading portfolio.

Notice I have security, a cost 6,000 with a market price at year end of 8,000. I have security B cost 3000 and an ERN has a market price of 10,000 security, C costs 5,000 and at year end has a market price of 2000. And you'll notice we have equity securities in there. That's securities in there because as you know, trading could be equity or debt securities, but here's the question.

What adjusting entry would we make? At December 31 year one. Well, this is fair value accounting. So we know what to do. We're going to debit investment in a 2000 notice. I'm literally going to write investment in a firm it's cost 6,000 up to its market price at year end 8,000. I'm going to debit investment in a 2000 same thing with B investment in beat cost 3000 when the market price at year end of 10,000.

So I'm going to debit investment in B 7,000. I write it up to fair value. Investment in C ERN cost 5,000 with a market price of 2000. I'm going to credit investment in C 3000. Notice I write up to fair value or I write down to fair value, but now you look at that entry. I simply need a $6,000 credit to balance the entry out.

That is the unrealized holding game. And you might want to write next to that for your notes. I S just remind yourself that even though that's an unrealized gain, just a gain on paper, we haven't sold anything. Even though it's an unrealized gain. It belongs on the income statement for your one because it's the trading portfolio.

Let's go ahead another year. Now let's say it's December 31 year too. We're looking at our trading portfolio. Notice a, B and C are gone. What happened to AB and C? We sold them. That's the nature of trading securities. We're buying and selling them all the time. So we're looking at our trading security at our trading portfolio at December 31 year two.

Now I have security D cost 4,000 with a market price of 10 at year end. So I'm going to debit investment in D 6,000. I'm going to write it up to fair value. E has a cost of 7,000, a market of six at year end. So I'm going to credit investment in E 1000. Security F costs 18,000, but at year end has a market price of 17,000.

So I'm going to credit investment in F a thousand. I write it down to fair value because as you know, this is fair value accounting. We write up to fair value down to fair value, but it is fair value accounting. And once again, the entry doesn't balance, I need a $4,000 credit to balance the entry out that is the unrealized holding gain.

And you right next to that ISS to remind yourself, even though it's an unrealized gain, it belongs on the income statement for year two, because it is the trading portfolio. Let's get into year three. Let's say in year three, they actually go out and they sell investment in F for $12,000. So now we're into year three and they ask to go out and they sell investment in app.

It's an equity security, and they sell it for 12,000. What do you do? Well, if you go out and you sell investment in F for $12,000, you know, you're going to debit cash for what you collected 12,000, but here's my question. Am I going to credit investment in F for 17,000 or 18,000? What am I credit to investment in F 18,017,000?

And it is 17,000 at year end year two. I wrote that investment from 18,000 down to 17,000, it's now carried in the financial statements at 17,000. So if I sell it, I'm going to credit investment in efforts, new carrying value, 17,000. And notice I debit our realized loss of 5,000 a realized loss. And of course the realized loss belongs on the income statement.

Realize gains and losses always go to the income statement. I don't care what portfolio that you're in. What you have to be careful about is how to handle unrealized, gains and losses. Hey, if it's trading portfolio unrealized, gains and losses, still go to the income statement. But again, I want to emphasize to you that realized gains and losses always go to the income statement.

I don't care what portfolio that you're in. Let's go to the available for sale portfolio. You'll notice we get to December 31 year one, we're looking at our availed for sale portfolio and I've got equity securities in there. I've got debt securities in there. And as you know, available for sale could be either equity, debt, securities, and I've got security queue cost 5,000 with a market price at year end of 3000.

I have security our cost 3000, but at year end as a market price of 12,000, I have security S costs. 10,000, but at year end has a market price of 15,000. What adjusting entry would I make at December 31 year one will remember. I use fair value accounting, but I do it in aggregate. I'm going to look at year end at the aggregate cost of the portfolio, which is 18,000.

Compare that to the aggregate market, 30,000. I'm going to debit an account called market adjustment, 12,000. Now that market adjustment account, that is a valuation account for the balance sheet. We'll say more about the balance sheet in a minute, but I'm going to debit market adjustment. Again, that's a balance sheet account market adjustment.

It's a valuation account for the balance sheet and I'm going to debit market adjustment 12,000. What do I credit? Other comprehensive income. Oh, see, I remember any unrealized holding gains or losses, any unrealized holding gains or losses from the avail for sale portfolio, don't go to the income statement.

They flow directly to stockholders' equity as an item of OCI. So notice I credit OCI 12,000. If you look at that entry, this is all having an impact just on the balance sheet. The income statement is not affected. Now, speaking of the balance sheet, I just want you to picture this. If we do our balance sheet at December 31 year one, here's what you'd probably see.

You would see avail probably in non-current assets. We don't really have a lot of information here, but we're doing our balance sheet at December 31 year one, probably in non-current assets. What you'd see is available for sale securities at cost 18,000. Plus the market adjustment account because it's a debit, right?

Plus the market adjustment account 12,000. So the available for sale portfolio was carried on the balance sheet at 30,000 it's aggregate market value. As I keep saying, this is fair value accounting. Let's go ahead. Another year we get to December 31 year two, we're looking at our available for sale portfolio.

We still have Q we still have our, we must've sold off as it happens. And now we have X. So what are we going to do at the end of year two? When we look at the aggregate cost, remember we always do it in aggregate. And if you're not sure why we do avail for sale in aggregate, you'll understand better in a moment, but we look at the aggregate cost 20,000, the aggregate markets now come way down to 16,000.

So think about it. If the agric cost is 20,000, the aggregate market is 16,000. Now markets below costs. Now I need a credit market adjustment account of 4,000. Don't I, because now market's below cost. Now I need a $4,000 credit market adjustment. So if you look at last year at the end of year one, didn't we set up market adjustment with a $12,000 debit balance.

So here's my adjusting fee. At the end of year two, I'm going to credit market adjustment, 16,000. I'm going to credit market adjustment, 16,000. I'm going to bring market adjustment from the $12,000 debit balance last year. To a $4,000 credit balance this year. See what I've just done by crediting market adjustments, 16,000, I just brought market adjustment from the $12,000 debit balance last year to a $4,000 credit balance, which is what I need now.

And what do I debit OCI, any unrealized holding gains or losses from the available for sale portfolio, don't go to the income statement. They flow directly to stockholders' equity. As an item of OCI. So I'm going to debit OCI here, 16,000. And by the way, if we were to do a balance sheet of ERN, what did I, what just happened down in stockholders' equity?

Well, if this is the only item of OCI we have, there could be others, but if this is the only item of OCI they have, then down in stockholders' equity, accumulated OCI just went from a $12,000 credit to a $4,000 deficit. That's what just happened here. It's all taking place on the balance sheet again, if this is the only item of OCI, they have, they go to others.

But if it's the only one they have then down in stockholders' equity, accumulated OCI just went from a $12,000 credit to a $4,000 deficit. That's what's just happened. Let's get into year three. What happens in year three? If we actually go out, we sell investment in X for $8,000. So now we get into year three.

We go out, we actually sell investment in X for $8,000. What are we going to do? Well, if we go out and we sell investment in X for 8,000, you know, we're going to debit cash 8,000. That's the amount we collected, but here's my question. What do I credit to investment in X 12,000 or 11,000? What do I credit to investment in X 12,000 or 11,012,000?

It's original cost. This is why we do avail for sale in aggregate. We didn't do avail for sale security by security. Notice that at year end, when we applied fair value accounting. Well, we wrote the avail for sale portfolio to fair value. We didn't do it security by security. We did it in aggregate, and this is why, because if we actually want, we sell a security to figure out the realized gain or loss, we go back to the original cost of the security.

So I'm going to credit investment in X for its original cost 12,000. And I'm going to debit a realized loss of 4,000. And as we said before, realize gains and losses belong on the income statement. Always. I don't care what portfolio that you're in realized gains and losses always go to the income statement.

As you can see, what you have to be careful about is how to handle unrealized, gains and losses. But that's why you do avail for sale. In aggregate trading, we do security by security, right trading. We do security by security, but avail for sale. We do an aggregate. Now you see why. Because if we actually go out and we sell a security to figure out the realized gain or loss that does go to the income statement, we have to go back to the original cost of the security.

Now, another thing I want to mention, if the FAR CPA Exam were to mention a permanent decline in market, they might mention this. If the FAR CPA Exam mentions a permanent decline in market, I want you to remember that the only time you care about a permanent decline in market, And let me say a permanent decline is something severe.

You know, we know every day the stock market goes up. The stock market goes down. We know that that's not what we're dealing with here. Hey, every day it goes up, it goes down. It's not, we're talking about a permanent decline in market is something unusual. Like Enron, it's a company going bankrupt. Now listen carefully.

You only worry about a permanent decline in market in held to maturity securities. Or avail for sales security. It's not an issue with trading. You don't care about it in trading, but again, you'd only worry about a permanent decline in market. If you're dealing with held to maturity, securities or Trey, or, or avail for sales securities, it's not an issue in trading.

Only worry about a permanent decline. If it's held to maturity or avail for sale. Now listen carefully. If the FAR CPA Exam sets there has been a permanent decline in market, you know, companies going bankrupt like Enron. You're going to debit a realized loss. It is considered realized you're going to debit or realized law.

And that's the income statement, and you're going to credit investment in Enron. You're going to write it off that's so they mentioned it. That's how you handle a w a permanent client market. Take a realize loss, debit, a realized loss for the income statement. It is considered realized and credit investment in Enron.

You're just going to write that investment off. In our next class, we'll do a problem on trading and available for sale. So I'll see you in the next class.

Welcome back in this far cpa review course. We're going to continue our discussion on how to account for a company's investments. And you know, in our last class, We spoke about how to account for held to maturity, securities trading securities, available for sale securities. Let's do a couple of problems in that area.

Number one says the following information pertains to smoke companies, investments in marketable equity, securities classified as available for sale. So these are all available for sale securities. On December 30, one of the current year smoke has a security with a $70,000 cost and a $50,000 fair value.

At year end, no market adjustment account currently exists. A marketable equity security costing 50,000 has a $60,000 fair value. December 30, one of the current year smoke believes that the recovery from an earlier lower fair value is permanent. And I don't think that would throw you off. We do care. If a decline in market is permanent, how can a recovery be permanent?

It really doesn't make a lot of sense. Does it? How could you say our recovery is permanent? You mean that investment could never go down again for the rest of eternity? That doesn't, that's really nonsense again, you would have to worry. As we said in our last class, if a decline in market is permanent, a company going bankrupt, like Enron.

That's a, that is something you'd have to worry about, but saying a recovery is permanent is really nonsensical. So we're not worried about that. What is the net effect of the above two items on the balances of smokes market adjustment account for available for sale securities at December 31 of the current year?

Well, as you know, when they got to year end, they use fair value accounting with avail for sale, but they don't adjust. Available for sale securities security by security. They do it in an aggregate. So let's think about this. They have the first security costs, 70,000 with a market of 50,000. The second security costs 50,000 with a market of 60,000.

So what is the aggregate cost? Of the available for sale securities, plus 50, 120,000. What is the aggregate market at year end 60 plus 50, 110,000. So here's the point because the aggregate cost is 120,000. The aggregate markets, 110,000. What's the adjusting entry that we make at year end. We're going to debit OCI 10,000 and we're going to credit market adjustment 10,000.

So the answer is D. What this creates is a $10,000 credit balance in market adjustment. Cause that's the adjusting entry. We would make it your rent. We would debit OCI 10,000 and we would credit market adjustment, 10,000. Let's do a set. Let's do two and three. It says sun had investments in equity, securities classified as trading costing 650,000.

On June 30th of year, two son decided to hold the investment indefinitely and reclassified the investment from trading to avail for sale. On that date, the investment fair value was 575,000 December 31 year one at June 30th, year two. It was 530,004 to 90,000, December 31 year two. So we know the market prices, the micro price of the investment was 575,000, December 31 year one, 490,000, December 31 year two.

And on the day they transferred the investments available for sale. June 30th market price was 530,000. Now let's go through this together. What would have, first of all, what would have happened at the end of year one? Just back up a little bit here. When they got the December 31 year one, remember it was classified as trading.

And trading is accounted for at fair value. And we adjust trading security by security. Remember we do trading security by security. So let's just think it through when they got to December 31 year one, the cost of the trading securities was 650,000. The market price, December 31 year one was 575,000. So what adjusting entry did they make?

Didn't they debit an unrealized holding loss 75,000 and credit. The investment 75,000. In other words, at the end of year one, they would have literally written the trading securities from the cost 650,000 down to the market price, 575,000. They would have debited and unrealized holding loss 75,000. And that loss would have gone to the income statement because it's trading and they would have credited the investment 75,000.

So they would have literally written these investments down to the market price, December 31 year one, 575,000. So they've written it down, down to market price, 575,000. Now what happens June 30th, year two, they transfer this investment from trading to avail for sale. When the micro price is 530,000. And that's why I wanted to get into this Rob with you.

How do we handle transferring investments from one portfolio to another? Well, what you're dealing with here is a rule. It's not a difficult rule. But it's a rule you have to be aware of. Listen carefully. When you transfer an investment from one portfolio to another, I don't care what port portfolios are involved.

Anytime you transfer on investment from one portfolio to another on the day of the transfer on the day of the transfer, right? That individual security to its fair market value. That's the rule on the day of the transfer. You always write that individual security to its fair market value because the effect they want, they always want a security to enter its new portfolio at fair value.

That is the effect that they want. They always want the security to go into its new portfolio at fair value. So let's, let's just apply the rule when they got to June 30th, year two. The securities in the portfolio now at 575,000, but it was written to 575,000, but on the day of the transfer, the market price, June 30th was 530,000.

So what would they, what would they have done? They would have debited and unrealized holding loss 45,000. See their job would have been to bring that security from the carrying value, 575,000 down to its fair value on the day of the transfer 530,000. So they would have debited on unrealized holding loss.

45,000 credit, the investment 45,000. That way the investment goes into its new portfolio at its fair value, 530,000. So now we can answer question number two. What amount of loss from investments would some report and it's year two income statement what's on the year. Two income statement would be that 45,000 answer.

A and how do I know what's on the income statement because trading's involved. Make sure it's clear in your notes that that's the adjusting entry I would make. If I'm transferring to, or from trading, anytime trading is involved. That's the entry I'd make. I would debit an unrealized holding loss 45,000 credit, the investment 45,000, that loss would go to the income statement.

That's why it's answer a, because trading's involved. That is the entry I would make. If I'm going to, or from trading. I just want to show you every possibility. What if I'm going. What if I'm going from avail for sale to held to maturity on same problem. What if instead we were going from available for sale to held to maturity or held to maturity to available for sale?

Well, if trading's not involved, the rule is the same. The rule doesn't change. I have to write the individual security to what's fair market value because they always want a security to go to its new portfolio at fair value. So notice I would still credit. I would still credit the investment 45,000. I have to write the security to its fair value.

I still have to write the security from 575,000 down to 530,000. So notice I would still credit the investment 45,000, but now I would debit OCI. So if trading's not involved, the rule is the same, but if I go held to maturity to available for sale or available for sale to held the maturity, I credit the investment for 45,000, but now I would debit OCI.

Now that unrealized loss, wouldn't go to the income statement because trading's not involved, but here trading is involved and that's why the answer is a, and that's the main reason I wanted to do this problem with you to talk about how you transfer investments from one portfolio to another. All right, now let's get to December 31 year to what happens at December 31 year two.

Well now, It's in the available for sale portfolio. And I do avail for sale in aggregate, of course. So when I got to the December 31 year two, I would look at the aggregate cost of the available for sale securities, which would be now 530,000. What's its aggregate market at year end 490,000. So what would I do?

I would debit OCI 40,000 and credit market adjustment 40,000. Doesn't that make sense? Because when I get to December 31 year two, Now it's in available for sale, which I do in aggregate. So I would look at the aggregate cost of my available for sale portfolio, which is the 530,000, but aggregate market at December 31, year two is 490,000.

So I would debit OCI 40,000 because now it's available for sale credit market adjustment 40,000. So now we can answer question number three. What amount would some report as unrealized loss from these investments in equity securities in OCI? At the end of year to answer a again, 40,000. Now we're going to continue our discussion of how to account for companies investments, by getting into derivatives and hedging activities.

Let me give you a couple of definitions, because mostly what this area is about is definitions. What is a derivative? A derivative is an investment. That derives its value. This is where the word comes from derivative because the investment derives its value from another security or another commodity.

It's an investment that derives its value from another security or another commodity. For example, if you invest in foreign currency options, well, that is a derivative investment because the total value of that investment is derived from whether the Euro. Got more expensive today or cheaper today. If you invest in grain futures, that is a derivative investment because the total value that investment is derived from whether the price of wheat went up or down today.

These are derivative investments. Now something I want to mention because this drives students crazy. Don't forget a derivative investment can be an asset or a liability. Now why? Because with the derivative investment, if I'm in a gain position, clearly I'm in an asset position. But with the derivative investment, if I'm in a loss position and it's big enough, It could be a liability position.

So keep that in mind, derivative investments can be assets or liabilities because again, with a derivative investment, if I'm in a gain position, clearly I'm in an asset position. But at then if I'm in a lie, if I'm in a loss position and it's big enough could be a liability position, it is possible. Now what's hedging.

Hedging is a strategy. Hedging is a strategy where a company invests in a derivative for the purpose of counter balancing a potential loss somewhere else. They're trying to counterbalance a potential loss in another security or another transaction. That's what hedging is. You've heard the phrase hedging your bets.

That's what hedging is. It's a strategy where a company invests in a derivative for the purpose. It's for the purpose of counter balancing. A potential loss in another security or another transaction. In other words, you're hoping you make enough profit on this investment that will counterbalance a loss that you could incur somewhere else.

You're hedging your bets. Now let's get to the most important part of this. How do we account for derivatives and hedging activities? Now I'm going to start with how we account. For a derivative, that's not being used as a hedge. So we're going to start with how we account for derivative. That's not being used as a hedge.

It's really very simple. If a company has a derivative investment that is not being used as a hedge, then that derivative will be on the company's balance sheet as either an asset or liability. It'll be on the company's balance sheet. As either an asset or liability and it's accounted for at fair market value.

It's fair value accounting. So if a company has a derivative investment, that is not being used as a hedge, it's not being used as a hedge. It's a non-hedge derivative. It's going to be on the company's balance sheet as either an asset or liability. It's a distinct asset or liability, and it's a pounded for at fair market value.

So, you know, what's coming. If I'm going to write a non-hedge derivative up to fair value we'll then I would have an unrealized holding gain. If I'm going to write a non-hedge derivative down to fair value. Well, then I'm going to have an unrealized holding loss and you have to remember, and he unrealized holding gains or losses, any unrealized holding gains or losses from a non-hedge derivative belong on the income statement.

These gains and losses are included in earnings. Now let's talk about. How you account for derivative that is being used as a hedge. Now listen carefully. How you account for derivative that is being used as a hedge. Depends on what kind of hedge that it is. There are two broad types of hedges. Here we go.

The first type of hedge is called a fair value. Hedge, a fair value hedge. Is a hedge against potential losses from the change in the fair market value of something. Again, a fair value hedge is a hedge against potential losses. That's what they all are. It's a hedge against potential losses from the change in the fair market value of an asset or liability you're hedging against potential losses from the change in the fair market value of an asset or liability.

Now, once you know what a fair value hedge is, how do you account for it? Well, a fair value hedge. Will be on the company's balance sheet as either an asset or liability. And yes, it is accounted for at fair market value. So once again, what's being required here is fair value accounting. So again, a fair value hedge will be on the company's balance sheet as either an asset or liability.

And yes, it is accounted for at fair value. So, you know, what's coming up. If I'm going to use fair value accounting, I'm going to have unrealized holding gains and losses. And let me say it, and he unrealized holding gains or losses from a fair value, hedge belong on the income statement. These gains and losses are included in earnings.

And if you're really listening to me and I know you are. What you've noticed is that a fair value hedge is accounted for exactly the same way we account for derivative. That's not being used as a hedge. It's identical. You're going to account for fair value, hedge. Exactly the same way you account for derivative.

That's not being used as a hedge at all. Now let's talk about a cash flow hedge. Now, what is a cash flow hedge? A cash flow hedge is a hedge against potential losses. It is a hedge against potential losses. From the future cash flows from an asset or liability. Again, a cash flow hedge is a hedge against potential losses from the future cash flows from an asset or a liability.

That's a cash flow hedge. Now, once again, once you know what it is, how do we account for it? Well, a cash flow hedge will be on the company's balance sheet. As either an asset or liability and yes, a cash flow hedge is accounted for at fair market value. So we need to say that a cashflow hedge will be on the company's balance sheet as either an asset or liability.

It is accounted for at fair value. So once again, what is required here is fair value accounting. So you know what we have to deal with on realized holding gains and losses. Now listen carefully. How you account for the unrealized holding gains and losses from a cash flow hedge depends on whether the hedge is effective or not.

I'll say it again. This is really the only tricky part of this, because how do we count how we account for the unrealized holding gains and losses from a cash flow? Hedge depends on whether the hedge is effective or not. Now if you have an effective cash flow hedge. And I think, you know what that means.

What is an effective cash flow hedge? I'm making a profit from this investment that is counterbalance, counterbalancing and loss somewhere else. That's an effective cash flow hedge. I have an effective cash flow hedge. If I'm making a profit on this investment that is counterbalancing a loss somewhere else.

If you have an effective cash flow hedge, that game does not go to the income statement. That gain goes directly to stockholders equity as an item of other comprehensive income. It's an item of OCI. If you have an effective cash flow hedge, that game does not go to the income statement. That game goes directly to stockholders equity as an item of OCI.

Now, what if it's ineffective? How could a cash flow hedge be ineffective? What if it drops in value? What, if you take a bath on this investment, who said it had to be effective? If you have an ineffective cash flow, hedge, that if it drops in value, that loss goes directly to the income statement. If you have an ineffective cash flow hedge, that loss would go directly to the income statement.

Now let's do a couple of entries. I want to illustrate what we've just said. Let's say a company has an investment in a. All right. And let's say it is a cash flow hedge. So a company has an investment in egg. It is a cash flow hedge, and let's say it is effective. Well, if investment in EY is a cash flow hedge, and it is effective.

Is it rising or falling in value? It's rising. So you're going to debit investment in a, you're going to write it up to fair value. And what are your credit OCI? Makes sense. It's an effective cash flow hedge. It's rising in value. So you're going to debit investment in a, you're going to write it up to fair value and you're going to credit OCI.

Now here's, what's a little tricky when the loss that you were hedging against finally gets on the income statement again, when the loss that you were trying to counterbalance, when the loss that you were hedging against finally does get on the income statement. That could be two years from now. Then you would debit OCI.

Take that gain out of stockholders' equity and credit gain on derivatives, you credit an income statement, account gain on derivatives because the effect they're trying to have here is that on your income statement, you're going to show the loss and how you counter balanced it. That's what we're trying to do here.

So again, later when the loss that you were hedging against finally gets on the income statement. And as I say, that could be three years from now, then you'll debit, OCI. Take that gain out of stockholders' equity and credit gain on derivatives. That way on your income statement, you can show the loss and how you counterbalanced it.

Now let's say the company also has an investment in B. It is also a cash flow hedge, but let's say it's ineffective. If a company also has an investment in B to cash flow, hedge, it's ineffective, it's dropping in value. You would simply debit loss on investments loss on derivatives. Take it to take the loss right to the income statement and credit investment in B.

Write it down to fair value. If you have an ineffective cash flow hedge, that loss goes directly to the income statement and you write the security down to fair value. Now, also in the area of derivatives and hedging activities, you get into the foreign currency. Derivatives. So you'll want to watch out for these.

If the FAR CPA Exam mentions a foreign currency, denominated from commitment, hedge, again, you gotta be careful. If the FAR CPA Exam were to mention a foreign currency denominated. In other words, it's the nominated, it's the nominated in a foreign currency. If the FAR CPA Exam mentioned is a foreign currency, denominated firm commitment, hedge, or a.

Foreign currency denominated available for sale securities Hetch. So either one of those, either a foreign currency, denominated from commitment, hedge, or a foreign currency denominated available for sale securities hedge. Those you treat those as fair value hedges. Just remember they are fair value hedges.

So just go right back to my notes on fair value hedges. We don't, we won't go through them again, but though, just so you know what, they are a foreign currency, denominated from commitment, hedge, or a foreign currency, denominated avail for sale securities hedge. Either one of those, those are, those are fair value hedges, just account for them as fair value hedges.

Now, if on the other hand they mentioned a foreign currency, denominated forecasted transaction hedge. I think you'd get it anyway. Because now you're talking about cash. If they mentioned they foreign currency, denominated, forecasted transaction, hedge, or foreign currency, denominated net investment in foreign operations hedge.

Again, I think you'd get, it sounds like cash, either a foreign currency, denominated forecasted transaction hedge, or a foreign currency, denominated net investment in foreign operations hedge. Those were cash flow hedges. So you just go right back to my notes on cash flow hedges, because those are treated of course, as cash flow hedges, because they are cash flow hedges.

So make sure you go over these definitions and how to account for derivatives and hedging activities. And I will look to see you in the next class. Keep studying.

Welcome back in this far cpa review course. The first thing I want to get into is research and development costs. Let me give you the bottom line. The bottom line is this any item that is defined as a research and development cost, and we'll go over some definitions in a moment, but any item that is defined as a research and development costs.

Must be expensed as incurred. In other words, companies are not allowed to capitalize R and D costs. Companies are not allowed to defer R and D costs. And as I say, that's the bottom line. Any item that is defined as a research and development costs must be expensed. As incurred companies are not allowed to defer R and D costs.

Companies are not allowed to capitalize R and D costs. Let's go over some definitions and I do this because you'll see when you do your homework, sometimes in some multiple choice, it's important to know exactly what research is exactly what development is. So let's go over a couple of definitions.

Research is a critical investigation aimed at the discovery of a new product or a new process, or even the improvement of an old product. Or an old process. Now I'll go over that again, but notice how broad it is. It's very broad research. It's a critical investigation aimed at the discovery of a new product.

That's the discovery of a new product or a new process, or even the improvement of an old product or an old process. As I say, it's very broad now what's development development. Is taking that research, taking new knowledge and then translating it into a plan or a design or a prototype. That's the development phase where you take new knowledge, you take the research and you translate it into a plan or a design or a prototype.

Now you can see already that. This is not a difficult area. You know, any item that is defined as a research and development cost. And now, you know, the definitions, those costs must be expensed as they're incurred. Now, it is a very easy area, but a couple of things can bother you. You're going to see when you do your homework, that a very common way for the FAR CPA Exam to test.

This is in a multiple choice. You know, they'll give you a list of costs. And they want you to pick out the research and development costs from a list and what they'll put in a list of costs. Sometimes it's something like this they'll put in setup costs, preparing for actual production. Again, what you might see in a list of costs would be set up costs, preparing for actual production.

Is that research and development? No, and I'm leading to a point. Just remember this basic point. Once the company is doing anything related to the actual production of the unit, once the company is doing anything related to the actual production of the item, even setting up, preparing for the actual production of the item by definition, they are no longer in research and development for that item.

In other words, that's the cutoff point. And I just think in an exam, just good to know that that's where research development cuts off. You know, once you're doing anything related to the actual production of the item, you know, even setting up, preparing to actually start producing the item by definition, you are no longer in research and development for that item.

Like I say, it's kind of good to know for, in an exam where it all cuts off right there. Now one more point, be careful of any research and development costs. That has quote, alternative future uses watch out for any, any research and development costs that has alternative future uses. I'll give you an example.

Here's the classic case. Let's say a company buy, let's say a company constructs, a laboratory building for research and development. That's the classic case, a company constructs, a laboratory building for research and development. Now I think we can agree that something like a laboratory building. Is probably not going to be all consumed in the current R and D project.

Something like a laboratory building probably has alternative future uses. So here's the point, even though the lab was built for research and development, the lab will get capitalized and only the depreciation expense on the lab would be part of your R and D expense for that year. Again. The lab probably has alternative future uses.

So even though the lab was built for research and development, the lab does get capitalized. And as I say, only the depreciation expense on the lab would be part of your R and D expense for the year, by the way, same thing with machinery, same thing with equipment. Those are normally the items you got to be careful about.

Watch out for laboratory buildings, machinery equipment. Normally these items have alternative future uses and when they do, they do get capitalized. And then as I say, only the depreciation expense on those items would be part of your R and D expense for the year. Let's talk about intangible assets. Now, you know that when we talk about intangible assets, we're talking about copyrights, patents, trademarks.

Goodwill as an intangible, a leasehold improvement is an intangible. A franchise is an intangible secret formulas. Aren't intangible. These are your basic intangible assets. Copyrights patents, trademark Goodwill is an intangible lease hold improvement. A franchise is an intangible secret formulas.

Aren't intangible. These are your basic intangible assets. And with intangibles, there's a couple of things. the FAR CPA Exam likes to get into first. What they love to ask you is this, what costs do we capitalize? You know, for a copyright, a patent, a trademark, I'm trying to make my notes broad here. Well, if they ask you.

What costs we capitalize for a copyright, a patent, a trademark watch out for three things. Number one, you capitalize purchase price. You do capitalize purchase price. So in other words, if I purchase your copyright for $8 million, I capitalize the 8 million. You do capitalize purchase price. If I purchase your.

Trademark for a hundred million dollars. I capitalize the a hundred million. So you do capitalize purchase price. Also, number two, you capitalize legal and other fees. That's legal and other fees to register a copyright, a patent, a trademark, whatever it is. So that's number two, you capitalize legal and other fees to register a copyright, a patent or trademark, whatever it is.

And then don't forget number three, cause they love it. You also capitalize. Legal fees in successful defense of a copyright, a patent, a trademark, whatever it is. So that's number three, you do capitalize legal fees in successful defense of a copyright, a patent, whatever it is. I've got to ask. What if the defense is unsuccessful?

Because they've asked if the defense is unsuccessful. Of course you just expense the legal fees, but also you'd write off the patent. Right. Yeah. You're going to expense the legal fees, but you'd also write off the patent because you no longer have legal rights to it. All right. Now, stay with me on the other hand.

Now there's only one thing you capitalize for Goodwill. Don't mess this up now. There's only one thing you capitalize for Goodwill. Goodwill is what a company is willing to pay over fair market value. To acquire another company is net assets. That's what Goodwill represents. Again, only one thing gets taken to a Goodwill account, and that is what a company is willing to pay over fair market value, not over book value.

Be careful not over book value over fair market value to acquire another company's net assets. That's the only thing you capitalize for Goodwill. Now be careful, the FAR CPA Exam is going to throw a lot of junk at you here. the FAR CPA Exam is going to say a company incurs costs to develop the Goodwill in the community, maintain their Goodwill in the community, restore their Goodwill in the community, enhance their Goodwill in the community, throw all those kinds of things at you.

Company and curse costs to develop Goodwill, maintain Goodwill, restore, Goodwill, enhance Goodwill, and with costs like that, they were expensed as incurred, not going to fall for any of that junk. All those costs to develop Goodwill, maintain Goodwill, restore, Goodwill, enhance Goodwill, that all those costs are expenses incurred, because I say again, there's only one thing you capitalize to a Goodwill account, and that is again, what a company is willing to pay over fair market value to acquire another company's net assets.

That's the only thing that you capitalize for Goodwill. Now, you know, when we talk about intangibles, Inevitably, we have to talk about amortization. And when you talk about amortizing and tangibles, you've got to be careful. There are basically two broad categories of intangibles. Here we go. The first category would be intangibles with a finite use life again, category number one, there are intangibles with a finite useful life will be an example.

Copyright. A patent. I mean, there are intangibles with a finite useful life, a copyright, a patent, a leasehold improvement. Here's the point. If a company has an intangible with a finite useful life, they must amortize that intangible over their best estimate of its useful life. You must amortize that intangible over your best estimate of its useful life.

Now listen to come up with your best estimate of its useful life. You have to consider legal requirements, regulatory requirements, contractual requirements, business needs. But again, if you have an intangible with a finite use for life, a copyright, a lease hold improvement patent. Yeah, the requirement is that you amortize that intangible over your best estimate of its useful life.

And as I say to come up with your best estimate of its useful life, you'll have to consider legal requirements, regulatory requirements, contractual requirements, business needs, but you must amortize that intangible over your best estimate of its useful life. Now there's a second category. You know what it is?

The second category. There are intangibles. With an indefinite useful life category. Number two, there are intangibles with an indefinite useful life. What's the big one. You know, Goodwill, Goodwill is an intangible with an indefinite useful life trademarks. In most cases, a trademark is an intangible with an indefinite useful life.

And here's the point. If a company has an intangible with an indefinite useful life, it's not amortized. It's not advertised. It's tested for impairment at least annually. So I'll say it again. If a company has an intangible with an indefinite useful life, it's not amortized. It's not amortized. It's tested for impairment at least annually.

And I'll give you the basic test. The basic test for impairment is, you know, at year end, if the carrying value on the books for that, you know, Goodwill for that intangible, if the carrying value on the books is greater than its fair value, it's impaired. That's the basic test. If the carrying value on the books for that Goodwill, you know, for the intangible that has an indefinite use of life.

If at year end, the carrying value on the books is greater than its fair value it's impaired. So what do you do? You'd debit a loss. You would take a loss to the income statement and credit Goodwill. You'd write Goodwill down to fair value, but if you have an intangible with an indefinite useful for life, it's not advertised, it's tested for impairment, at least annually.

Let's go to question number one. It says during the year J company incurred research and development costs of 136,000 in its laboratories. And it led to a patent related to a patent that was granted July one cost of registering the patent total 34,000. Let's stop right there. What are we going to capitalize for this patent?

Now, you know, we're going to pick up the 34,000, the legal and other fees to register the patent. That 34,000, that's going to be capitalized to the patent account. How about the 136,000 of research and development costs that led directly to this patent capitalize or expense expense R and D costs are expensed as incurred.

So don't fall for that. It doesn't matter that they said that the R and D costs led directly to this patent R and D costs are expensed as incurred. So let's a great that what we're going to capitalize for this patent is the 34,000. The legal and other costs and fees to register the patent. Now, can we agree that a patent is an intangible with a finite useful life?

It's a category it goes into. So if it's, if it's an intangible with a finite useful life, we must amortize that intangible over our best estimate of its useful life. Now what's our best estimate. Well, the patents legal life is 20 years. The economic life is 10. What's your best bet there. The legal life, 24 economic life, 10, 10, the period of economic benefit.

You know, it doesn't matter. The legal life is longer. We want to amortize it over the period. The company is going to receive economic benefits. So use the 10 years. So we're going to take the 34,000 that we capitalize for the patent divided by 10 straight line years. It's just straight line. That's 3,400 of amortization for a full year, but I don't want a full year.

It was granted on July one. We're going to take a half years amortization or 1700. So when they ask us at the bottom in the December 31 balance sheet, at what amount would Jay report as the patent net of accumulated amortization, what will be the patent? 34,000 minus the accumulated amortization would just be the 1700 answer a number two on January one, Jan bond purchased equipment for use in developing a new product.

Jan Bon uses the straight line depreciation method. The equipment can provide benefits over a 10 year period. However, the new product development is expected to take five. She understand the basic facts here. There's a piece of equipment it's going to be used in research and development. The R and D project is going to go for five years, but the equipment has useful life of 10.

So they ask at the bottom, what would be the expense for the year? You know, it's going to come down to B or C. If you think you should expense that equipment over the life of the project, it would be answered B spends one fifth every year. If you've got to use the life of the equipment, which is 10 years, you're going to expense one 10th every year.

Would it be B or C here? Neither. Cause they went on to say. The, the equipment can be used only for this project. You might want to underline that they said the equipment can be used only for this project. Think about it. If the equipment can be used only for this project, there are no alternative future uses.

Are there. If the equipment can be used only for this project, watch out. That means there are no alternative future uses. And if there are no alternative future uses, the answer is a. You'd expense a hundred percent. You're one like any other R and D costs. Remember that the only exception to that is alternative future uses.

So if they say the equipment can only be used for this project, they're auto alternative future uses. And again, if there are no alternative, future uses you expense a hundred percent year one like any other R and D costs. And the answer is a let's stay on this for a second. What if they said the equipment does have alternative future uses?

What if they said that. Same question. They said, by the way, the equipment does have alternative future uses. Would it be B or C? It would be answers C because you're going to use the equipment for its whole ten-year life beyond the five-year project. Right? It doesn't have alternative future uses the answer would be C because you're going to use that equipment for its whole 10 year life beyond the five-year project.

But again, here, the equipment can only be used for this project. There are no alternative future uses. So we expense a hundred percent year one like any other R and D costs. And the answer is a don't fall behind. Keep up with your work and I'll look to see you in the next class keeps studying.

Welcome back in this far cpa review course. I want to talk about when you set up a liability. For contingencies, as you know, a contingent loss is a loss that might happen. It's a loss that could happen depending on the outcome of some event. In other words, contingent upon the outcome of some event. And of course the classic example of a contingency is a lawsuit.

That's the classic case. Let's say we're a corporation we're being sued for a billion dollars. Do we have a loss? It depends. If we win in court, we don't have a loss. If we lose in court, we do have a loss. Isn't that a loss that's dependent. It's contingent upon the outcome of the lawsuit. Now I'm not saying that a lawsuit is the only possible contingency, but a lawsuit.

Great example of a contingency. Now what you have to remember for the FAR CPA Exam. Is that there are three categories of contingencies. Let's go over them. There's three categories. And the key to the FAR CPA Exam when you're doing the question is to nail down what category you're in category category. Number one, there are probable contingencies.

What does that mean? It is highly likely the company is going to incur a loss. It's if it's a lawsuit, it's highly likely. That the company is going to, we're going to, is going to lose that lawsuit. It's highly likely the company is going to lose that lawsuit and incur loss. So there are probable contingencies category.

Number two, there are reasonably possible contingencies. It's not highly likely the company is going to incur a loss, but it is possible. It's reasonably possible. The company could incur a loss. And then finally, category number three, there are remote contingencies, meaning it's highly unlikely. The company is going to incur a loss.

If it's a lawsuit, it's probably a frivolous suit. There's a lot of those now. All right, let's go over the criteria. You must accrue a contingent loss. Contingent losses must be accrued. If it needs two tests, task, number one, the loss must be probable notice. Only probable contingencies. Get accrued. Not reasonably possible, not remote, only probable contingencies get, get accrued so that, so that's test number one, the loss must be probable.

And this began there. You can reasonably estimate the amount of the loss. So when the loss is probable and you can reasonably estimate the amount of the loss, you must accrue the loss. Now, as you can see, this is not a really difficult area, but to show you how the FAR CPA Exam could play with it a little bit, let's go over some cases.

All these cases are going to be based on a lawsuit. You know, we're a corporation we're being sued for a million dollars. Let's look at case number one, let's say we're a corporation, there's a lawsuit we're being sued for a million dollars. A lawyer says we're probably going to lose the case. That's the opinion of counsel.

So we know the category, as I said, the whole key to the FAR CPA Exam on this is nailed down what category you're in. So our lawyer thinks we're probably going to lose the case. So this is a probable contingency and notice. Our lawyer thinks that we're going to S we're going to settle for $800,000, even though we're being sued for a million, our lawyer estimates that we're going to settle the case for 800,000.

So what do you think, would we accrue something here? Would they be a journal entry? Yes, let's go over that. You know, me, I don't like to get too far from entries. What's the entry because our lawyer thinks we're probably going to lose the case because this loss is probable and we can reasonably estimate the amount.

We're going to debit lawsuit loss 800,000 notice we're throwing a loss for our income statement, 800,000. What do we credit on accrued liability for our balance sheet of 800,000? So that's how you handle it. It's probably, you can reasonably estimate the amount you accrue a loss for your income statement.

You accrue a liability for your balance sheet, but we're not done. Be careful. Also you have to have a footnote, and this is a case where they care about footnotes. The company's also going to have to have a footnote that says what the 800,000 is only an estimate and could go as high as a million. So you're going to have to have a footnote that discloses the company is still exposed to more loss.

So you have to have a footnote that says the 800,000 is only an estimate and could go as high as a million. Let's do another case case two. Once again, we're being sued for a million dollars. A lawyer thinks we're probably going to lose the case. That's the opinion of counsel. So that. So we nail it down.

We know this is a probable contingency, but now our lawyer is saying that there's no reasonable way to estimate the amount of the settlement. All right. So what do we do with case two? Would you book an entry? No, there'd be no entry here. Why because it fails the second prong. Remember it is a two-prong test.

The loss must be probable and you can reasonably estimate the amount because this fails the second prompt, we have no reasonable amount of the settlement. We have no reasonable estimate, no reasonable estimate of the settlement of the loss. There'd be no journal entry here. We wouldn't book anything case two would only be a footnote.

Let's go to case three. Once again, we're being sued for a million dollars. Our lawyer thinks we're probably gonna lose the case. So that nails down the category, this is a probable contingency, but now our lawyer says that we're going to settle between. We're going to settle for between 200,000 and 700,000.

They give us a range of settlement. That's how you right now, the FAR CPA Exam loves the Rangers. So our lawyer, thanks. We're gonna lose the case. It's probable that we are going to lose the case and we're going to settle for between 200,000 and 700,000. What do you think in case three? Do we accrue a loss? Yes.

The 200,000. When you're given a range of settlement accrue the minimum, that's the rule of thumb. If you, if your lawyer gives you a range of settlement, you accrue the minimum. So we're going to debit. Lawsuit loss 200,000. That goes to our income statement. We accrue a loss for our income statement. We're going to credit an accrued liability for our balance sheet 200,000, but you know, we're not done.

There's going to have to be a footnote. A footnote that says the 200,000 is only an estimate and could go as high as a million, not 700,000 a million. What the footnotes all about is disclosing maximum exposure. You don't, you wouldn't say up to seven, it could go high as high as 700,000. That's just an estimate.

That's a lawyer's opinion. Now what the footnotes all about is maximum exposure. So you're going to say in your footnote that the 200,000 it's just an estimate and could go as high as a million. The whole point is to footnote, to disclose to shareholders, investors, creditors, other interested parties, that the company is still exposed to more loss.

Now that one, my body, you might say well, but Bob, what about conservatism? Why wouldn't we accrue the maximum, I think why the reason they didn't go that way is because, you know, re of what lawyers alike you know, in practice, what the lower limit tends to be is compensatory damages. The upper limit tends to be punitive.

And those punitive damages to are very speculative. You know, you know, they ask for everything under the sun. So I think that was the feeling that if your lawyer gives you a range like this, they're admitting. That they don't expect the loss to be less than 200,000. So let's accrue that now and footnote, it could go higher.

Like I say, those punitive damages are very speculative. So if you've given a range, accrue the minimum and footnote, it could go higher. I think it's, it makes a lot of sense case for once again, we're being sued for a million, a lawyer thinks we're probably going to lose the case. So we know it's a probable contingency.

Again, we have a range. Our lawyer thinks we're going to settle for between 200,000 and 700,000, but. Their best estimate in that range is 425,000. In case forward, you accrue a loss. Yes, four 25. Just to make the point. If the FAR CPA Exam gives you a reasonable estimate within the range, you have to use it. So I'm going to debit lawsuit loss 425,000 credit.

An accrued liability for 425,000. Again, the whole point is I accrue a loss from my income statement. I accrue liability for my balance sheet, but you know, I'm not done. There's going to have to be a footnote that says the 425,000 is only an estimate, but could go as high as a million. You have to footnote that you're still exposed to more loss case five.

Once again, we're being sued for a million dollars, but now our lawyer says. That the chance we'll lose this case is not probable it's reasonably possible that we'll lose the case and settle for 400,000 in case five, would we accrue a loss? No only probable contingencies get accrued replace. Remember that only probable contingencies get accrued case five.

They'd be no entry footnote only if the chance of a loss is only reasonably possible. That would only be a footnote case six. Again, we're being sued for a million dollars. Now our lawyer says the chance we'll lose this case is not probable. It's not reasonably possible. It's remote, which means highly unlikely.

As I say, it's probably a frivolous suit. A lot of those now, you know that I don't know if you've heard. I, I collect these. Did you see the case where. Somebody got, they were riding their bicycle and they got hurt. And the lawyer sued the bicycle company wanted zillions in damages. And the, the basis of the suit was that the lawyer argued.

They should have been a warning label on the bicycle that when the bicycle goes downhill, it goes faster. Lawyer felt they should have been that warning label. Be careful when this bicycle goes downhill, it goes faster. I think it was thrown out, but that's, that's what you're dealing with. So here, the chance of a loss is remote.

You know, there's no journal entry. If the chance of a loss is remote, you're not going to book anything. We know that only probable contingencies get accrued. Now the question is. Would you footnote this and no, no. Generally speaking, if the chance of a loss is remote, it's not even a footnote, but they did mention two special cases.

First, if the company guarantees the death of somebody else, if they co-sign a debt, even if the chance of a loss is remote, you've got to footnote that, you know why? Because that's an example of off balance sheet risk. Think about it. If you co-sign a debt. That does not show up on your balance sheet as a liability, because it only becomes your liability if the other person waltz, but obviously you've taken a big risk and you're always required to footnote off balance sheet risk.

So if the company guarantees the debt of a law, if the company guarantees the debt of somebody else, even if the chance of a loss is remote, you have to footnote that. The other one they mentioned. If the company makes a guarantee that they will purchase another company's receivables under certain circumstances, if the company makes some kind of guarantee that they will purchase another company's receivables under certain circumstances, even if the chance of a loss was remote, you've got to footnote back because that's an example of off balance sheet risk.

You always must footnote off balance sheet risk, but generally speaking, if the chance of a loss is remote, obviously. There's no journal entry, only probable contingencies get accrued. And generally it's not even a footnote. Let's do a couple of questions. Number one, during year four, Haft became involved in the tax dispute with the IRS on December 31 of year four.

Half tax advisor believed that an unfavorable outcome was probable. So that's the word we're looking for? Got to nail down the category. We know this is a probable contingency. A reasonable estimate of additional tax was 200,000, but could go as high as 300,000. We have a range after the year four financial statements were issued.

They finally settled with the IRS for two 75. What amount of accrued liability would have to have reported December 31 of year four on the balance sheet. Well, you know, when you're given a range, you accrue the minimum. The answer is a, and you would have footnoted. It could go higher. You didn't know about the two 75 in time.

You didn't, you didn't know about the two 75 settlement till after you issued the statements. The best you could have done when you issued the air force statements is a crew, the minimum 200,000 answer a and footnote. It could go as high. It could go as high as 300,000. Question number two on January 17th, year two.

An explosion occurred at Sims plant causing extensive property damage. Although no claims had yet been asserted against Sims by March 10th, year two Sims management and council concluded. It is likely the claims will be asserted. You can bet they will, and it's reasonably possible. That's we're looking for what category we in it's reasonably possible.

Sims will be responsible for damages. They estimate the damages would be. 1 million, two 50, they think that's a reasonable estimate. Notice they have a comprehensive public liability insurance policy for 5 million. It has a $250,000 deductible in the December 31 year, one financial statements. How would this be reported?

Well, first of all, this is also a subsequent event. It occurred after the balance sheet date, but because it's casualty losses. Because it's casualty losses, you would footnote this in year one. Again, even though it occurred after the balance sheet date, this would be footnoted in year one because it's casualty losses.

You want to make sure people know what's going on, but what is the footnote? What is the footnote? Well, because again, it's a reasonably possible contingency. It would be footnoted in year one, but what is the footnote? The answer is B. You'd have a footnote disclosure. What's their total exposure. Just the deductible.

Think about it. If they're right and they settled for 1 million, two 50, they pay the deductible. Then the insurance company takes over. Right? If they're right and they settle for 1 million, two 50 in damages, all they pay is the deductible. Then the insurance company picks up the rest. So the exposure to the company is a possible loss of 250,000.

So watch out for those deductible clauses. Sometimes that'll mess people up. Let me ask you this. What if our best estimate of the settlement is 6 million? What if we really are? We really sit down and we estimate we're going to be responsible for 6 million in damages. What do we pay? What's the exposure to the company, the deductible to 50 and anything over 5 million number, the insurance has captured five.

So then your footnote disclosure would be 1 million, two 50. So, you know, gotta be really careful and watch out for those deductible clauses. Number three, December 30, one of the current year date company. Was awarded judgment in a lawsuit on a competitor's infringement of dates, patent legal counsel believes it's probable.

That date will win the suit and the most likely, and the most likely award to gather together in a range of possible awards. How would the lawsuit be reported? In the current year financial statements. So now that we've changed sides here, now we're suing somebody and our lawyer thinks we're probably gonna win.

You know, at the first of all, what they're getting at you accrue gains, you know, you don't, if a loss is probable and you can reasonably estimate the amount of a loss, you accrue it, you don't accrue gains. Generally. You don't recognize any gains until they realized, so you get a check. But you do footnote.

This, the answer is a, this would be footnoted that, that surprises. Some people gain contingencies are footnoted. You just think you can't mislead. In other words, your footnote can't make it sound like it's a foregone conclusion. You're going to get this money. But what you footnote with gain contingencies are facts who you're suing.

What the issue is when the court date is, is scheduled. If it's under appeal, That, but it, but you do footnote gain contingencies. And again, you footnote facts who you're sewing. What the issue was when the court date is scheduled, if it's under repeal, that sort of thing. But yes, gain contingencies are footnoted, but you never accrue gains.

Generally. You don't recognize gangs until they're realized, keep studying. I'll see you next time.

Welcome back in this far cpa review course. We are going to begin our discussion of a very heavily tested topic. And that is how do you account for leases? You're going to find as we get into this, that how you account for leases certainly makes good multiple choice and would also make a good simulation as well. Now, as I start this, I think, you know, already.

What the basic issue is with any lease. The basic issue is this. If I'm a lessee and I sign a lease, am I using that lease to just rent the property? Am I just renting or am I using that lease in substance to purchase the asset? Now let's talk about some terminology. If I'm a lessee and I sign a lease and I'm using that lease to just rent the property.

If I'm just renting, we call that an operating lease. That's an operating lease. But if I'm using that lease in substance to purchase the asset, if in substance, the lease is a way to purchase the asset. We call that a capital lease. Now, same idea on the less sore side, remember in the FAR CPA Exam with least problems, you could be on the lessee side, you could be on the less or side.

And as I say, it's really the same concept on the West or side, if I'm a less or, and I signed the lease, if I'm using that lease to just rent out my property, if I'm just renting out my property again, we call that an operating lease spot. If I'm using that lease. In substance to sell my property. If in substance, the lease is a way to sell the asset.

Well, then there are two possibilities for the less, or it could be a sales type lease for the, or, or it could be a direct financing type lease for the less or so those are the different possibilities. Now we're going to begin with operating leases. Now let's start on the lessee side. As I said a minute ago, if I'm a lessee and I sign a lease and I'm using that lease to just rent the property, we call that an operating lease.

So, you know what it means, basically, if I'm a lessee, you know, I signed an operating lease, all the lease payments I make, get debited to rent expense. It's really that simple. If I'm a Westie and I signed an operating lease. All the lease payments that I make just simply get debited to rent expense. Now, how could they complicate this?

I'll show you how they could complicate this. Let's say I'm a lessee. I signed an operating lease and my lease payments are going to be 10,000 every year for 10 years. But to get me to sign the lease, the last order says, Bob, the first two years, rent are free. Well, if the first two years rent are free, what am I going to end up paying?

I'm going to end up paying 10,000 every year. For eight years, I take $80,000 divided by 10 years of rent. My rent expense for year one is $8,000. Not zero. Remember on even rental payments are incurred evenly. Don't let them mess you up with that. Uneven rental payments are incurred evenly. It doesn't matter how you pay it.

You expense it evenly. Same idea on the or side, if I'm a less, or I signed an operating lease, I'm just renting out my property. So let's say I'm a Lester. I signed an operating lease. Again, the lease payments are going to be 10,000 every years, every year for 10 years. But to get the person to sign the lease, I say, well, first two years rent or free will.

If the first two years rent or free, what am I going to collect? I'm going to collect 10,000 every year. For eight years, I'm going to collect $80,000 for 10 years rent take 80,000 divided by 10. What I earn in year one is $8,000. Not don't forget on even receipts. On even receipts are still earned evenly.

It doesn't matter how you collect it, you earn it evenly. And they met some people up with that. You know what I'm really saying? Bottom line, if you're in the FAR CPA Exam and you get questions and operating leases, fundamentally a question on an operating lease is a question about a cruel accounting. That's really what they're about.

Let me just mention a couple of other issues they can throw into these are, here are some issues. That they can throw in to operating lease questions. We'll start on the West East side. What if the lessee pays prepaid rent? What if, what if you see prepaid rent? Because they'll throw this stuff in.

Remember prepaid rent is an asset prepaid rent for the lessee is an asset. It's not expensed till the proper period. What if the lessee pays a non-returnable deposit? If the lessee pays a non-returnable deposit? They set up an asset and they amortize it to rent expense over the term of the lease. I hope that makes sense.

Lessee pays a non-returnable deposit or it's non-returnable then you set up an asset and you amortize it to rent expense over the term of the lease. What if the lessee pays our returnable deposit? Well, if the lessee pays a returnal deposit, they set up an asset, but don't amortize. It it's like a receivable.

They're going to get it back. How about if the lessee pays. On initial direct costs, like a finder's fee. They'll throw that in. If the lessee pays on initial direct cost, like a finder's fee, they set up an asset and they amortize it to rent expense over the term of the lease. There's a lot they can throw in to these operating these questions.

One more thing. What if the lessee has a leasehold improvement? A leasehold improvement is capitalized and amortized. Over the useful life. To me, the lessee again, leasehold improvement would be capitalized and amortized over the useful life. To me the last eight, I'll give you an example. Let's say I have an operating lease on my office.

Okay. And I put in brand new hardwood floors in my office to lease hold improvement. The hardwood floors have a useful life of a hundred years. My lease is going to run out in three years and I intend to leave the building. Now, you know, that hardwood floors would be a leasehold improvement. So I would capitalize it.

Do I amortize it over a hundred years or three, three, the useful life. To me notice not the useful life of the floors. No, the useful life to me three years, because I'm going to leave after my I'm going to leave the building after my lease runs out in three years. All right. Same idea. On the lesser side, let's talk about some things that can throw in.

To an operating lease question on the less or side, what if the less or collects rent paid in advance? If the less or collects rent paid in advance, they set up a liability, but remember it's not. Income. It's not revenue until the proper period. What if the lessor collects a non-returnable deposit? Well, if the lessor collects a non-returnable deposit, they set up a liability and they amortize it to rental income rental revenue over the term of the lease.

What if the less or collects a returnable deposit? Well, if it's returnable set up a liability, don't amortize it because you have to pay it back. And one more thing. What if the less sore pays? On initial direct costs like a finder's fee will, if the last or pays on initial direct costs, like a finder's fee, the less source sets up an asset and amortizes it to expense over the term of the lease.

I say again, fundamentally, if you get a problem on an operating lease, it's really about a cruel accounting. Let's do one in your viewers guide question. Number one says on January 1st of the current year park. Signed a 10 year operating lease. Notice the FAR CPA Exam is telling you it is an operating lease for office space.

$96,000 is the annual rent. Okay. The lease includes a provision for additional rent of 5% of annual company sales over 500,000. Anything in excess of over 500,000 is additional rent of 5% park sales for the year and ended December 31 were 600,000. So unless there a hundred thousand above that threshold.

Upon execution of the lease park paid 24,000 as a bonus for the lease. And they want to know parks, rent, expense. All right. Now, what do we know going into this problem? They said, it's an operating lease. We're on the lessee side. And you know what that means. If a lessee signs an operating lease, they're just using that lease to rent the property.

So all the lease payments they make, get debited to rent expense, and that's what they want to know here. What is the rent expense for the year? Well, you know, we're going to pick up the 96,000 annual rent. You know that, how about that bonus? How about that $24,000 bonus. Now I just went over a list of items that they could throw at you in operating these questions on my list that I just gave you.

What do you think I would call that bonus? That's right. It's an initial direct cost. Isn't it? That 24,000, like a finder's fee. That bonus is like another example of an initial direct cost. So, what does the lessee do? They set up an asset and amortize it to expense over the term of the lease. So what park is going to do is take that 24,000 it's a 10 year lease divide by 10 straight line years.

They'll amortize 2,400 of that to rent expense this year. So we'll pick that up. And then there's also that other provision that if their sales exceed 500,000, there's an extra 5%, their sales were 600,000. There are a hundred thousand above that threshold times 5%. That's another 5,000. Add it all up. The rent expense would be answered C 103,000.

Let's do another one. Question. Number two, wall company, leased office premises to Fox for a five-year term beginning, January one of the current year. Under the terms of the operating lease. Notice they tell you it's an operating lease. Rent for the first year is 8,000 and rent for years. Two through five is 12,500 per year.

However, as an inducement to enter the lease wall, granted Fox the first six months rent free in the current year, December 31 income statement, what would wall report as rental income? So again, you're in the FAR CPA Exam. What do you already know when you read this question? They said it's an operating lease, Ron, the less sore side.

And you know what it all means. If I'm a West soar and I signed an operating lease, I'm using that lease to rent out my property. So all the lease payments I collect get credited to rental income. That's what they want to know. Rental income. Now let's work it out. The rent for the first year is 8,000. But to get the person to sign the lease.

We said, Hey, first six months of free. So what we're going to collect for the first year is not 8,004,000. And then in years, two, three, four, and five, we're going to collect 12,500 each year. That's another 50,000. If your wall, what you're going to collect over the term of the lease is 54,000. Take that 54,000 divided by five years of rent.

What wall earns in year one is answer C 10,800. Because on even receipts still get earned evenly. It doesn't matter how you collect it. You earn it evenly. So watch out for that. As I keep saying, fundamentally, you get a problem on an operating lease. It's all about a cruel accounting. Now I have to say that operating these questions are not bad, but they're not as heavily tested either.

You're not as likely to be tested on operating leases, although they come up in the CPA exam, what is much more likely to come up in the CPA exam is a capital lease. So let's turn our attention to that. Now I'm going to begin on the lessee side. We'll talk about the less sore side later on in these classes, but to start us off, I want to talk about the lessee side.

Now, as I said earlier, if I'm a lessee. And I signed a lease and I'm using that lease in substance to purchase the asset. If in substance, the lease is a way to purchase the asset. We call that a capital. He says, you know, now the first thing that comes up in the FAR CPA Exam, how do you know that the lease is a capital lease?

How do you know that in substance, the lease is a way to purchase the asset? Well, here we go. The lessee has a capital lease. If any one of four criteria are met again, the lessee has a capital lease. If any one of four criteria are met, let's go over them first. If there's a transfer of ownership, always look for that.

In other words, either during the lease or at the end of the lease, does the ownership of the asset transfer from the less or to the lessee watch out for that? Is there a transfer of ownership either during the lease or at the end of the lease? Does the ownership of the asset transfer from the lessor to the lessee or, or is there a bargain purchase option either during the lease or at the end of the lease?

Does the lessee have the option to purchase the asset at a bargain price? Is there a bargain purchase option or, or is the term of the lease equal to. Or greater than 75% of the remaining life of the asset again, is determined the least equal to, or greater than 75% of the remaining life of the asset, or one more, or is the present value of the lease payments, present value of the lease payments equal to, or greater than 90% of the fair value of the asset.

Now, I hope I've made this clear. All of these criteria do not have to be met. Any one of them. If any one of these criteria are met, it is a capital lease in substance. You're using a lease to purchase the asset. Now let me say what is perhaps obvious you can't go in the FAR CPA Exam and not have that criteria down cold.

You won't be able to deal with multiple choice or a simulation on this. If you don't have the criteria down cold. So I give you a memory tool. Remember to bop 75 92. Remember that criteria because you have to just remember to bop 75 90. You see what it stands for? Tio two. Is there a transfer of ownership either during the lease or at the end of the lease?

Does the ownership of the asset transfer from the less to the lessee or Bob? Is there a bop, a bargain purchase option? Hey, either during the lease or the end of the lease, does the lessee have the option to purchase the asset at a bargain price? What 75 meters is the term of the lease, the term of the lease equal to, or greater than 75% of the remaining life of the asset.

And what's 90 mean is the present value of the lease payments equal to, or greater than 90% of the fair value of the asset. If any one of those criteria are met in substance, the lease is a way to purchase the asset. It is a capital lease. Now that we have the criteria down. We're ready to try a problem.

If you look in your viewers guide, you'll see. Illustrative problem. Number one, let's take a look at it now again, I remind you, I'm starting on the lessee side here. We will talk about the less sore side later in these classes in illustrator problem. Number one, the lessee signs, a lease contract, which transfers ownership.

Stop right there. You're in the FAR CPA Exam. You see the least transfers ownership. You already know it's a capital lease because that's how you think in the FAR CPA Exam to Bob 75 92 buck, 75 90, any one of those criteria are met. It settles it. It's a capital lease. It's a transfer of ownership here. The lease was signed January 1st year one.

Notice the MLP, the minimum lease payments, the M L P the minimum lease payments are going to be 10,000 every year for five years. And the first payment is on December 31st year one. Now we have to talk about something. You gotta be aware of this. You have to be aware that a lease contract always represents an annuity.

Now, you know, what that is on annuity is a series of equal periodic payments over a specified number of periods. You know, that an annuity is a series of equal periodic payments over a specified number of periods. But what some people forget is that there are two types of annuities. Let's go over this.

This is important. There are two types of annuities. The first type is called an ordinary annuity or a deferred annuity or an annuity. In a rears again, first type is called an ordinary annuity or a deferred annuity or an annuity in arrears. And what does that mean with an ordinary annuity? The equal payments are made at the end of every period, the end of every month, the end of every quarter, the end of every year.

That's what makes an ordinary annuity when the equal payments are made at the end of every period. Now, the second type of annuity is called an annuity due. Or an annuity in advance. And I know you're ahead of me with an annuity, do the equal payments were made at the beginning of every period, the beginning of every month, the beginning of every quarter, the beginning of every year, the beginning of every period.

That's what makes an annuity due. The reason I mentioned this is that you can't solve any lease problem. You've got to find this a stroke. You can't solve any lease problem until you nail down what kind of annuity you're dealing with. So in this problem, When did the lessee sign? The lease contract January one.

When is the first lease payment due December 31, the end of the first year. This is an ordinary annuity. All right, now they give us some facts. The asset has a useful life of eight years with no salvage. The lessee's incremental borrowing rate is 10% and now they give us some interest factors. We have present value of a single dollar.

We don't want that present value. We want an ordinary annuity. Right because the first payment is made at the end of the first period, the payments made at the end of each period. It is an ordinary annuity five periods of 10%. The factor is 3.79. Here's what the lessee is going to do. The lessee is going to take that factor on January 1st year one, the lessee is going to take that factor 3.79 times equal payments, 10,000 and the less he's going to debit.

Lease property, 37,900 and credit lease liability 37,900 notice what's happening in substance. They purchased this asset, so they actually put up, if this is a piece of equipment, they're putting a fixed asset on the books. Lease property 37 nine for the discounted present value of the payments. And they're going to credit a lease liability for the discounted present value, the payments 37 nine in substance.

They purchase this asset. Now let's go ahead a year. It's now December 31 year one, go through it with me. Let's start with the liability. Didn't they have a balance outstanding in the liability for the entire year of 37,900 times. The interest rate, 10%. They're going to debit interest expense 3,790. I hope you see where I got that they had a balance outstanding in their liability for the entire year of 37,900 times.

The interest rate, 10%. They're going to debit interest expense 3007 90. What are they credit to cash? That's right. 10,000. That's what the lease contract says. The lease contract says I make a $10,000 payment. Every December 31. So we're going to credit cash, 10,000, the entry doesn't balance. I need a debit of 6,000 to 10 to balance the entry out.

That's the pay down of principal. I'm going to debit my lease liability 6,000 to 10. That is the pay down of principal for the first year. And it's a plug. That's the entry that they would make at the end of year one. Now, are we finished? No. Don't forget to depreciate the asset. Remember this is a capital lease in substance.

They purchased this asset. They have an asset on the books, lease property at 37 nine. They have to depreciate that asset. Now there's a wrinkle here and I want to make sure you see it in this problem. What's the term of the lease five years. I hope you see that. Isn't the term of the lease five years.

What's the useful life of the asset eight years, no salvage. So you're in the FAR CPA Exam. You know, you have to depreciate this asset, this lease property 37 nine. Do I depreciate over eight years, the life of the asset or five years, the term of the lease. I hope you see that wrinkle. That bothers a lot of students.

So what do you use? Eight years or five? There's a rule. There's a rule and you have to know it. the FAR CPA Exam loves this rule. So make sure you remember it. If the two of the bopper men, if there's a transfer of ownership or a bargain purchase option, if the two of the bopper mat depreciate over the life of the asset, but if the 75 or 90 criteria is met depreciate over the term of the lease, you have to know that rule.

If the two of the bopper mat depreciate over the life of the asset, if the 75 and 90 criteria is met depreciate over the term of the lease. Now, the criteria that's met here is a transfer of ownership. So we're going to use the life of the asset. So we're going to take that $37,900 lease property. That equipment, no salvage.

They said if there was salvage, we pack it out. But they said no salvage over eight straight line years. So we're going to debit depreciation expense 4,007 37 50. And we're going to credit accumulated depreciation 4,007 37 50. Don't forget to depreciate that fixed asset. In substance, you purchase that fixed asset.

Let's go ahead. Another year. It's now December 31st year two. What do we do? Well, first you have to manipulate the liability. Be comfortable with the liability. Didn't we start out with a balance in our liability of 37,900, but at the end of the first year, We paid off $6,210 a principal. So that means the balance that was outstanding in my liability all through year two was 31,690.

I'm going to take that 30 1006 90 times the interest rate, 10%. And I'm going to debit interest expense 3001 69, and I'm going to credit.

I'm going to credit cash for my equal payment, 10,000. That's what my lease contract says. I make a $10,000 payment every year, every December 31. So I'm going to credit cash 10,000 at the entry doesn't balance. I need a debit of 6,008 31 to balance the entry out. I'm going to debit lease liability 6,831.

That's the pay down of principal for the second year. And it's a plug. And by the way, if I had done a balance sheet a year ago, that's 6,008 31 would have been the current portion of my lease liability. Because it's got to be paid off within a year. I want you to understand that if I had done a balance sheet a year ago, that's 6,008 31 would have been the current portion of my lease liability.

The rest would be noncurrent. Don't forget that about lease liabilities. They get divided up into the current and non-current portions. Am I done? No, don't forget to depreciate the fixed asset. Because there's a transfer of ownership. I'm going to depreciate over eight straight line years, and I'm going to debit depreciation expense 4,007 37 50.

And I'm going to credit accumulated depreciation 4,007 37 50, please. Don't forget to depreciate that fixed asset in substance, you purchase the asset. You have a fixed asset on the books and it has to be depreciated. We will continue our discussion of leases in the next class. I'll see you then. Welcome back in this far cpa review course, we are going to continue our discussion of how to account for leases.

And as I'm sure you remember, in our last class, we discussed accounting for leases on the lessee side. And in our last class, we did illustrate a problem. Number one, now let's continue. With how to account for leases from the lessee side. And let's move on to illustrative lease problem. Number two, maybe a little bit more challenging noticing this problem in your viewers guide.

The lessee signs, a lease that has a term of 10 years and the lessee signs the lease on January 1st year one, the MLP, the minimum lease payments. Are going to be 15,000 every year. And the first payment is due when January 1st year one, the same day, you know what I'm getting at? This is an annuity due or an annuity in advance where the equal payments are made at the beginning of every period, the beginning of every month or the beginning of every quarter or the beginning of every year, we have an annuity in advance here.

As I said, in our first class, you really can't solve any lease problems. Until you nail down, what sort of annuity that you are dealing with here? We have an annuity in advance. Now we have some more information. The asset has a useful life of 15 years with no salvage notice. At the end of the lease, the asset has a fair market value of $25,000, but the lessee has the option to purchase the asset at a bargain price, 10,000.

You know what that is? It's a Bob, it's a bop, it's a bargain purchase option. What do we already know? It's a capital lease because you're in the FAR CPA Exam. And you're thinking to bop, 75 92, Bob 75 90, any one of those criteria are met. You know, you have a capital lease. Now we have some more information and there's a little game here that the FAR CPA Exam can play with interest rates.

They tell us that the lessee's incremental borrowing rate is 12%. The less oars implicit rate. The rate implicit in the lease is 10% and that's known to the lessee. So of course you're in the FAR CPA Exam. What interest rate do you use? Well, there's a rule we have run up against now another rule and you have to know it let's go over the rule.

The basic rule is use the less oars rate. Use the rate implicit in the lease, the less oars rate, if it's both, it has to be both lower than the lessee's rate and known to the lessee. That's the rule. Say it again. You're going to use the rate implicit in the least the less oars rate. If it's both lower and known, it has to be both lower than the less rate and known to the lessee, both lower and known.

Now in this case, The rate implicit in the lease, the less, his rate is 10%. It's both lower than less use rate, 12% lower. And they say the less he knows about it. So here we're going to use 10%. So let's get our factor. We have present value of an ordinary annuity. We don't want that. We want present value of an annuity in advance, 10 periods, 10%.

The factor is 6.76. We're going to take that factor. 6.76 on the lessee. Now, what entry do I make on January 1st year one? Because it is a capital lease because in substance, the lessee is using the lease to purchase the asset on January 1st year one, we're going to take that factor 6.76 times the equal payments, 15,000.

And that comes out to 101,400, but I'm not done. What's different in this problem. Is there's a bargain purchase option. They said at the end of the lease, the asset has a fair value of 25,000, but the lessee has the option to purchase the price at a purchase the asset at a bargain price, 10,000. You have to assume that that is such a bargain that they'll take advantage of it.

So theoretically, that is another $10,000 cash that goes out at the end of the lease. You have to discount that also. Remember in a lease problem, you have to discount all the future cash flows. So again, that's such a bargain, you're assuming that's another 10,000 that will flow out at the end of the lease.

So let's discount that also now for this 10,000, I don't want present value of an annuity. This is not a series of equal payments. It's one lump sum that goes out at the end of 10 years at the end of the lease. So now I want present value of a single dollar. 10 periods of 10%. That factor is 0.3, eight, six.

I'm going to take that factor 0.38, six times the bop 10,000, that comes out to 3008 60 added up. They're going to debit leased property for 105,000 to 60. And they're going to credit lease liability 105,000 to 60. That's the entry that the you would make on January 1st year. One, notice that we're setting up a fixed asset for the discounted present value.

Which of all the payments, including the bop was setting up the lease liability for the discounted present value of all the payments, including the bop. In other words, what you're getting out of this discussion, I hope is that bops get capitalized. They trick a lot of people with that. Remember a bop gets capitalized.

All right, so we've debit at least property one Oh five, two 60. We credit lease liability one Oh five to 60. Now what kind of annuity is this? This is an annuity and advance. So when did they make the first $15,000 payment right away today. So, can we agree if they make the $15,000 first payment right away?

January 1st, it would all be principal. They'd be no interest because no time has passed. So we're going to debit lease liability 15,000 and we're going to credit cash 15,000. They make the first payment the very first day. And again, because no time has passed, it would all be principle. So debit lease liability 15,000 and credit cash, 15,000.

Now let's go ahead a year. It's now December 31 year one. First of all, let's work out the balance in our liability. We started with the principle balance in our liability of one Oh five, two 60, but this was an annuity in advance. We made a $15,000. First payment on the first day, it was all principal. So that lowered the balance in our liability down to 90,000 to 60.

So I had a balance outstanding in my liability all through the first year of 90,000 to 60 times, 10%. We're going to debit interest expense 9,000 Oh 26. What do I credit cash? No. Remember my lease says I make a $15,000 payment every January one. I'm at December 31 making my accruals. So I'm going to credit interest payable, 9,000 Oh 26.

I hope you see that don't credit cash. Your lease contract says that you make a $15,000 payment. Every January one, I'm at December 31 making my accruals. So I would credit not cash. I would credit interest payable, 9,826. Am. I done no tone for a get to depreciate, the fixed asset. Remember we have in substance purchased this equipment, whatever it is, we have an asset on the books, lease property at one Oh five, two 60.

There's no salvage. So, and again, if there were salvage, you would take it out, but there's no salvage. You know what I'm going to ask you. Should I appreciate that. Over 10 years, the term of the lease. Or 15 years, the life of the asset that's right. 15 years, because what's the rule. If the two of the bopper met, if the two of the bopper mat depreciate over the life of the asset, but if the 75 and 90 criteria is met depreciate over the term of the lease, what we have here is a bump.

So we're going to depreciate over the life of the asset, which is 15 years. I know what you might be thinking, Bob. What if there's a bop and it also meets the 90 criteria, or what if there's a transfer of ownership and it also meets the seventy-five criteria. Use the life of the asset. Any time two or bop is met, even if some others are met.

I hope you're with me on this. Once you see transfer of ownership of bargain purchase option. If the two of the bopper met, you've got to use the life of the asset, even if some other criteria is met. But anyway, in this case, we have a bop. So we're going to use the life of the asset at 15 years. So I'm going to take our fixed asset one Oh five to 60, over 15 straight line years.

No salvage. I'm going to debit depreciation expense 7,000 Oh one seven. And I'm going to credit accumulated depreciation 7,000 Oh one seven. Don't forget to depreciate that fixed asset. I worry about you. People do forget on a detail like that. Now, maybe you can help me on this. When is the next time is an entry.

That's right. January 1st, year two on January 1st year too, they're going to credit cash 15,000, because that's what the lease says. The lease says I make a $15,000 payment every January one. So on January, first of year two, they're going to credit cash 15,000. Now, what do you do? Debit that's right.

Interest payable. 9,000 Oh 26. Entry doesn't balance. I need a debit of 5,009, 74 to balance the entry out. That's the pay down of principal for the first year. And all obviously, if we were doing a balance sheet a year ago, that 5,974 would have been the current portion of my lease liability. The rest would be noncurrent.

Don't forget that about lease liabilities. They do get divided up into their current and non-current portion. I hope you're with me on this problem. And you know, you know me so well now, you know, I'm not happy. I'm just not happy. If we don't do a second year, let's go to December 31st year to, first of all, let's work out the balance in our liability.

Gotta be able to manipulate the liability. We know we started with a balance in our liability of one Oh five, two 60, but this is an annuity in advance. So they made a $15,000 payment the first day. That brought the liability down to 90,000 to 60. Then at the end of year one, we paid off 5,009, 74 of principal.

Didn't wait. So the balance that was outstanding and our liability, all three-year to 84,000, two 86, I hope you're comfortable with working out the balance and that liability. 84,002 86. I'm going to take the balance. That was outstanding in my liability all through year two 84,002 86 times the interest rate 10%, and I'm going to debit interest expense 8,004 29.

Now it's actually 8,000 for 28 and 60 cents. We won't get into Penny's, I'll just round it off. So we're going to debit interest expense, 8,004 29. Do I credit cash? No. My lease contract says I make a $15,000 payment every January one. So here I'm at December 31 making my accruals. I would just credit interest payable, 8,004, 29.

When's the next time there's an entry right now. Don't forget to depreciate that fixed asset. You have a fixed asset on the books. There's a trend, there's a bargain purchase option. So we're going to depreciate over the life of the asset. We're going to debit depreciation expense. 7,000 Oh one seven and credit accumulated depreciation, 7,000 Oh one seven.

Don't forget your promises to me. You promise me that you're not going to forget to depreciate that fixed asset. When's the next time there's an entry there. That's right. January 1st year three, January 1st, year three, we credit cash 15,000. Why? Because our lease says we make a $15,000 payment every January one.

Now I would debit that interest payable, 8,004 29. And 3000 balance. I need a debit of 6,571 to balance the entry out. That's the paid on a principle for the second year.

I'm hoping that seeing some entries helps you understand leases even better. I think they do. I think entries help a lot. I think if you can do the entries either you can, you can answer anything they can come up with. All right now. I want to show you a couple of other little wrinkles. They can throw into a capitalist problem for the lessee.

I want to go back for a minute to our first entry member back on January 1st year one. And this particular in this problem, back on January 1st year one, remember what we did. We discounted all the cash flows, even the bop and we debit at least property one Oh five, two 60. We credited lease liability one Oh five to 60.

That's our first originating entry. Well, we set up a fixed asset and a liability for the discounted present value of all the cash flows, including the bop one Oh five, two 60. Now, let me just show you a couple of things that could throw in. What if they said St. Problem, that the lessee had to pay $3,000 in initial direct costs, like a finder's fee?

What if the lessee in this problem had to pay $3,000 in initial direct costs? Like a finder's fee? Well, If you saw that instead of debiting lease property one Oh five to 60, you would debit lease property one Oh eight, two 60. I'll say it again. If they paid $3,000 in initial direct cost, like a finder's fee, you wouldn't debit in this problem.

Lease property one Oh five to 60, you would credit lease property one Oh eight to 60. You'd still credit the liability one Oh five to 60 in your credit cash, 3000. I'm just illustrating the point that initial direct costs like a finder's fee would get capitalized. Debit leads property one Oh eight, two 60 credit, the lease liability still one Oh five, two 60 and credit cash.

3000. You see initial direct costs. They get capitalized now. Same problem. What if they said this same problem? They said the lessee has to pay $2,000 in annual execratory costs. That's something like maintenance. Again, if you see annual execratory costs, think maintenance. If the lessee has to pay $2,000.

In annual execratory costs when they made their first payment, they would credit cash, not 15,000. They would credit on that very first day. Remember it's an annuity in advance when they make their first payment on that first day, they wouldn't credit cash 15,000. They would credit cash, 17,000 debit, the lease liability 15,000.

A debit and expense execratory costs 2000. Just want to show you that annual executive costs are not capitalized their expense every year. It's usually something like annual maintenance. Think of it as annual maintenance. But the point I'm making is it's not capitalized it's expense every year. So when you make that first payment debit, the lease liability 15,000 debit, an expense executor costs 2000 credit cash, 17,001 more thing.

We know that when we. Calculated the discounted present value of all the payments, including the bop. It came out to one Oh five to 60. What if they, what if the FAR CPA Exam through this end? What if they said that the asset has a cash price, a fair value of 95,000. So now they throw in that the asset, the equipment, whatever it is, has a cash price, a fair value of 95,000.

Listen to me carefully. If the asset has a fair value, a cash price of 95,000, you can't debit. Lease property one Oh five to 60. You can't record an asset. Higher than its cash price. So in that case, you would debit lease property 95,000 and you would credit lease liability 95,000 and the rest must be interest.

You're paying a lot more than 10% interest. That would be the analysis there. You can't record an asset higher than its cash price. It's fair value. Now I'm not saying an exam do that a lot, but it is a possibility. They start telling you, Hey, the asset has a cash price of 95,000. That's what it would sell for in cash.

And you work out the discounted present value, the payments it's one Oh five, two 60. You can't debit leased property one Oh five, two 60. You can't write an asset above it's cash price. So in that case, you would debit leased property, 95,000 and credit lease liability. 95,000 and the rest really would be interest.

The analysis would be you're paying much more than 10% interest in reality. And as I say, it's not something that the FAR CPA Exam would be throwing at you all the time. But since we're into this, I thought I'd mentioned it. Now. You'll notice that. And your viewers guide. There are three questions in this module, and I want you to promise me, you will do these three questions before you go to the next module and don't cheat.

Don't look ahead. It's very important that you do these three questions, get your answers, and then we'll go over them in our next module, but you have to do them first and I'll see you then.

Welcome back in this far cpa review course, we're going to continue our discussion on the accounting for leases. And, you know, at the end of our last class, I assigned those three questions and I know you did them as I wanted you to before coming to FAR cpa review course. So let's look at these three questions, first of all, this clay.

And if you go right to the bottom, they want to know the balance in the lease liability. And I have a question for you. You're in the FAR CPA Exam. What is the only way you're going to know you have a capital lease? That's right. To Bob seventy-five 92, Bob seventy-five 90. You're always thinking of that criteria.

It's the only way to be sure. So let's apply the criteria in this problem. Is there a transfer of ownership? No, they said at the bottom that the possession of the machine reverts back to Sachs the less or. So, no, there's no transfer of ownership. Is there a bop? Is there a bargain purchase option? They don't mention one.

No. All right. What's 75. I hope you don't have to look at your notes. What 75 mean is the term of the lease equal to, or greater than 75% of the remaining life of the asset? So let's work it out. What's the term of the lease? 10 years. What is the useful life of the asset? 15. If you take 10 over 15. No. The term of the lease is about 66%, two thirds of their meaning life of the asset.

No, it's not equal to or greater than 75% of the remaining life acid. It's not what's 90 mean is the, the present value of the lease payments equal to, or greater than 90% of the fair value of the asset. I have to work it out. Let me ask you this. Is this an ordinary annuity or an annuity and advance? It's an ordinary annuity.

No, it's not. It's an annuity in advance because they said rental payments are made at the beginning of each period. Right. That's what they said. There was that word beginning, equal payments made at the beginning of each period. So this is an annuity do it's an annuity in advance, but you always think of that issue.

You can't solve a lease question until you nail down. What type of annuity you're dealing with. This is an annuity and advance, so let's get our factor. We want present value of an annuity. In advance of 10:00 PM for 10%, the factor 6.76. These are a factor. So we're going to take that factor. 6.76 times the equal payments in the least 50,000, the discounted present value.

The payments comes out to 338,000. I'm going to take that 338,000 over the fair value of the asset, which is 400,000. It's about 84 and a half percent. No, the present value of the lease payments are not equal to, or greater than 90% of the fair value of the asset. It's about 84 and a half percent. You know what I'm asking you, if none of the four criteria are met, what kind of leases?

This that's right. It's an operating lease and all the lease payments they make, get debit into rent expense. You're just renting the asset if none of the criteria are met. So the answer is D there is no lease liability. Remember the only way, you know, you have a capital lease is to Bob seventy-five 90 always be thinking of that criteria.

And as I say, if none of the criteria are met, it's not bringing leads and there is no lease liability. And that's why the answer is date. I think you just learned something very important there, you know, when you start to do lease questions, you realize when you see a zero for an answer that always gets your attention, you know, there's a zero there.

You stop and think maybe I've got to check the criteria and make sure that it is a capital lease. Let's go to number two Robbins, a few interesting things going on with Robbins. First of all, with Robbins, we know it's a capital lease because they say it, they say it's a capital lease. I mean, there's also a bop here as well, but they do say it's a capital lease.

And I want you to know if the CPA exam says it's a capital lease. Then you don't have to, you don't have to worry about the criteria. They're not trying to fool you. They're not going to say it's a capital lease, but really it's not nothing like that. They say it's a capital lease. Don't worry about the criteria that settles it.

All right. So it's a capital lease and notice that payments are made beginning immediately. So we know always pick that up. We know what's an annuity due or an annuity in advance. We know that. And how about the interest rate? Well, Robbins, the lessee's incremental borrowing rate is 14%. The lease specifies an interest rate of 12 what's the rule use the rate implicit in the lease in this case, 12%, if it's both lower than the lessee's rate 14, which it is and known to the lessee and they must know about it because the lease specifies it.

So we are going to use 12% here. So once again, they want the balance in the lease liability. Let's work it out. I'm going to go to my factors. I want present value of an annuity due 12%. I am going to use 12% 10 periods. The factor is 6.328. I'm going to multiply that factor. 6.3 to eight times the equal payments, 10,000, the minimum lease payments that comes out to 63,280, but I can't stop there because there's a Bob.

Did you notice at the end of the lease, the property has a fair value of 20,000, but Robbins has the option to purchase the asset for 10,000 a bargain price. That's a bop. And as you know, bops get capitalized. So let's get the factor for that. I want present value of a single dollar, not an annuity. This is not a stream of payments.

It's one lump sum that theoretically goes out at the end of the lease. That's the way we look at it, that this is such a bargain. We have to assume Robbins would take advantage of it. So at the end, the lease, this is another 10,000 that flows out. We have to discount all the cash flows, including the bop.

So let's get present value of a single dollar, 12% for 10 periods, the factors 0.3 to two, you multiply that factor. Point three to two times the bop that comes out to 3000 to 20, add a 3000 to 20. Plus our 63,280. You're going to have a fixed asset and a lease liability at 66 five. And the answer is C.

They wanted the balance in the lease liability and it would be 66 five, but don't forget. Bob's get capitalized. Let's go to question the third question East company. Now here again, what they're asking right at the bottom is what would be the capitalized asset now there's no zero for an answer. So it must be a capital lease there.

No zero there. So it must be a capital lease, but how do you know it? Well, we know it right off the bat because the term of the lease is 10 years remaining. Life of the asset is 12, 10 over 12. The term of the lease is about 83% of the remaining life of the asset. So that's equal to, or greater than 75%. So we know it's a capital lease anyway.

Now is this an ordinary annuity or annuity and advance annuity and advance because notice the payments made at the beginning of each year, there was that word beginning. So we'll get our factor. We want present value of an annuity and advanced 10 periods. At 14% factor is 5.95. I'm going to take that factor 5.95 times the equal payments 40,000 that comes out to 238,000.

Now, is there a bop notice? They said East has the option. To purchase the machine at the end of the lease by paying 50,000, which approximates its fair value. That's not a bargain. That's not a bop. They have the option to purchase the asset at its fair value. All that's terrific. They'll let me buy it at its fair value.

Well, they may or may not take advantage of that. Listen to me carefully only capitalize a purchase option. If it's a bargain purchase option, it's got to be a bargain price. As I say, if they just have to pay fair value. They may or may not take advantage of that. They might, at that point, just lease a new machine.

The only capitalize a purchase option if it's a bargain purchase option. So they're going to debit the fixed asset, leased property and the liability for 238,000. They wanted the balance in the fixed asset. It would be answered B 238,000. You wouldn't capitalize the purchase option because it's not a bargain purchase option.

So be careful of that now. To this point in these classes on leases, all we've talked about is the lessee side. Now let's go to the West soar side. Let me remind you on what we said back then when we began this discussion, if I'm a less or, and I signed a lease and I'm just renting out my property, we call that an operating lease as you know, but if I'm a less or.

And I signed a lease and I'm using that lease in substance to sell my property. If in substance, the lease is a way to sell the asset. Well, then there's two possibilities for the less or for the less, or it could be a sales type lease, or it could be a direct financing type lease. Now this is the first thing that comes up in the FAR CPA Exam.

How do you know that the less or has a sale? That's the first thing that's going to come up? How do you know. If the lease is in substance, a way to sell the property, you have to know the criteria. The lease has to meet all this criteria to be a sale. First, the two bop, 75 90 criteria has to be met from the Les oars perspective.

Right? So the two Bob 75 90 criteria has got to be met from the Les oars perspective. And just because I worry about you, if this came up in a written communication, You don't say to bop 75 90, right. That that's for us. Right? You would spell it out. I mean, I just, I worry about you, but you wouldn't say in a written communication.

Yes. The two bops, 75 90 criteria. They won't know what you're talking about. You'd spell it out. Of course, if there's a transfer of ownership or a bargain purchase option, you know that I know, you know that, but I worry. But anyway, first the two bops, 75 90 criteria has to be met from the less oars perspective and collectability of the minimum lease payments.

Must be reasonably assured and notice collectability of the lease payments. The MLP, the minimum lease payments must be reasonably assured and there are no material uncertainties regarding any future costs. There are no material uncertainties regarding any future costs. If all that criteria is met in substance, the lease is a way.

For the less or to sell the property in substance, it is a sale. And as I said, if in substance, it is a sale, then there are two possibilities for the less, or it could be a sales type lease, or it could be a direct financing type lease. Now let's start with a sales type lease. And I think to illustrate a sales type lease, the best thing to do is go back to a problem that we did earlier.

Cause you sorta know the numbers. We're going to go back to something we did earlier. Illustrative problem. Number one, and just to refresh your memory, remember what the lessee did in that problem. The lessee it's a problem we did earlier. Took the factor 3.79 times equal payments, 10,000 debit at least property 37, nine credit lease liability 37 nine.

That's what the lessee did now. Let's assume it's the same problem, but now we're on the less sore side. Same problem, but with a less, or it is a sales type lease, it is a sales type. And let's say the asset has a cost of the lesser of 30,000. So it's a sales type lease and the asset has a cost of less or of 30,000.

Let me show you the entries in a sales type lease. First of all, how many payments, how many payments will the less or collect here the less, or is going to collect? If you remember the facts. Five payments of 10,000 each in this problem. Again, if you the less or you're going to collect five payments of 10,000 each, so you're going to debit gross, lease receivable 50,000 notice in a sales type.

Lease your credit sales in this case, 37 nine. Notice I credit sales for the discounted present value of the payments 37 nine, or they might just give you the sales price. But the important thing is in a sales type lease you credit sales, and again, I'm crediting sales. For the discounted present value to payments in this case 37, nine, or they might just give me the sales price, but here I have the discounted present value the payments.

So I'll credit sales, 37 nine, and I credit discount for the rest 12,100. Now I said, let's assume the asset has a cost to the lesser of 30,000. Now the less, or makes another entry where they debit cost of goods sold 30,000 and credit the asset 30,000. Those are the entries that you make. In a sales type lease.

Now with those entries in mind, what could the FAR CPA Exam ask you? the FAR CPA Exam could ask in a sales type lease. What is the profit on sale? What is the profit on sale? If you look at the entries it's obvious, take the sales 37 nine minus the cost of good sold 30,000. The profit on sale is 7,900. They could ask you that that's the profit on sale.

Take the sales 37 nine minus the cost of goods sold 30,000 profit on sale. Is 7,900. Now, once you get the profit on sale, there's only one thing remaining they could ask you. And that is how much interest income, the less, or the less, or would record see now with the less, or does is take that discount of 12,100 and amortize it to interest income over the term of the lease.

Again. Now the less store is going to take that discount while thousand 100 and amortize it. The interest income over the term of the lease. So let's go ahead a year. It's now December 31, what will the less or do well to work out the interest income? You have to get the balance in the net receivable. You always want to work on the net receivable.

So I'm going to take the gross receivable 50,000 minus the discount. 12 one, the net receivable is 37,900 times. The interest rate, 10% and the less or we'll debit discount, 3007 90. And credit interest income, 3007 90. Notice the less, or amortizes the discount to interest income over the term of the lease.

Now, bottom line, what you've just seen that is a sales type lease. When in a sales type lease, there's a profit on sale and they make some money on financing. Again, that's a sales factor lease where they make some, they make some profit on the sale in this case. The 7,900 and they make a little money on financing by amortizing the discount to interest income over the term of the lease.

Let's go to a problem. And FAR cpa review course let's go to question number one, peg and how it says peg leased equipment from how. July one of the current year for an eight year period equal payments under the lease are 600,000 and our due July, one of each year, the first payment was made July one of the current year.

So what is this? An annuity and advance. If the person, if the first payment is made right away, it's an annuity. Do an annuity in advance the rate of interest contemplated by pagan house, 10%. The cash selling price is 3 million, five 20. As I said before, sometimes the FAR CPA Example, just give you the selling price in this case, 3 million, five 20 and the cost of the equipment on house books, 2,000,008.

They'll notice the lease is appropriately recorded. As a sales type lease. the FAR CPA Exam will tell you when you get into the last store side, if it's a sales type lease, they'll tell you if it's a direct financing type lease. They'll tell you if a sales type lease, what is the amount of the profit on sale and what is the interest revenue that how would record the lesson would record?

For the current year ending December 31 while I'm not saying you have to do entries, but entries, I hope make it very clear. Let's do an entry here. What's the entry that, that, how would make, how is the less or it's we know it's a sales type lease. If you're, how, how many payments are you going to receive?

You're going to receive eight payments of 600,000 each. So you're going to debit gross, lease receivable 4,000,008. Again, you're going to collect. You're how the less, or you're going to collect eight payments of 600,000 each. So you're going to debit gross, lease receivable 4,000,008, and in a sales type lease you credit sales, they gave you the cash selling price 3 million, five 20.

And as I say, the important thing is in a sales type lease. You just credit sales, 3 million, five 20, and you would credit discount 1 million, two 80. Now what was the cost of the asset on house books? W 2,000,008. So they make a second entry where they debit cost of goods sold 2,000,008 and credit the asset 2,000,008.

Those are the entries you make in a sales type lease. Now let's answer the questions. First of all, they ask you, cause these, these are the two logical questions that flow out of this fact pattern. They ask you what's the profit on sale. Well, if you look at the entries, it's obvious, take your sales.

3,000,005, 20 minus your cost of goods sold 2,000,008 profit on sale, 720,000. So it's gotta be answer a or B. We've got the profit on sale. Now, as I say, now, all that's left is they make some money on financing by amortizing, the discount to interest income over the term of the lease. So that's what they want in the second column.

Just revenue. This is a little bit tricky here. Remember I said the key to working out the interest revenue on December 30, one of the first year. Is to work with the net receivable. That's always the key to interest income is where you have to work with the net receivables. So let's work it out. I'm going to take the gross receivable, 4,000,008.

Didn't the gross receivable start out at 4,000,008, but what's tricky is this is an annuity. Do an annuity in advance. The first $600,000 payment came in right away. It would all be principal. They'd be no interest because it's made the first day. So right away that would lower the gross receivable from 4 million, eight down to 4 million to back out the discount.

1 million, two 80, the net receivable is 2 million, nine, 20. It's a little tricky. So the net receivable you had to work with here, 2,000,009, 20, what's the interest rate. 10%, but be careful. It's only a half a year. The lease was signed July one. They want interest income, six months later, December 31. So don't use 10% to half a year.

Use 5% times, times 2 million, nine 20. You're going to debit the discount 146,000 and credit interest income, 146,000. And the answer is B. And as I keep saying, that's the key to a sales type lease. There's a profit on sale. Mm, they make some money on financing by amortizing, the discount to interest income over the term of the lease.

They make a profit on sale, and then there's a little money on financing, a little money on financing by amortizing, the discount to interest income. The term of the lease that is a sales type lease. We'll look at a direct financing type lease in our next class. See you then.

Welcome back in this far cpa review course, we're going to finish our discussion on the accounting for leases. And you remember when we left off in our last class, we were talking about the less or side, and we said, if in substance, the lease is a way to sell the property. Then you have two possibilities for the less, or there's a sales type lease perhaps.

And in our last class, we went through how you handle a sales type, lease the other possibility for the less, or is a direct financing type lease. And that's what we're going to look at in this far cpa review course. Let's look at a direct financing type lease. Now, once again, I want to go back to an illustrator problem.

Number one that we did earlier, we've now done a couple of times because you're used to the numbers. And I want to use that problem again. So let's go back to illustrate a problem. Number one, but now let's assume we're on the last or side, and this is for the less or a direct financing type lease. And as I said in our last class, one of the good things about the FAR CPA Exam is they'll say it.

When you get into the less source, the less or side, if it's a sales type lease, they say it. If it did rec financing type lease, they say it they'll spell that out. So they tell you now we're on the list or side, and it's a direct financing type lease. Now listen very carefully. There's one big thing to remember about a direct financing type lease in a direct financing type lease.

There will never be any gain or loss on the sale of the asset. Again, in a direct financing type lease, there will never be any gain or loss on the sale of the asset. That's not, that's not how they make money. They're a financing agent, a company that uses a direct financing type lease. They make all their money by amortizing, the discount to interest income over the term of the lease.

They're a financing agent. They never will be. They'll never be a gain or loss on the sale of the asset. So I'm telling you in illustrator problem, number one, if this had been a direct financing type lease, the asset would have had a cost of less or of 37,900. I'm telling you that if this had been. On the lesser side, a direct financing type lease.

The asset would have had a cost to the lessor of 37 nine. So when you take, when you take the sales price, the discounted present value, the payments 37 nine minus the cost of the asset, 37 nine. There's no gain or loss on sale. Let me show you the entry. What is the entry that we make in a direct financing type lease?

Well, if I'm the less, or I know I'm going to collect five payments of 10,000 each, I'm still going to debit gross lease receivable. Five payments times, 10,000, 50,000 notice though, in a direct financing type lease. I don't credit sales. I just credit the asset for its cost. And I'm assuming that's 37 nine, but notice I don't credit sales, it's not a sales type lease.

It's a direct financing type lease. So I just credit the asset for its cost. And I was assuming that was 37 nine and I credit discount, 12,100 a company like this. That uses a direct financing type lease. They make all their money by amortizing that $12,100 discount to interest income over the term of the lease.

And you know how to do that? Let's say a year goes by it's now December 31. How are you going to work out the interest income? Remember you work with the net receivable, I'm going to take the gross receivable 50,000 minus the discount 12 one, the balance and the net receivable is. 37, nine times the interest rate, 10%.

They're going to debit discount, 3,790 credit interest income, 3007 90. They're a financing agent. They make all their money on the financing. They make all their money by amortizing that discount to interest income over the term of the lease. That's a direct financing type lease. There's never a gain or loss on the sale of the asset.

They're a financing agent. So that's how they make their money by amortizing that discount. The interest income over the term of the lease. Let's look at question number one on August 1st at the current year current, lease the machine to a company for a six year period requiring payments of 10,000. At the beginning of each year, the machine costs 48,000, which has also the fair value on the lease date has an estimated life of eight years, no residual value, and they give us the implicit interest rate.

They give us all these factors at the bottom Kern. W who was the less or appropriately recorded this lease as notice a direct financing type exam tells you. They want to know the balance in the gross lease receivable. Let's think about the entry. If you're current, how many payments are you going to collect?

Six of 10,000 each. So you're going to debit gross, lease receivable 60,000 so that you already know the answer is, Hey, that's all they wanted. All they wanted was the balance in the gross lease receivable. And again, if I'm current the less, or I know I'm going to collect six payments of 10,000 each, I'm going to debit gross, lease receivable 60,000.

Now, what do I do? I just credit the asset. Don't credit sales. It's not a sales type lease. You just credit the asset for its costs. 48,000 and credit discount, 12,000. They're going to make all their money by amortizing, that discount to interest income over the term of the lease. They're a financing agent.

And by the way, all those interest factors are meaningless. They just want you to sit and examine, stare at them. You don't do anything with them. You just credit the asset for its cost, but you know, 48,000 credit discount, 12,000. And that's how they're going to make their money by amortizing, that discount to interest income over the term of the lease.

They're a financing agent. So there's never any gain or loss on the sale of the asset. And again, all of I wanted here was the gross lease receivable and that was easy. Right. And the answer was that there's one more thing we have to talk about before we leave the world of leases. And that is something I know you're going to like, and that is sale.

Lease back now, listen carefully in a sale. Lease back. A company sells an asset to somebody and then leases the same asset right back from the person they sold it to. That's a sale. Lease back a company, sells an asset, and then they lease the same asset right back from the person they sold it to sale.

Lease back. Let me give you an example. Let's say a company takes an asset that costs 80,000 and they sell it to somebody for a hundred thousand. All right. So a company takes an asset, the cost 80,000. They sell it to another company for a hundred thousand. And then they lease the same asset right back from the person.

They just sold it to sale. Lease back. Now, one thing that I think helps you as a student is to remember when you see sale, lease back. There's two distinct transactions, there's a sale, and then there's a lease. There's a sale. And then there's a lease. There's two separate transactions. So let's start with a sale.

We know that they're going to debit cash for what they collected here. A hundred thousand. We know they're going to credit the asset for its carrying value. 80,000. Now, obviously. There's a $20,000 gain indicated here. The question is, should I credit gain? Here's the point if by leasing the same asset back now, listen carefully.

If by leasing the same asset back from the person you just sold it to, the seller has retained a substantial economic interest in the property sold. If by leasing the same asset, back from the person, they just sold it to the seller has retained. A substantial economic interest in the property sold. Then they have to credit deferred gain credit, deferred gain 20,000.

You can't put the gain on your income statement if by leasing the same asset back, that they just, if you lease the same asset back from the person you sold a tip, if by leasing that asset back, the seller has retained a substantial economic interest in the property sold the game just cannot go to your income statement.

You're going to credit deferred gain. That is the main point. Now, you know what we're heading to. How do you know if the seller has retained a substantial economic interest in the property sold? How do you know? Well, here's the criteria first. If the term of the lease is a large percent of the remaining life of the asset.

Again, first, if the term of the lease is a large percent. Of the remaining life of the asset, they've retained a substantial economic interest in the property. So by the way, does it have to be equal to, or greater than 75%? No that's capital lease? No. All they said was a large percent. You have to use judgment.

There was no, again, that equal to, or greater than 75%. That's the criteria for capital lease here. You have to use judgment. In other words, arguably 60% is enough. Arguably have to use judgment. But if the term of the lease is a large percent of the remaining life of the asset, the seller has retained a substantial economic interest in the property sold or, or our old friend.

If the present value of the lease payments are equal to, or greater than 90% of the fair value of the asset. If the present value of lease payments are equal to, or greater than 90% of the fair value of the asset, the seller has retained a substantial economic interest in the property sold. So again, when the seller has retained a substantial economic interest in the property sold, you have to credit deferred gain.

Now what happens to that deferred gain? It gets amortized. It gets amortized against rent expense. If they now set up an operating lease, remember there's two possibilities by leasing. The asset back could be an operating lease, could be a capital lease. So what happens to that deferred game? It gets amortized against rent expense.

If the seller now sets up an operating lease in other words, every year, You're going to debit to for a game credit rent expense, debit, deferred game credit, rent, expense, debit, deferred gain credit rent expense. You amortize it against rent expense. If they set up an operating lease, you'll amortize that deferred gain against depreciation expense.

If they set up a capital lease. In other words, every year, you're going to debit deferred gain credit depreciation, expense, debit, deferred gain credit depreciation expense. If they set up a capital lease. So that's what happens. The amortized that deferred gain against rent expense. If they now set up an operating lease, amortize it against depreciation expense.

If they set up a capital lease, let's look at question number two in a sale leaseback transaction, the seller who becomes a lessee, retains the right to substantially all of the remaining useful life of the equipment sold. So they have retained a substantial economic interest. The profit on the sale would be deferred that's right.

And subsequently amortized by. The lessee when the lease is classified as a capital lease yes. Operating lease. Yes. The answer is D double. Yes. Because again, if it's classified as a capital lease, you'll amortize the deferred gain against depreciation expense. If it's classified as an operating lease, you'll amortize the deferred gain against rent expense.

I hope you see why this is. Yes. Under both. Let's go to question number three, the following information pertains to the sale and lease back of equipment by mega. Notice the sales price, 400,000 carrying them out 300,000. Let's think about the entry, always deal with the sale. First. Remember, there's a sale, then there's a lease.

There's two separate transactions. So what was the sale? Well, we know they would have debit and cash for the sales price. 400,000. They would credit the asset for its carrying value 300,000. Now we, we agree don't we, that there's a a hundred thousand dollars gain in this transaction. Now, you know what I'm going to ask?

What is always the issue in the CPA exam? When sale lease back comes up. You know, what's always the issue they're going to test you on. Should you defer that game? That's that's what the issue will be. If sale lease back comes up in the CPA exam, should they defer that gain? Will they should, right. There's a hundred thousand dollars gain here in the sale.

They should defer that game. If by leasing the asset back, they have retained a substantial economic interest in the property, salt. And how do you know that? How do you know if by leasing the asset back mega has retained a substantial economic interest in the property sold? Well, first. Is the term of the lease, a large percent of the remaining life of the asset?

Well, in this case, the term of the lease is one year remaining. Life of the asset is 25 years. No, the term of the lease is not a large percent of the remaining life of the asset. It's not what's. The other criteria is the present value of the lease payments equal to, or greater than 90% of the fair value of the asset.

Well, the present value of the lease payments they gave you that 36 nine over the fair value of the asset 400,000. That's less than 10%. No, they did not retain a substantial economic interest in the property sold. So the answer is a, that wouldn't be a deferred gain that entire gain of a hundred thousand can go to their income statement.

There is no deferred gain. You only defer the gain. If by leasing the asset back, they have retained a substantial economic interest in the property sold. I hope you see. That they did not retain a substantial economic interest in the property sold because the term of the lease is one year. The remaining life of the asset is 25 years.

That's not a large percent of the remaining life of the asset. And the present day, the lease payments is less than 10% of the fair value of the asset. Not equal to a greater than 90%. They did not retain a substantial economic interest in the property sold. So there is no deferred gain. The entire game can go to your income statement.

That's why the answer is a, let's do another one. Number four. Seven 31 of the current year park sold ed Lowe on airplane with an estimated remaining life of 10 years. And then at the same time they lease it right back. We have a sale and lease back. The sales price was 600,000 carrying value, the airplane a hundred thousand.

So let's deal with the sale. Remember, there's a sale, then there's a lease. What's the sale. We know they would have debited cash, 600,000. They'd credit the airplane for its carrying value 100,000. And we both agree. That there's a $500,000 gain indicated here was the issue with the CPA exam. When you see sale lease back, should they defer that gain?

They should. If by leasing the airplane back, they retain a substantial economic interest in the airplane they sold. So let's go through the criteria is the term of the lease. A large percent of the remaining life of the asset will determine the lease. Here is three years remaining. Life of the asset is 10 it's about 30%.

No, it's not a large percent of the remaining life of the asset. Or is the present value of the lease payments they gave you that one 95, 81 equal to, or greater than 90% of the fair value of the asset, which is 600,000. Now it's about 32%. No, they did not retain a substantial economic interest in the property sold, but this is a tricky problem.

What the FAR CPA Exam would call this. Now, listen, the FAR CPA Exam would call this is retaining more than a minor interest, but less than a major interest again, what they would call this. Is retaining more than a minor interest, but less than a major under C and the last problem, they only retained a minor interest less than 10%.

And since they retained less than a minor interest, we didn't defer any part of the game. So there was no different game. What they would call this is retaining more than a minor interest, but less than a major interest, here's the point. If an a sale lease back, you retain more than a minor interest, less than a major interest.

You have to defer the gain up to the present value of the lease payments. Again, if you retain more than a minor interest and less than a major interest by leasing the asset back, you have to defer the gain up to the present value, the lease payments. Now I know Bob I've lost the will to live. Don't feel that way.

the FAR CPA Exam does not hammer on this point, but since we've come this far in leases, we might as well look at it. Now, how do you know if it's more than a minor interest, less than a major interest will. Again, he's supposed to use judgment. There aren't any really numeric guidelines. But if you look at past exams, obviously they look at it.

If it's more than 10%, less than 90, that you're in that area. Again, if you just look at past exams and they do not, they do not hit this a lot, but if you retain, you know, more than 10%, less than 90%, then you're into this area. So let's do the entry again. When they make a sale, you know, they're going to debit cash for the selling price.

600,000. You know, they're going to credit the airplane for its carrying value a hundred thousand and notice I credit deferred gain for one 95 81. I only defer the gain up to the present value of lease payments. So I'm going to credit deferred gain one 95 81. That's why the answer is B because they want to know the balance and defer a gain.

If there is a deferred gain here. Up to the present value of the payments because they retained more than a minor interest, less than a major interest. So I'm going to credit the for game one 95, 81, and then the rest of the $500,000 gain three Oh nine, four 19 can just go to your income statement. So I'll just create a gain for the rest of the $500,000 gain, which is three Oh nine, four 19.

That can go right to your income statement. So when you retain more than a minor interest, less than a major interest, you only defer the game up to the present value, the payments. That's why the answer is B. That finishes our discussion on the accounting for leases. I'll look to see you in the next class, keep studying

welcome back in this far cpa review course. We're going to begin our discussion of accounting for pensions. And as you may know, there are two types of pension plans. There are defined contribution plans and there are defined benefit plans. We're going to begin. With defined contribution plans, what you will come to think of as the easy one in a defined contribution plan, all that is defined, all that is defined is what the company, the corporation is obligated to contribute to the plan each year.

That is all that is defined what the company is obligated to contribute to the plan each year. Let me give you an example. Let's say that a corporation has a defined contribution plan. And this year the corporation is required to make an $850,000 contribution to the plan. Well, if the corporation this year is required to make an $850,000 contribution to the plan, they're going to debit pension expense 850,000.

It really is that simple in a defined contribution plan. Your pension expense in any year is whatever the company is obligated to contribute that year. So if they're obligated to make an $850,000 contribution to the plan this year, then the corporation is going to debit pension expense, 850,000. Now, assuming they actually did turn $850,000 cash over to the trustee that administered the fund.

Then you would simply credit cash, 850,000. And we would call that an example of being fully funded. Now stay with me. Same example company has a defined contribution plan. This year, the company is obligated to make an $850,000 contribution to the plan. So we know they're going to debit pension expense, 850,000.

That's not going to change. In a defined contribution plan. Your pension expense in any year is whatever the corporation is required to contribute to the plan that year. But now let's assume they only turn $200,000 cash over to the trustee that administered to the fund. So obviously we're going to credit cash 200,000.

Well, of course, in this case they would be underfunded. So we would credit an underfunded pension liability, 650,000. Same example company has a defined contribution plan. This year, the company is obligated to make an $850,000 contribution to the plan. So we know they're going to debit pension expense, 850,000.

That's not going to change in the defined contribution plan. Your pension expense in any year is whatever the company is obligated to contribute to the plan that year. But now let's assume instead they turned. $950,000 cash over to the trustee that administered to the fund. So naturally we would credit cash 950,000.

In this case, we would say they are over. So what would we do? We do that a hundred thousand dollars debit to balance the entry out. We would debit a prepaid pension or an overfunded pension asset for a hundred thousand. Now please listen carefully. I want you to know. That this is pension accounting. In a nutshell, pension accounting boils down to this always first work out the expense, get that first, the expense and in a defined contribution plan.

That's easy. It's whatever the corporation is obligated to contribute that year. But my point is this. Once you have the expense, you're always back to three possibilities. Are they fully funded? Are they underfunded or are they overfunded? I want you to know that you can't get away from those three possibilities.

That's pension, accounting, figure out the expense and the defined contribution plan. That's pretty simple. What is the corporation obligated to contribute this year? But once you have the expense in any kind of, in any kind of plant, you have to deal with three possibilities. Are they fully funded? Are they underfunded or are they over-fund.

That's really pension accounting. And you know, what a defined contribution plan is. This is a 401k, it's what the overwhelming majority of us have. That's how a corporation would account for a 401k. Let me just say that the FAR CPA Exam does not test defined contribution plans very heavily at all. They barely mentioned defined contribution plans and you know why there's it's from an accounting standpoint.

Way too easy. Let's get to the main point. If the FAR CPA Exam is going to test you on pensions, what they're probably going to test you on is a defined benefit plan. Let's get into a defined benefit plan. Just remember that in a defined benefit plan, what is defined are the pension benefits that will be paid out at retirement?

That's what we mean by a defined benefit plan. Now, what is defined are the pension benefits that will be paid out at retirement. And here's the bottom line in a defined benefit plan. There are six elements that make up the pension expense for the year. Now in a defined benefit plan, there are six elements that make up the pension expense for the year, and you're going to have to know them.

Let's go over. The six elements that make up the pension expense for the year in a defined benefit plan element. Number one is service cost. Let me define it. Service cost is the discounted present value of all the pension benefits earned by your employees. This period service costs discounted, present value of all the pension benefits earned by your employees.

This period. And I want you to know that's always a plus always an addition to your pension expense for the year. You're going to see as we go through these six elements, some of them are pluses. Some of them are minuses and that's a big trouble spot in the FAR CPA Exam. So you want to remember that service costs is always a plus always on addition to your pension expense for the year now, number two, the second element is more difficult, but you will get used to it.

Number two is interest. On projected benefit obligation interest on PBO interest on projected benefit obligation. Let's talk about it. Here's what happens, what a corporation does with a defined benefit plan is they make a projection notice. This is called projected benefit obligation. The company does a projection and what they do is project out their total obligation for pension benefits into the future.

And this is a difficult calculation because they have to project out years of service, future salary levels, retirement ages. It's very complex, but that's what the company does. They project out their total obligation for pension benefits into the future. And what they've done is discount that obligation back to January one.

But now it's December 31 a year has passed and that obligation would have grown just a little bit because of the passage of time. Interest on PBO interest on projected benefit obligations. It's always a plus always an addition to your pension expense for the year. Third element is the actual return on plan assets.

Now we know what's going to happen every year. A corporation is going to turn the corporation is going to turn cash over to the trustee that administered the fund. Obviously the trustee. Makes investments. And the point is the better those investments do. That's good for the company that lowers the pension expense for the year.

So your actual return on plan assets is a minus, it lowers your pension expense for the year. Number four is amortization of prior service costs. Now just think for a minute, what do you think prior service cost is? But the name help? Well, prior service costs is the present value of all the pension benefits earned by your employees.

In years before we had a plan prior service cost, Hey, that's the present value of all the pension benefits earned by our employees in years before we had a plan prior service costs. And what we're going to do is amortize. Some of that prior service cost is one of our six elements. It's a plus. It's an addition to your pension expense for the year fifth element actuarial gain a loss.

Here's what happens. We bring in actuaries. And the point is that a corporation can have a gain, a loss because of actuary changes. People are living longer. People are retiring. Later. Company could have a gain or loss just because of actuarial changes. Now, you know, That you don't have to be an actuary to take the CPA exam.

That's obvious the FAR CPA Exam is going to have to give you this. But what you have to remember is that an actuarial gain is good for you. Lowers your pension expense for the year. And actuarial loss is bad for you, increases your expense for the year. And then finally, the sixth element is transition. Asset transition, transition obligation.

That's your sixth element, transition, asset transition obligation. Here's what's going on. When you begin a defined benefit plan, when the corporation starts their defined benefit plan. If the year they start that plan, they are initially overfunded. If they start the plan and they're initially overfunded, they have what you would call a transition asset.

A transition asset is good for you. Lowers your expense for the year, but if they're initially underfunded, when they start to plan it, if they're initially underfunded, we would call that a transition obligation. That's bad for you that increases your pension expense for the year. And those are the six elements.

And I know this is obvious, but I always feel better. If I say it, you can't go in the FAR CPA Exam and not know those six elements. You can't begin to break down multiple choice. Handle any problem on defined benefit plans without knowing those six elements. So I'm going to give you a memory tool. It may seem silly, but it really works to remember the six elements.

Just remember, sir, Pat S I R P a T, sir. Pat, if you know, sir, Pat, you've got all six elements, let's go over it. You know what asset is? Service costs and you know what that is. Hey, that's the present value of all the pension benefits earned by my employees, this period, this period, always a plus always an addition to the pension expense for the year.

I is the hard one interest on PBO interest on projected benefit obligation. Let's go over it again. What happened here? The company did a projection. They projected out their total obligation for pension benefits into the future. Then they discounted that obligation back to January one. But now it's December 31 a year has passed.

So that obligation has grown just a bit because of the passage of time. What happens is that obligation gets bigger and bigger and bigger. As people get closer and closer and closer to retirement, always a plus always an addition to your pension expense for the year. The R is the return on plan assets.

Every year you turn cash over to the trustee that administers the fund. They make investments. Better those investments. Do the return on plan assets is a minus lowers your expense for the year. The P is prior service cost amortization. You know what prior service cost is? Hey, that's the present value of all the pension benefits earned by my employees in years before I had a plan prior service costs.

We're going to advertise some of that prior service costs is one of our six elements. It's a plus it's an addition to your pension expense for the year a is actuarial gain a loss. You bring an actuaries, you can have a gain, a loss because of actuarial changes. And you have to remember that if you've had an actuary loss, it's bad for you, increase your expense for the year.

And actuarial gain is good for you low as your expense for the year. And then finally transition asset transition obligation. The year, the corporation starts a defined benefit plan. When they begin the plan. If they're initially overfunded, they have what we would call a transition asset. A transition asset is good for you, lowers your expense for the year, but if they're initially underfunded, they would have a transition obligation.

I transition obligation is not good for you. That increases your expense for the year. My point is. If you know, sir, Pat, and I know you will, you've got the six elements and as you're going to see, once you get the six elements down that is more than half the battle, you get those six elements down, you're ready to attack problems.

And in our next class, we'll attack a problem together. I'll see you then

welcome back in this far cpa review course. We're going to continue our discussion on the accounting for pensions, and we're going to get back. To define benefit plans. And now that we know, sir, Pat, I know you're dying to try it out. So let's do a problem on a defined benefit plan. If you look in your viewers guide, you see, you'll see the illustrator problem.

We're told that the company started the plan January one year one, and then on December 31 year one, they made a million dollar contribution to the plan. They turn a million dollars cash over to the trustee. That administers the fund. Then we're told that the unrecognized or the unamortized prior service costs, you know, what prior service cost is?

That's the present value of all the pension benefits earned by our employees in years before we had a plan prior service cost, and notice as of January one year one that totaled 480,000. And we have a note of where that came from. If you read that note, you'll notice that. Eventually we expect to pay those people in the future, $2 million worth of benefits.

And the way we got the 480,000, we looked at the average remaining service period for those employees 12 years. And we talk, present value of a dollar for 12 periods because that's the average remaining service period for those employees at a 10% discount rate or settlement rate, the factor was 0.2, four.

We took that factor 0.2, four times the $2 million worth of benefits. We're going to pay these people. And that came out to four and 80,000. And I just want to quickly show you this. What's the entry for that? Well, for that prior service cost, January 1st year one, we debited OCI other comprehensive income, 480,000.

And we credited as of January one, an underfunded pension liability for 480,000. That's the first entry that we made debit OCI Ford, an 80,000 credit underfunded pension liability, 480,000. And we're also told in the information that the year one service cost was 400,000. Now you'll notice that we've listed, sir.

Pat, think where we are in terms of dates. It's December 31 year one. That's where we are right now, December 31 year one, we have to figure out the pension expense for the year. Well, I think, you know, my point, anytime my students have to work out the pension expense for the year in the defined benefit plan, they're thinking S I R P a T let's fill it in the S the service cost present value of all the pension benefits earned by your employees.

This period, that's 400,000. They gave us that I is the hard one. Interest on PBL. Now don't get lost on this point. Listen carefully. The day a company starts a plan. What is their only obligation for benefits prior service costs. I want you to see that when a company starts a plant, the day they start a plant, their only obligation for benefits is prior service costs because nobody's earned anything else.

So I want it to make sense to you that the day a company starts to plan the day, a company starts to plan prior service costs and projected benefit obligation. Pardon me are one in the same, did the same thing. So think of what happened here. This company did a projection. They projected out their total obligation for pension benefits into the future.

They expect they're going to pay these people $2 million worth of benefits into the future. What they did is discount that obligation back to January one year one came out to Ford and 80,000, but now we're at December 31 year, one a year's past. So using the discount rate that obligation would have grown 10%, times four to 80,000.

That obligation would have grown 48,000, just because a year goes by interest on PBL, always a plus always in addition to your pension expense for the year. So we'll add that 48,000. The R is the return on plan assets. We turn a million dollars cash over to the trustee that administers the fund, but that was on December 31.

It hasn't earned anything yet. So right now that's zero, no return on plan assets. The P is prior service cost amortization. What we're going to do straight line. Is take that 480,000 of prior service costs divided by 12 straight line years. The average remaining service period for these employees that are involved, straight-line calculation for an 80,000 divided by 12 straight line years and had another 40,000 as one of our six elements.

It's a plus it's an addition to your pension expense for the year a is actuarial gain a loss. They don't have any apparently. T is transition, asset transition obligation. They don't have any, and you have to start getting used to this in the FAR CPA Exam. Not all six elements will necessarily be there. You have to deal with what they, what they provide, what they give you.

And as I say, not all six elements necessarily will have to be there, but you have to know the six elements to look for. My point is, though, if you add it up, if you add up surpass, it all adds up to 488,000 at year end, this company has got a debit pension expense, 488,000. That's what surpass does for you.

It gives you the pension expense for the year in a defined benefit plan. Now we know they're going to credit cash a million, cause that was the funding and notice they're overfunded. So what do you do? Well, when I recorded the prior service cost didn't I set up an underfunded pension liability of 480,000.

Well, now I funded that. So I'm going to debit underfunded, pension liability, 480,000. I still need a debit of 32,000 to balance the entry out because they're still overfunded. And that would be a debit to overfunded pension asset. Basically the same idea as a prepaid pension debit overfunded pension asset 32,000.

That's the entry that we would make in this case, in your, in your won, they were overfunded. Let's go ahead. Another year, a year goes by it's now December 31 year two, and we're told that. The company funded another $475,800 to the trustee, December 31 year to their year two service costs 425,000. And we're also told that pension assets are earning 10%.

We're just going to assume that pension assets are earning 10%. So you know where we are CRN. It's now December 31 year two. We have to figure out the pension expense for the year. So we think S I R P a T or Pat, but before we do that, there's something we have to calculate first. Let's work out the balance and projected benefit obligation.

We know that back on January one year, one projected benefit obligations started at 480,000. Why because the day you start a plan, your only obligation for benefits is probably service cost nobody's earned anything else. So the day you started the plan January 1st year one prior service costs projected benefit obligation were the same thing.

So back on January one year, one projected benefit obligation was 480,000. Now just stop and think during year one, what increased that obligation? Well, first that obligation would have increased. By 48,000 because of interest on PBO, don't forget interest on PBO that 48,000 increased your obligation.

What else increased your obligation? Well, the year one service costs all the pension benefits earned by your employees in year one, 400,000. That increased your obligation. Now you've got to be careful if the company pays out any benefits. I'm assuming here there was none, but if they pay out any benefits, that would be a minus.

Why? Because they've met that obligation. They no longer have that obligation. So you backed that out, but we're assuming there were no benefits paid here. If you added up the balance in projected benefit obligation January 1st year to 928,000. 928,000. Now we can get to sir Pat, Hey, it's December 31, year two.

What's my pension expense for the year. Well, the S is service costs and we know the service cost for year two was given 425,000. Maybe I should ask you this. Does the FAR CPA Exam have to give you service costs or could they ask you to calculate it? They have to give it to you. That is a complicated number. It takes experts to come up, come up with that.

Actuaries. It's a very difficult number would have to be given in the FAR CPA Exam. So the S service costs. How about the, I, we know what the service cost is always a plus always an addition, your pension expense for the year. How about I interest on PBO? We'll think what happened here? This company did a projection didn't they.

They projected out their total obligation for pension benefits into the future. And what they did was discount that obligation back to January 1st year two came out to 928,000, but now a year has gone by a year's past where at December 31 year two. So that obligation would have grown 92,800, just because a year goes by.

Interest on PBO, always a plus always an addition to your pension expense for the year. The R is your return on plan assets at the end of year one, didn't we give a million dollars cash to the trustee. Wasn't that invested all through year two. And we're assuming it are in 10%. We're assuming pension assets earning 10%.

So that would be a minus 100,000. Hey, better those investments do that's good for the company lowers the pension expense for the year. Why didn't I worry about the 475,800 funding in year two. That's right, because it wasn't until the end of year two, it hasn't heard anything yet. The P is prior service cost amortization.

Hey, that's just straight line. Take the hundred and 80,000 prior service costs divide by 12 straight line years. Why 12? Because that's the average remaining service period for those employees. And we add another 40,000 plus. On addition, your pension expense for the year, actuarial gain a loss. We're assuming there's none transition asset transition obligation.

We're assuming there's none. If you add it up, the sir Pat adds up. To 457,800. So this company at year end is going to debit pension expense 457,800. Why? Because that's what surpass does for you. It gives you your pension expense for the year in a defined benefit plan. Now we know they're going to credit cash for the funding 475,800.

And once again, they are overfunded. So what do I do? I debit the overfunded pension asset 18,000. Notice what a defined benefit plan really comes down to, sir, Pat, do an entry, sir. Pat, do an entry, sir. Pat, do an entry. It's how you approach it. Let's do year three in year three, notice they funded another $300,000 cash to the trustee, December 31 year three.

We're also told that the year three service cost is 430,000. And we're still assuming that pension assets are earning 10% now, where are we? It's December 31 year three. We've got to work out the pension expense for the year. So we're going to think S I R P a T. But before we do that, let's work out the balance in the projected benefit obligation.

Let's go back a year. What was the balance and projected benefit obligation January 1st year three. 900 and January 1st, excuse me, year to 928,000. We work that out, right? The balance in PBO January 1st year two was 928,000. Now just stop and think during year two, what increased that obligation? Well, don't forget interest on PBO.

That obligation would grow by 92,800, just because a year passes. And also how about all the pension benefits earned by your employees in year two that would increase your obligation? So add the year to service costs of 425,000. And I want to point out again, if they pay out any benefits to employees, that's a minus because if the payout benefits they've met that obligation, they no longer have that obligation you back it out, but we're assuming there were no benefits paid.

If you added up the balance in PBO, January one year three, 1,445,800. Now I want to make a point that calculation where you work out PBO, anytime you're doing year to year information, you've got to work out the balance and PBO exactly the way we've been doing it. So I w I always make my students do that calculation a couple of times, because if the FAR CPA Exam wants to get nasty, Because of course they're known for that.

If they want to get nasty on pensions, they'll have you do year to year information. And anytime you're doing year to year information, you're going to have to work out the balance in PBO. So you make sure, you know, that schedule, how to work that out. Now, the good news is that that's pretty much all they can do with PBL.

That's pretty much all they can do. They can't ask you for the 425,000, the service cost that takes, that takes experts. All they can really do with PBO. Is make you work it out year, year to year. So just remember anytime you're doing year to year information on pensions, you've got to work out the balance in PBO each year by following that simple schedule.

But once we have that, now we can turn our attention to the main thing. What is the pension expense for the year? Hey, it's December 31. What's my pension expense in a defined benefit plan. S I R P a T. So we fill it in the S the service cost. They gave us that the service costs, the pension benefits earned by the employees in year three, 430,000.

That's a plus an addition to your pension expense for the year. How about the I, the interest on PBL, they did a projection. They projected out their total obligation for pension benefits into the future. And what they did is discount that obligation. Back to January one year three came out to 1 million, 445,800, but now it's December 31 years a year has passed.

Pardon me? So obligation would have grown by 144,580, just because a year goes by interest on PBO. It's a plus an addition to your pension expense for the year. The R is the return on plan assets. Let's work it out. Didn't we turn a million dollars cash over to the trustee at the end of year one wasn't that invested all through year two and are in 10%.

So that grew to 1,000,001. And then we gave the trustee another 475,800 at the end. The point is what was invested all three year three. Was 1,575,800 and it's earned 10%. So that's a minus one 57, five 80 better those investments. Do that lowers your pension expense for the year. Let me just go over that again.

We gave the trustee a million dollars cash at the end of year one. It was invested all through year two and earn in 10%. So it grew to 1,000,100 thousand and then we gave the trustee another 475,800. So what we had invested all through year three, Is 1,575,800 that are in 10%. So that's a minus one 57, five 80.

The P is prior service cost amortization. We simply take the prior service costs 480,000 divided by 12 straight line years. The average remaining service period for the employees. It's another 40,000 plus on addition to your pension expense for the year. And. You may have noticed that I don't keep saying that the prior service cost amortization is always a plus always in addition to pension expense for the year, I can't say always because there could be theoretically, some agreed upon reduction of benefits with the pension, with the.

With th with the union, with the retirees, there could be some agreed upon reduction of benefits. In that case, the amortization of prior service costs could be a minus it's possible, but I doubt you'd see that in the FAR CPA Exam prior service costs amortization, it's going to be a plus on addition, your pension expense for the year, the a is actuarial gain a loss.

There's none. Transition asset transition obligation. There's none. The added up, it adds up to 457,000. This company at year end is going to debit pension expense 457,000. As I keep saying, that's what surpass does for you. It gets you the pension expense for the year in a defined benefit plan. Now we know they're going to create a cash for the funding 300,000 and in year three, they are underfunded.

So, what do I do? Well, don't forget that. Back in year one, we set up an overfunded pension asset of 32,000. And then in year two, we added another 18,000 to the overfunded pageant asset. So don't, we now have on the balance sheet, an overfunded pension asset of 50,032 plus 18. Well, we're no longer overfunded if you're now.

Oh, we you're not underfunded. You've got to get rid of that overfunded pension assets. So I'm going to credit overfunded pension asset, 50,000 and credit, an underfunded pension liability, 107,000 notice, sir, Pat, do an entry, sir. Pat, do an entry, sir. Pat, do an entry it's defined benefit plan. And notice how we never get away from the idea of we get the expense and then we have to deal with, are we fully funded?

Are we underfunded? Are we overfunded? You never get away from that. But if you're always thinking, sir, a Pat do an entry, sir, Pat do an entry. You know, you're on the right track. Now in our next class, we're going to continue our discussion of a defined benefit plan. But I want you to do two questions before you start the class.

Do the first two questions before you start the class and then we'll do them together. I'll see you then

welcome back in our last class. I assigned two questions that I wanted you to have done before coming to FAR cpa review course. So we'll start with those questions in the first question they say the following information pertains to the year one activity for WRAL corporations, defined benefit plan. And at the bottom they ask, what is the pension cost?

What is the pension expense for the year? This is a classic type of question. the FAR CPA Exam would have on a defined benefit plan where they just give you a bunch of information and say, what is the expense for the year? Well, you know what I want my students to do. If you have to figure out the expense in the defined benefit plan, you're thinking S I R P a T.

So you fill it in, you go to your scrap paper, write it down, fill it in. The S is service costs. That's 300,000, always a plus always. In addition to a pension expense for the year, I is interest on PBO, 164,000 a plus on addition to your pension expense for the year, the R is the return on plan assets.

That's 80,000 and that's a minus. Remember the actual return on plan assets, the better those investments do. That's good for the company that lowers the expense for the year. That would be a minus. And maybe I should mention if they took a loss on plan assets, then it would be a plus that's bad for you.

The stock market plummets, and you take a loss on plan assets, then it would be a plus. But if it is a return on plan assets, that's good for the company. It lowers the expense for the year. Back that out the P is prior service cost amortization. Apparently they don't have any, as I've said, you have to deal with the elements they give you.

Apparently this company. Is not going to give credit to employees for years before they had a plan. There isn't any prior service cost amortization. As I say, that's something you have to get used to when you have to deal with the elements they give you. Yeah. Today's actuarial gain a loss here. There's an actuarial loss.

That's bad for you. It's a plus on addition to your expense and then transition asset transition obligation here, it's an obligation. So it's bad for you. The amortization of that obligation would be a plus. And increased your pension expense for the year. And if you add it all up, the pension expense for the year is answer B 484,000, as I've said, time.

And again, that's what sir Pat does for you. It'll get you your expense in any defined benefit plan. And the second question we're talking about, say the company and they want to know what would be the balance in projected benefit obligation December 31 year one. Let's do this calculation go back a year, January one year one, the projected benefit obligation was 72,000.

Now you just have to stop and think during year one, what would increase that obligation? Well, don't forget interest on PBO at a 10% discount rate that obligation would grow by 7,200, just because a year goes by. That increases your obligation. And don't forget all the pension benefits earned by your employees in your one, that 18,000, the service costs that increases your obligation for pension benefits.

And then as I've pointed out, if they pay out any benefits here, there's 15,000 of benefits paid that lowers your obligation. Why? Because you've met the obligation. You no longer have that obligation and you add it up the balance in PBO. At December 31 year one at the end of the year would be 82,200 answer D and as I mentioned in our last class, that calculation becomes particularly important.

Anytime you're doing year to year information, that's why it's important to understand that schedule. And as I pointed out also in our last class, the good news is that's pretty much all they can do with PBL. And in fact, I want to. Go over the six elements. Let's just think about the six elements in surpass the S service cost.

There's no idea. Exam could make you calculate that it has to be given. It takes experts to come up with that. So it'll have to give you that interest on PBL. You've now seen every way they can test that. As in question number two. That's pretty much all they can do with PBL. Let's talk about the, our return on plant assets.

Now you may remember that in the problem we did in our last class, I was assuming every year that plan assets were earning 10%. So it was pretty easy to work out the return on plan assets. Well, in the FAR CPA Exam, they might ask you to actually calculate the return on plan assets. So I want to show you how to do it.

It's not that bad when you see it. Well, let me show you what I mean in question number three, they say the following information pertains to galley company's defined benefit plan, and you see the kind of information we're given. We know the fair value plan assets at the beginning of the year, the fair value plan assets at the end of the year, the employer contributions and the benefits paid, and they say in computing, pension expense for the year, What would galley use as the actual return on plan assets than making you work it out?

I think it'll make sense to you when you see the calculation at December 31, the plan assets have a fair value of 525,000. A year ago, back on January one, plant assets had a fair value of 350,000. So the first thing you notice is that in the last year plan assets have increased by 175,000. And notice that the answer is C, but it's not that simple.

Just all we know right away is that in the last year, plant assets have increased by 175,000. Think for a minute, did all that increase occur in the stock market? Is that where we made all that increase? No, because the employer put in 110,000 notice the employer contributions. So we backed that out. So you backed out that you back out the employer contribution of 110,000, that brings you down to 65,000.

That's answer a, but that's not it either because they also paid our benefits of 85,000. Add back the benefits. The actual return on plan assets is 150,000. Answer B. Once in awhile, they'll make you actually work out the return on plan assets. And that's how it's done. You know, it's not going to all client assets earning 15%.

No, you look at the fair value plan assets at the end of the year, back out the fair value plan assets at the beginning of the year. Okay. They increased by this much. Then you back out employer contributions, add back benefits paid, and that'll give you the actual return on plan assets. Now let's go back to surpass.

So we've talked about service costs. What the good test there. It has to be given interest on PBL, what they could test their return on plan assets. We've now discussed how you calculate the return on plan assets. The prior service cost amortization, the P there's not much they can do with that. It's just a straight line calculation.

Over the average remaining service period for the employees. Let's talk about actuarial gain a loss know let's say a company has. You know, an $80,000, a hundred thousand dollar actuarial loss, do they just put in as their fifth element, a hundred thousand dollar actuarial loss? That's the fifth element?

No, but there's a minimum amount they have to take. Let me show you a problem where we have to amortize the actuarial gain and loss in number four McMurtrie company has a defined benefit plan. Okay. And we know several things. The first thing they give us is the accumulated benefit obligation. You want to put a line through that?

I want you to know that ABO accumulated benefit obligation is not used in anything. And the FAR CPA Exam puts that in a lot of problems just to make you stare at it. What do I do with that? It's not used for anything. Just put a lot, just scratch it out, laugh at it. It's not used in anything. So you never worry about the accumulated benefit obligation.

Now we also know the projected benefit obligation 600,000 circle that we know the fair value plan assets is 630,000, but the market related value plan assets is 650,000 circle that our actuarial loss is 80,000. And the average remaining service period for the employees is 10 years. They say at the bottom.

The amount of this actuarial loss that McMurtry has to include in their calculation of pension expense for the year would be what? Well, of course a lot of students would go, Oh, I think I see it. I'll take the actuary to loss of 80,000 divided by 10 straight line years. The average remaining service period for the employees that are involved, that are going to get benefits.

And you say, I'm looking at your answer D but it's not that simple. Here's how you do this calculation to do this amortization, to figure out the minimum actuarial gain or loss that you have to put in your six elements for pension expense, you have to look at two numbers. The two I add your circle. You look at the market-related value plan assets.

650,000 and also the projected benefit obligation of 600,000. Those are the two numbers. You look at the market related value plan assets and the projected benefit obligation. Now you might be thinking well, Bob, what's the difference between the fair value plan assets and the market related value plan assets?

Well, the fair value plan assets is as of December 31 as of a given date where the Mocket related value plan assets is a weighted average for the year. And, you know, don't get discouraged about that difference. The only time you worry about that difference between the fair value plan assets and the market related value plan assets is when you do this calculation for actuarial gain or loss, it's not used in anything else.

So you look at those two numbers, market-related value plan assets, 650,000 projected benefit obligation, 600,000 take 10% of whatever number's larger. Why 10% it's a rule. It's a threshold. So because the market related value plan assets is larger. I'll take 10% of 650,000 that comes out to 65,000. Notice the actuarial loss 80,000 is 15,000 higher than that threshold.

They're going to take that $15,000 difference divided by 10 straight line years. The average remaining service period for those employees, the minimum amount of actuary loss they have to take as their element of expense. Would be answer a 1500 that's pretty much all the FAR CPA Exam can get into with actuarial gain actuarial loss.

Let's get to the T transition asset transition obligation. What could they test there? Let's go to question number five. We'll go right to the numbers. Notice. Initially when they started the defined benefit plan, their projected benefit obligation 780,000, but the fair value plan assets on that date, 600,000.

So notice when they started the plan, their projected benefit obligation was underfunded by 180,000. So they started with an initial obligation, a transition obligation of 180,000. They go on to say, December 31 year seven, all amounts accrued as net periodic pension costs had been contributed to the plant.

The average remaining service period for the employees, the participants that will receive benefits is 10 years. Then they go on to say, well, some participants are going to work 20 years. Some are going to work 25. They do that all the time. That means nothing. All you ever care about in these problems is the average remaining service period for the employees.

Again, they'll go on and say, well, some people going to work 30 years, some people going to work 40 years, we don't care. What we're always looking at in these problems is the average remaining service period for the employees the 10 years, then they say in the last sentence to minimize, you might want to circle that word to minimize the accrual for pension expense for the year.

What is the transition obligation that would be amortized for the year? Well, of course the tempting thing is to go. I think I see it. Take the 180,000 divided by 10 straight line years. The average remaining service period for the employees involved that'll receive benefits and say how low date, but no, there's another rule.

And here's the rule when you're doing this amortization of transition asset transition obligation. If the average remaining service period for the employees is less than 15 years, if it's less than 15 years here, it's Ted. To minimize the hit on the income statement. They'll let you go up to 15. So I'll say it again.

When you do your amortization of transition asset transition obligation. If the average remaining service period for the employees is less than 15 years, if it's less than 15 here at stead, they'll let you go up to 15. So we're going to take that 180,000 divided by 15 straight line years. And the answer is safe.

That way, it minimizes the hit on the income statement and they said that's what they wanted to do. Minimize the accrual. So the answer is C what if the average remaining service period for the employees was 24 years? Well, you use 24 member. If the average remaining service period is less than 50, they'll let you go up to 15.

If it's less than 15, they'll let you go up to 15 and here again, that's pretty much all they can do with transition asset transition obligation. Now, when I see you in the next class, once again, there are two questions that I want you to have done before coming to that class. So get those first two questions done, and then we'll go through them together.

I'll see you then

welcome back in our last class. I assigned two questions that I wanted you to have done before coming to FAR cpa review course. So let's begin with those questions. In the first question we're talking about lock company lock company has a defined benefit pension plan. We know that anytime you see a defined benefit plan, the way you work out, the pension expense for the year is surpass.

So right away you go to your scrap paper list down S I R P a T, and you work it out. Now in this problem, they combined the service cost and the interest on PBO together. Add up to 620,000. Plus on addition to your expense, how about the, are the return on plan assets? Well, the funding was a million dollars cash to the trustee during the year or in 10%.

That's a minus a hundred thousand. It's good for you. Lowers your expense. Prior service cost amortization. They don't have any actuarial gain a loss. They don't have any transition asset transition obligation. They don't have any, when you add it up. It adds up to 520,000. So we know they're going to debit pension expense, 520,000, and we know the funding was a million, so we know they're going to credit cash a million.

They are overfunded. So they're going to debit an overfunded pension asset for 480,000. And that's what they're asking for the overfunded pension asset. So it's answer C 480,000. In number two, Cain company has a defined benefit plan. Let's work out the pension expense for the year. They sort of listed it for you.

The service cost 19,000 is a plus interest on PBO. 38,000 is a plus the return on plan assets. 22,000 is a minus the prior service cost amortization 52,000 is a plus. They don't have actuarial gain a loss. They don't have transition asset, transition obligation. Add that all up. You've got a debit pension expense for 87,000 and we know the employer contribution was 40,000.

So credit cash, 40,000, they are underfunded. So what do we do? You have to get that overfunded pension asset off the balance sheet. So credit the overfunded pension asset 2000 and set up an underfunded pension liability, 45,000. And that's what they wanted. The underfunded pension liability would be answer a 45,000.

Now there's something else you have to know about a defined benefit pension plan. And that is that when a corporation has. A defined benefit pension plan. They are required to report the funded status of that defined benefit plan. You are required to report the funded status of any defined benefit plan.

Let me show you how we have to do this. Let's say a corporation has a defined benefit pension plan. They get to December 31 and here's the situation they have projected benefit obligation 1 million, 200,000, but the fair value plan assets on that day, a million. So notice their projected benefit obligation is underfunded by 200,000 listen carefully because their projected benefit obligation is underfunded by 200,000.

They are required. To have a liability on the balance sheet for pensions of 200,000. Again, because their projected benefit obligation is underfunded by 200,000. They are required to have a liability on the balance sheet for pensions of 200,000. So at year end, they would have to debit OCI 200,000 and credit underfunded pension liability, 200,000.

You have to report the funded status of any defined benefit plan, same example. Let's say the company gets to December 31, their projected benefit obligation 1 million, 200,000 fair value plan assets on that day, a million. So once again, their projected benefit obligation is underfunded by 200,000. So we know that they are required to have a liability for pensions on the balance sheet of 200,000.

But let's say the FAR CPA Exam tells you that they already have. A liability for pensions on the balance sheet of 45,000. Well, then your job would be to adjust that from 45,000 up to 200,000. So you would have to debit OCI 155,000 credit underfunded pension liability, 155,000 to bring that liability from 45,000 on the balance sheet, up to 200,000.

Because you are required to report the funded status of any defined benefit plan, and they could ask you in the FAR CPA Exam, what additional liability must be recorded? What additional liability one in this case, one 55 same example we get to year end, December 31, projected benefit obligation 1 million, 200,000.

But let's say the fair value of plan assets is 1,500,000. Okay. So it's December 31. Projected benefit obligation 1 million, 200,000, but the fair value plan assets is 1,500,000 were overfunded by 300,000. If it ERN they're overfunded by 300,000, would I debit an overfunded pension asset? 300,000 and credit OCI 300,000?

Yes. Yes, because you are required. To report the funded status of any defined benefit plan, either overfunded or underfunded. Let's look at question number three, question number three, they say it December 31 year seven. The following information was provided by the current corporation for their defined benefit plan.

We know the at year end, December 31, their projected benefit obligation 5,000,007. The fair value plan assets. 3,000,004 50. What are you going to do with the ABO? The accumulated benefit obligation, laugh at it. It's ridiculous. It's not used in anything. And of course they want you to sit in the FAR CPA Exam and stare at it.

What do I do with that? Nothing it's not used in any calculation. Just scratch that out. But the point is at year end, December 31, isn't there PBO underfunded by 2 million, two 50. So they would have to debit OCI 2 million, two 50 and credit on underfunded. Pension liability for 2 million, two 50, answer a B, because they are required to report the funded status of any defined benefit plan.

Look at number four, Payne implemented a defined benefit plan for its employees January 2nd, year three. And here we are at December 31 year three. We know the PBO is 103,000 plan assets. Have a fair value of 78,000 on that day. Also during the year, the net periodic pension cost was 90,000 and the employer contributions 70,000.

And they say, what amount would Payne record as additional pension liability for the year? Well, when they booked their pension expense for the year don't we know that they debited pension expense for that 90,000. And of course, the way they got that 90,000 was looking at sir pack all six elements. So they gave that to you.

That's made up of all six elements in sir, Pat, but it's given. So we know they would have debited pension expense for 90,000. The employer contribution was 70. So they would credit cash 70,000. So one day, the first year underfunded by 20,000. So they would credit underfunded, pension liability, 20,000, but stop and think.

If they've recorded and underfunded pension liability of 20,000, what is the minimum liability they have to have for pensions on the balance sheet? Well, if the ERN, the PBO is 103,000, but the fair value plan assets is just 78,000. Their PBO is underfunded by 25,000. You have to report the funded status of any defined benefit plan.

So the minimum liability that have to have on the balance sheet is 25,000. Because their PBO is underfunded by 25,000, they are required to have a liability for pensions on the balance sheet of 25,000. Since they already have 20, they would debit OCI 5,000 and credit underfunded, pension liability, 5,000.

And the answer is B that is the additional liability that would have to be recorded because. Corporations are required to report the funded status, either overfunded or underfunded of any defined benefit plan. Let's talk about post retirement benefits, not pensions. Now. Post retirement benefits. Post retirement benefits refers to any defined benefit plan.

Again, post retirement benefits refers. Okay. Any defined benefit plan for fringe benefits? That's what we're talking about. Post retirement benefits refers to any defined benefit plan for fringe benefits. In other words, we all are retired employees, healthcare, dental care, fringe benefits. Now there are six elements that make up your post retirement benefits expense.

And I just want to show you it's still surpass. If, you know, sir, if you know, sir, Pat, you know, a lot and I'm going to show you, it just, it means basically the same thing. Because these six elements make up your post retirement benefits, expense, the SS service costs. You know what that is. Hey, that's the present value of post retirement benefits earned by your employees?

This period, always a plus always. In addition to your expense for the year, the, I is basically the same idea, but it's a mouthful. I now stands for. Interest on accumulated post-retirement benefit obligation interest on APRB Oh, interest on accumulated post-retirement benefit obligation. It's a mouthful.

Just think of it as interest on the obligation. Same idea. It's a plus on addition to your expense, every time the R's return on plant assets, same idea. Every year you turn cash over to the trustee. They make investments. The actual return on those plan assets is good for you. Lowers your expense. That's a minus.

The P prior service cost amortization. You already know what price service cost is. Hey, that's the present value of post retirement benefits earned by your employees in years before you had a plan, we're going to give credit for those years. And amortize. Some of that prior service costs is one of our six elements.

A plus on addition to your expense, a is still actuarial gain a loss. You can still have a gain or loss because of actuarial changes. And you know, if it's an actuarial gain, Hey, that's good for the company lowers the expense. It's minus actuarial loss is not good for the company. It's increases the expense.

It's a plus. And then finally transition asset transition obligation. Initially when they start the plan. If they are initially overfunded, they have what they call a transition asset. That's good for you. I transitioned asset lowers your expense. It's a minus, but if initially you're underfunded, when you start to plan, that's bad for you, that's a transition obligation increases your expense.

That would be a plus. So I just want to show you that if you know, sir, Pat, not only do you know the elements of the pension expense in a defined benefit plan, you also know the elements that make up your expense. In a post retirement benefit plan for fringe benefits. Now, listen carefully. Don't forget that, sir.

Pat just gives you the expense, but then you're with, with post retirement benefits, you're still back to the same concepts. Are they fully funded? Are they overfunded? Are they underfunded? In other words, you might want to put in your notes. Entries are all the same. I'm not going to make you do the entries, but the Andrews would be the same.

Because you're always back to those three possibilities. Are they underfunded? Are they overfunded? Are they fully funded? So sir, Pat gives you the entry and then overfunded underfunded, fully funded. It still comes down to sir, Pat, do an entry, another little picky thing. Remember in pensions. When we were amortizing transition, asset transition obligation, we said if the average remaining service period for the employees is less than 15 years, they'll let you go up to 15.

Well, here you go. Up to 20. the FAR CPA Exam likes that little picky difference when you're amortizing transition, asset transition obligation for post retirement benefit plans. If the average meaning service period for the employees is less than 20 years, less, less than 20. They'll let you go up to 20 years. So try to remember that little difference.

One more point a company has to report the funded status of any post retirement benefit plan. So if an ERN. They are AP RBO, their accumulated poster time and benefit obligation is 4 million, but the fair value plan assets is 2,000,006. Isn't there APR BPO underfunded by 1,000,004. So they'd have to debit OCI, a million, four, and credit underfunded poster time.

Instead of it liability 1,000,004, cause you have to report the funded status of any defined benefit plan, whether it's a pension plan or post retirement benefit plan. That applies as well. Keep studying. I'll look to see you in the next class.

Welcome back in this far cpa review course. We're going to continue our discussion of the type of problems that can come up in the FAR CPA Exam on recognizing revenues and expenses. And we're going to continue now with revenue. And as we said in our last class, Normally in accounting, normally the act of billing gives rise to the recognition of revenue and therefore profit.

That's what we're used to. Anytime, a company, debit accounts receivable, they credit sales. When you bill you've earned, it's very simple. You bill you've earned well. Now we're going to look at another odd approach. The installment sales method in the installment sales method. We're going to defer the recognition of revenue.

Until the installments come in until the payments come in. That's what we mean by the installment sales method, where you defer the recognition of profit, basically until the installments come in until the payments come in. Now, basically companies can use the installment sales method when collection of receivables.

Is not reasonably assured or indeterminate. That's when it's, that's when it's used, it's not used that often in practice, but you can use the installment sales method when collection of receivables is not reasonably assured or in determinant. Now, once again, this is another case where if you see the entries on the installment sales method, you'll understand that much better.

And I want to emphasize again, that. I'm not suggesting in any way that if you get a multiple choice on this, you got to lay out all these entries. You don't have time, but you'll see my point. When you see the entries, it makes a lot more sense. You're looking at a viewer's guide. You'll see a problem on the installment sales method.

Notice in year one, the company made a $10,000 installment sale. The customer agrees to pay in installments. Customer's going to pay a thousand dollars each year for the next 10 years, starting in year two, the merchandise cost the seller. $7,000. So what entries would we make in year one? Well, when they make the sale, they're going to debit year one accounts receivable, 10,000 and credit sales, 10,000.

Again, the first entry they make when they make the sale debit year, one accounts receivable and credit sales, 10,000. So the first thing you notice to use this method, a company has to keep track of receivables. By year I debit year one accounts receivables, 10,000 credit sales, 10,000, because to use this method, you have to keep track of receivables by year.

Now I'm going to assume that this company uses a perpetual inventory system. Not that they have to, but in a perpetual inventory system, it'll make more sense. Now we were told that the merchandise. The entertainment center, whatever it is, cost the seller 7,000. So in a perpetual inventory system, they'd make a second entry where they would debit cost of goods sold 7,000 and credit inventory.

7,000. Now there were no collections in year one. So let's go to our closing entry. What's our closing entry at the end of year one. Well we'll debit sales, 10,000, close it out. We'll credit cost of goods sold 7,000, close it out. And we credit. Deferred gross profit, 3000 credit deferred gross profit 3000.

That's a balance sheet account deferred gross profit. We're going to defer the recognition of profit until the installments come in until the payments come in. Now you had to notice this notice in year one, they made $3,000 gross profit on a $10,000 sale. Take 3000 over 10,000. The gross profit percentage for year one.

30% and you need that. All right. Now, listen carefully now learned a lot to use this method. There are two critical pieces to this puzzle. The two things you have to have to use the installment sales method. You've got to keep track of receivables by year, and you have to keep track of gross profit percentage by year.

Let me say that again. Do you use the gross profit method? There are two essential pieces you have to have. You've got to keep track of receivables by year and you have to keep track of gross profit percentage by year. Let's go to year two. And you're to the customer from year one makes the first thousand dollar payment.

So the company is going to debit cash, a thousand credit. What year? One accounts receivable. Let me keep track of receivables by year. So credit year one accounts receivable a thousand, and now that they've collected some cash, they can recognize some profit. I'm going to take the gross profit percentage from year one.

30% times the collection from the year one sale, a thousand, and I'm going to debit deferred gross profit 300 and credit realized gross profit 300. And that account realized gross profit. That goes to the income statement for year two. We recognize profit. When the installments come in now also in year two, the company made another $15,000 installment sale.

The customer agrees to make. Installments of $1,500 every year for 10 years, starting in year three, the merchandise cost the seller $10,000. Let's do some entries when they make that sale. When they make that sale, they're going to debit year two accounts receivable. I mean, you keep track of receivables by year.

So they're going to debit year two accounts receivable, 15,000 credit sales, 15,000. And if they use a perpetual inventory system, We were told that the merchandise cost the seller 10,000. So they'll debit cost, a good sold 10,000 and credit inventory. 10,000. Let's go to our closing entry. What's the closing entry at the end of year two.

Well, we're going to debit sales, 15,000, close it out. Credit cost of goods sold 10,000, closed it out and credit deferred gross profit 5,000. As I said before that account deferred gross profit is a balance sheet account stays on the balance sheet until the installments come in. Now you had to notice this in year two, they made $5,000 gross profit on a $15,000 sale.

So the gross profit percentage from year two is 33 and a third percent. So it turns out in year two, they made $5,000 gross profit on a $15,000 sale. So we know the gross profit percentage for year two is 33 and a third percent. And remember, those are the pieces of the puzzle. We have to have to use the installment sales method.

We have to keep track of receivables by year, and we have to keep track of gross profit percentage. By year, let's go to year three and year three. The customer from year one makes the second thousand dollar installment. So you know what to do, companies going to debit cash a thousand credit year, one accounts receivable.

A thousand because they keep track of receivables by year. And now that they have some cash, they can recognize some profit. They'll take the gross profit percentage from year one 30% times. The collection from the year one sale, a thousand they'll debit deferred gross profit 300 and credit realize gross profit 300.

And again, that account realized gross profit. That goes to the income statement for year two. Then it says the customer from year two makes the first $1,500. Installment. So the company is going to debit cash 1500 credit year to receivables, 1500. And now that they have some cash, they can recognize some profit take the gross profit percentage from year two 33 and a third percent times the collection from the year to sale 1500, we're going to debit deferred gross profit 500 and credit realized gross profit 500.

And again, that realize gross profit goes to the income statement for year three. These are the entries that are made in the installment sales method. Now, as I already said, I don't expect you to, in a multiple choice, go through all these entries. It takes too long. So I want to show you a couple of shortcuts.

There's a couple of things. the FAR CPA Exam likes to ask on this, listen carefully. Now the installment sales method does come up in your exam. What they love to ask is this. They'll ask you what is the realize? Watch out for these words. What is the realized gross profit on the income statement for given year.

Now, listen, if they want to know that if they want to know what is the realized Rose profit on the income statement for given year don't do entries takes too long. Just know the formula. Let me give it to you. Anytime you want to work out. Realize gross profit take profit percentage by year times, collections by year.

I'll give you that again. If you want to work out, realize gross profit, you don't do entries. Just do the formula. Take gross profit percentage by year times collections by year. So I'm saying if I were in this exam and they said, what's the realized gross profit for year three, I wouldn't do entries. I'd do the formula.

I would take the gross profit percentage from year one 30% times. The collection from the year one sale. A thousand. I know that's 300 of realized gross profit. I would take the gross profit percentage from year two 33 and a third percent times the collection from year, from the year to sale 1500. I know that's 500 realized gross profit.

What's the realized gross profit on the income statement, 300 plus 500, 800. All right. Now let's say several years go by. And here's what they have. Several years later, they have a balance in year one receivables. Of $3,000. Remember they keep track of this. They keep track of receivables by year. So several years later, they have a balance in your one receivables of 3000 and they have a balance in year two receivables of 6,000.

Now the second thing the FAR CPA Exam loves to ask in this method is what is the balance in deferred gross profit on the balance sheet at a given point in time. No, he listened carefully. They want to know the balance in deferred gross profit on the balance sheet, you don't do entries. Just know the formula.

Here's the formula. If you want to work out the balance in deferred gross profit take gross profit percentage by year times, outstanding receivables by year. One more time. Anytime you want to work out the balance and deferred gross profit. Takes take gross profit percentage by year times, outstanding receivables by year.

So if I were in this exam and they said, what's the balanced and deferred gross profit on the balance sheet, I would take the gross profit percentage from year one 30% times, times the balance and year one receivables right now. 3000. I know that's 900 of deferred gross profit. I would take the gross profit percentage from year two times the bounce that's 3303rd percent times the balance in year two receivables right now, which is 6,000.

I know that's 2000 of deferred gross profit. What's the balance and deferred gross profit 900 plus 2020 900. If you know those two formulas, you can answer anything. They come up with. On the installment sales method, let's do a couple of problems

in your viewers guide. Problem. Number one says on January 2nd, IR one Blake sold a used machine to Cooper for 900,000 resulting in a gain of 270,000. So right away, we know what, if you are Blake, you made $270,000 gross profit. On a $900,000 sale, take 270,000. Over 900,000. We know there's a 30% gross profit margin from that sale on that date, Cooper paid 150,000 cash and signed a $750,000 note bearing interest at 10%.

The note was payable in three annual installments of 250,000 beginning, January sec, second year two. Blake appropriately accounted for the sale. Under the installment method, you made a timely payment of the first installment of 325,000. And that included 75,000 of interest by the way, interest has no bearing on this, on any of the things, any of the formulas I've given you where anytime you see interest and there's usually interest in an installment contract like this.

If you see interest, that's just a debit to cash. That's a lot of interest, 75,000 and accredited interest income, 75,001 more time. If you see interest in an installment contract like this, which is typical, it doesn't really affect what we've talked about. Just debit cash, 75,000 credit interest income, 75,000 that's handled separately.

They say what amount of deferred you look to the word you're looking for? What amount of deferred gross profit. Would be on the December 31 year, two balance sheet. All right. Now here's what I want. I always want my students, if they have a problem like this, to start with a formula, how do I always get deferred gross profit it's gross profit percentage by year, I've got that.

It's 30% times outstanding receivables by year. See if you know the formula, you know the pieces you have to have to solve it. I need the gross profit percentage from the sale. I've got that. What you had to work on is the balance in the outstanding receivable. Now the receivables started out. At 900,000 now what's been collected.

They got $150,000 down payment and they also got the first installment of 250,000. So back out one 50 back out to 50 isn't the receivable down to 500,000. Now you can solve it. If I take the gross profit percentage from that sale, 30% times the balance and the outstanding receivable, 500,000, there is answer a 150,000, a deferred gross profit.

The formula always works. Gross profit percentage by year times, outstanding receivables by year. We'll always give you deferred gross profit. And as I say, don't let the interest factor ever messy up. That's just debit cash. 75,000 credit interest income, 75,000. Don't let that throw off your focus. Let's try question.

Number two on January 2nd of the current year Yardley. Sold a plant ivory for 1,000,005 on that date, the plants carrying them out. It was a million. So what do we know right away? We know if you Yardley, you made $500,000 gross profit, right. 500,000 gross profit on 1,000,005 sale. The gross profit percentage from that sale is 33 and a third percent.

We need that. Every gave Yardley a $300,000, 300,000 cash and a 1 million, $200,000 note payable. And for annual installments of 300,000 plus a 12% interest rate, I remade the first principal interest payment afforded. It's a lot of interest, four and 44,000. So there's 144,000 of interest in that. But again, the interest that's just debit cash, 144,000 credit interest income, 144,000.

It doesn't affect our analysis. Yardley uses the installment sales method in the current year income statement. What is realized gross product. Oh, what is realized gross profit. Well, as I said before, I like my students to start with a formula you're in the FAR CPA Exam, start with a formula because you've memorized it.

How do I always get realized gross profit it's gross profit percentage by year. Got that 33 and a third percent times collections by year gross profit percentage by year times collections by year. So if you know the formula, you know the pieces you have to have. So with the question, the question is, were there any collections.

In the current year, what were the collections in the current year? Well, we got the down payment in the current year, 300,000 and we also got the another 300,000 installment in the current. That was all that was by December 31 in the current year. So we got the, they got the down payment 300,000 in the first installment by December 31, 300,000.

Do we have, did we have 600,000 of collections this year? Take the gross profit percentage from that sale, 33 and a third percent times. The collections this year, 600,000. The answer is B this 200,000 of realized gross profit. Those two formulas are very powerful. Hey, if you want deferred gross profit it's gross profit percentage by year times, outstanding receivables by year.

Oh, you want realized gross profit it's gross profit percentage by year times, collections by year.

Now there's one more method I want to talk about as well. And that is the cost recovery method in the cost recovery method. We're going to defer the recognition of profit until we recover a hundred percent of our costs. That's what we mean by the cost recovery method, where we're going to defer the recognition of any profit until we recover a hundred percent of our cost.

Another way to put it. In the cost recovery method, we're going to defer the recognition of profit until all cash received. That's principal and interest, by the way, until all cash received equals cost of goods sold. Is that another way to put it? That's the cost recovery method, where we defer the recognition of profit until all cash received, principal and interest equal cost of goods sold.

We don't recognize any profit till we recover all of our costs. By the way, this is considered the most conservative method. There's no profit until we recover a hundred percent of our costs. Now, just a quick point, we can use the cost recovery method. It is acceptable when collection of receivables is doubtful.

It's when collection of receivables is doubtful, the transaction is highly speculative, some creative transaction we've never tried before in the company. That's when you might see it's very rare. But you can use the cost recovery method when collection of receivables is doubtful because the transaction is highly speculative in nature, some creative, new transaction.

Now I want to go right to a problem here. I'm not going to show you entries. I don't think entries would help very much here. Let's just go right to a problem. You look at the next problem. It says several of Fox's customers are having cashflow problems and they give us information for year one and year two.

Notice in year one, the sale was 10,000 cost of goods sold eight, and they collected seven of that. Then the next year they collected the final three of that and they made another $15,000 sale. Cost of goods sold is nine and they collected 12 and they say at the bottom, if the cost recovery method is used, what, what amount would Fox report as profit in year two?

They went on the profit for a year or two. Now, again, without doing entries, just look back in year one, just do this with me mentally. It looked back and you won. The sale was 10,000 cost of goods sold 8,000. They collected 7,000. How much profit would they have recognized in year one? None because the cash, they collected 7,000.

Hasn't covered their cost of goods. Sold eight. If that makes sense to you, there would have been no profit in year one because the cash they collected 7,000. Hasn't covered the cost of good sold yet eight. Now let's go to year two notice. Now they collect the other 3000 from that sale. So now they've collected all 10,000 from that sale that covers their cost of goods sold eight plus 2000.

In other words, recognize 2000 of profit from the year one sale in year two. One more time on that now that they've collected seven plus three, all 10,000, that covers their cost of goods sold eight plus two. They can recognize 2000 the profit from the year one sale. In year two that's that's really, that's all what's going on.

Once you recover your cost, every dollar you collect after that is profit. Look at year two, the sale is 15,000 cost of goods sold nine, but they collected 12. Well, if they've collected 12,000, that covers their cost of goods sold 9,000 plus three, they can recognize 3000 of profit from the year two sale, 2000 profit from the year one sale.

The answer is C they can recognize 5,000 profit. That's all what's going on there. You don't recognize any profit until you recover your cost to good soul. Once you cover your cost of goods, sold every dollar you collect after that is pure profit. That's the most conservative approach don't fall behind.

Keep studying. I'll look to see you in the next class. Welcome back in this far cpa review course. We're going to begin our discussion. Of an absolutely huge topic, a very important topic. And that is the income statement and the accounting issues that are raised when we prepare an income statement, when we report the results of operations.

And one thing we want to be clear about in these classes is exactly what belongs on the income statement and what does not belong on the income statement. And I'd like to begin with prior period adjustments. Now in accounting, when we treat an item as a prior period adjustment, we are doing exactly what the words tell us to do.

We are doing literally what the words tell us to do. We're going to go back and adjust the financial statements of some prior period. In other words, when we treat an item as a prior period, adjustment, what we're doing is going back to the financial statements of a prior period, and we're doing the statements over again.

We're going to restate. So remember that's what prior period adjustment means. It means we're going to restate now one item that qualifies to be treated as a prior period. Adjustment is errors. If a company has made errors of a material nature in prior statements, they are required to treat that as a prior period adjustment, they must go back to the financial statements of that prior period.

And do the statements over again. Now there's another point. As we said, when you treat an item's a prior period adjustment, you are going back to the financial statements of a prior period, doing the statements over again, but don't forget this. We always highlight what we've done. We highlight this idea that we've gone back and redone statements by showing the prior period adjustment as an adjustment to the opening balance of our retained earnings on the statement of retained earnings and.

The prior period adjustment is always net of tax. Remember, prior period adjustments are always reported on the statement of retained earnings and they are always reported net of tax. I think the only way to really understand exactly what I've just said is to see an example, let's do an example. Let's say that we're working on the financial statements for the year ended December 31 year nine.

And. As we're working on the financial statements for the year ended December 31 year nine. We discover that in the two previous years, year seven and year eight, we made errors in depreciation. What we've discovered is that for those two years, year seven and eight, we understated our depreciation by $5,000 each year.

And let's assume that this corporation has a 40% tax rate. So we know what has to be done here. When we discover. That we made errors in depreciation in year seven and year eight. We understand that our depreciation each year, while it's, we know an automatic prior period adjustment, if you made errors of a material nature in prior statements, we know that's an automatic prior period adjustments.

So the first thing we'd have to do is go back, redo the financial statements for year seven and year eight, put the correct amount of depreciation in. So let's say we've done that. All right. So we've gone back. We've redone the financial statements for year seven, year eight. We put the correct amount of depreciation in, well, here's what I want you to focus in on.

Now we're doing the statement of retained earnings for the year ended December 31 year nine. Here's what it's going to look like. We're going to start with beginning retained earnings as previously reported. So we're going to start with beginning retained earnings. Notice the wording as previously reported and we'll just make up a number.

Let's say that's 150,000. Now let me have you think about something as previously reported? Is that number correct? No, it's not. Because if in the two prior years we understated our depreciation 5,000 each year, a combined 10,000. We would have overstated our income for those years, 10,000 and therefore overstated.

Beginning retained earnings. That's the problem. If you understate your depreciation, you overstate income, you overstate beginning retained earnings. So now we're going to add this. We're going to say we have a prior period adjustment due to errors in depreciation. Notice less $4,000 taxes. This company has a 40% tax rate.

We say less $4,000 taxes. And we're going to show this as a $6,000 adjustment to beginning retained earnings. That now gives us what we need beginning retained earnings as adjusted notice beginning retained earnings as adjusted would be 144,000. Now, once you get down to that line, once you get down to beginning retained earnings as adjusted, now, it's just a normal statement of retained earnings.

You would add in the net income for the year back out, any dividends paid, and that would give you ending retained earnings. So. Here's how we handle a prior period adjustment. Yes, we go back. We redo the statements. We put the correct amount of depreciation in. Yes, but we always highlight what we've done by showing a prior period adjustment as an adjustment to the opening balance of retained earnings on the statement of retained earnings.

No, it's not the income statement. Notice the prior period adjustments, not on the income statement. No, it's an adjustment to the opening balance of retained earnings on the statement of retained earnings. And it's always net of tax. Now I want to say more about this idea that we show prior period adjustments on the statement of retained earnings, net of tax.

What we're forced to deal with here. Is in tra period tax allocation. I N T R a not to be confused with I N T E R intermediary tax allocation. So let me pause here for a moment and let's just talk about this issue. Remember on an income statement, getting back to the income statement for a moment we know on an income statement, the net income of a company gets broken down into three components.

Let's go over the components. What are the components, net income? Well, first there's net income from continuing operations. Then there's discontinued operations. We'll talk about that in another class. There's also extraordinary gains, extraordinary losses. Those are the three components to net income income from continuing operations, discontinued operations, extraordinary items.

And by the way, that is their proper order presentation. Sometimes the FAR CPA Example asks you that, and that is the proper order, continuing operations, discontinued operations, extraordinary items. And one way you can always remember that order is it is alphabetical, right? It's C D E C, continuing operations, deep discontinued operations, extraordinary items.

It's just an alphabetical presentation. Now, when the FAR CPA Exam talks about. I N T R a in tra period tax allocation, it refers to the idea that on an income statement, each of those three components to net income must be reported with their related tax effect, which is to say that each of those three components to net income must be reported net of tax.

So when you see in trough period tax allocation, it is referring to this idea that on an income statement, each of those three components, net income must be reported with their related tax effect. Each of those three components to net income must be reported net of tax. And the idea that we report prior period adjustments on the statement of retained earnings.

NetApp tax. That is another illustration of in Trump, within the period tax allocation. So it refers to that as well. Now I don't want to dwell on this, but just very quickly. So you see the difference. What would the FAR CPA Exam mean by I N T E R intermediary tax allocation? Well, if they mentioned intermediary tax allocation, that's all about setting up deferred tax assets and deferred tax liabilities.

Because there are differences between the net income accompany reports on their income statement and their taxable income on the tax return. That's why we need I N T E R intermediary tax allocation. And we'll get to that in other classes. In other words, what we're talking about now in these classes is I N T R a in trial period tax allocation.

Now, what I want to get into next is accounting changes. Let's get right into it. There are three types of accounting changes that you have to get sorted out for the FAR CPA Exam. First, there are changes in accounting principle. Second, there are changes in accounting estimates. And number three, there are changes in accounting entity.

That's how it breaks down. Changes in principal changes in estimate changes in entity. Let's begin with a change in accounting principle. Now, the first thing I want to cover on this is to define exactly what we mean by a change in accounting principle. Let's talk about this. We know that in terms of accounting, here's, what's supposed to happen.

What's supposed to happen in terms of accounting, is that a corporation is supposed to adopt a generally accepted accounting principle for certain types of transactions. And furthermore, they're supposed to apply that principle on a consistent basis. We know that's, what's supposed to happen. And why do we care about consistency?

Well, because of compatibility, you know, that ultimately financial reporting is infinitely more meaningful when we can compare one year's financial statements to obvious financial statements. And you can only do that in a meaningful way. If gap has been applied on a consistent basis. So one thing to keep in mind in this discussion is how essential in accounting it is to have consistency and compare ability.

Consistency and compare ability. So with that in mind, what do we mean by a change in accounting principle? While remember anytime a company changes from an old generally accepted accounting principle to our new generally accepted accounting principle for the same transactions for the same set of circumstances.

That is always how we would define a change in accounting principle. Let's say it again. If a company changes from an old generally accepted accounting principle to our new generally accepted accounting principle for the same transactions, for the same set of circumstances, that is always a change in accounting principle.

Let me ask you this one. We just asked you to think about this. Let's say I'm a company, I'm a corporation and I have always used. Generally unacceptable accounting principles. Okay. So I've always used generally unacceptable accounting principles. And by the way, very consistently, I'm very proud of that.

Now this year I've seen the light and this year I want to switch over to generally accepted accounting principles. You know what I'm going to ask you, is that a change in accounting principle? No, it's not. That is not a change in principle. What is that that's correcting an hour. The first thing we talked about, see, that's correcting an error.

If you go from an unacceptable accounting principle to an acceptable accounting principle, that is not a change in principle that is correcting an error, and we know how you handle correcting an error, automatic PPA, automatic prior period adjustment. You've got to go back, redo prior statements and put the total impact.

The cumulative effect on all prior periods caused by making that change. On your statement of retained earnings, net of tax. It's the first thing we went over in this far cpa review course. So always be careful of that difference when you go from an unacceptable principle to an acceptable principle, that is not a change in principle that is correcting an error automatic prior period adjustment.

Go back to the definition. What is a change in accounting principle? Anytime a company changes from an old generally accepted accounting principle to a new generally accepted accounting principle for the same transactions. That is a change in accounting principle. Let me give you some examples. Classic examples you look for in the FAR CPA Exam.

In terms of inventory pricing. If a company changed their method of pricing inventory from first in first out to last in first out or a life vote to fight Bo five vote, a weighted average, something like that. That is always a change in accounting principle. Let me say it again. If a company changes their method of pricing inventory from  to life, a life boat, a Five-O five boat, a weighted average, whatever, always a change in accounting.

Principal, the FAR CPA Exam loves that example. Another one, if a company would have changed their method of accounting for long-term contracts, say from percentage of completion to complete a contract or from the completed contract method to the percentage of completion method, that is always a change in accounting principle.

You see these a lot in the FAR CPA Exam, always be looking for those examples. That's a change in accounting principle. So let's get right down to it. How do we account for a change in accounting principle? When a company does change a principle, how is that accounted for? Just remember all changes in accounting, principal, all of them are treated as a prior period.

Adjustment, all changes in accounting principle. There are no exceptions. All of them are treated as a prior. Period adjustment. Let me give you an example. Let's say that a company began operations January one, year three, and let's say that all through the company's history, they have always used the completed contract method to record ignite income from long-term construction projects.

They've always consistently used the completed contract approach. Let's say on January 1st year nine. This company has decided to change their method of accounting for long-term contracts, from the completed contract method to the percentage of completion method. Of course, what I've just described is a change in accounting principle.

They went from an old generally accepted accounting principle, completed contract to a new generally accepted accounting principle, percentage of completion for the same transactions. We have a change in accounting principle. Let's say this company has a 30% tax rate. So, what are we going to do? Well, when we change that principle, we know that all changes in accounting principle must be, must be reported as a prior period adjustment.

We have to go back and redo statements. It's an automatic PPA, automatic prior period adjustment. We're going to have to go back and redo statements under the new approach under the new method. So let's do an analysis. We do an analysis and notice. For all of those prior periods for all those prior periods, year three, four, five, six, seven, eight, for all those prior periods income under the completed contract approach, the old method amounted to $600,000.

Well, then we ask a question. If the new method had been used, if the new method had been used, if we had used percentage of completion all those years, Income would have been, let's say 900,000. Well, I think, you know, it is that $300,000 difference that I'm after that is the cumulative effect. The total impact on all prior periods caused by making this change.

And again, let's assume that this company does have a 30% tax rate. All right. So how do we do this? Well, when they make this change in your night, We know all changes in accounting. Principle must be treated as a prior period adjustment. So we would go back and redo statements. We're going to go back and redo statements under the new method.

We'd go back and redo statements under the percentage of completion method, by the way, how, how far back do we go? Well, as far back as we're going to present statements, if we're going to show the last two years statements for comparison purposes, we would redo. The last two years, the last two years statements, we're going to show the last three years statements for comparison purposes.

We'd actually have to redo the last three years statements, but here's again, what I want you to focus on. Now we're doing the statement of retained earnings for the year ended December 31 year nine. Here's what's going to look like I know you're getting used to it. We're going to start with beginning retained earnings as previously reported.

Let's assume that's 400,000. I'm just making up a number. But let's say that beginning retained earnings as previously reported. And remember, as previously reported, it was the old method completed contract. So we have beginning retained earnings as previously reported 400,000. Now we add in what we have a prior period adjustment due to a change in accounting principle.

What was the total impact on all prior periods caused by making this change 300,000, but I take out 30% tax. Don't forget in tra period tax allocation, take out 30% tax or 90,000. And I'm going to show this as a $210,000 adjustment to opening retained earnings. So now I have what I need beginning retained earnings as adjusted 610,000.

Now, once you get down to that line beginning retained earnings as adjusted. Well, now it's just a normal statement of retained earnings. I would add in the net income for the year back out, any dividends paid, and that would give you ending retained earnings. So here again, that's how you handle a prior period adjustment.

Yes, you go back. You redo statements, but you always show the total impact on all prior periods. The cumulative effect on all prior periods caused by making this change as an adjustment to the opening balance of retained earnings on the statement of retained earnings. And it's always. Net of tax. One more point when you change an accounting principle, I don't care what it is.

You have to footnote the nature of the change. Exactly what you did and why it's justified. You have to put note the justification for the change. So don't forget that anytime you change a principle, you have to footnote the nature of the change. Exactly what you did and. The justification for the change.

Why are you doing this? Why are you doing this? Is there a new pronouncement you're supposed to apply gap on a consistent basis? So anytime you make a change like this, you have to put note the nature of the change and the justification for the change. We'll continue our discussion on exactly. What's on the income statement.

What's not on the income statement. When I see you in the next class, keep studying.

Welcome back in this far cpa review course, we're going to continue our discussion of accounting changes. And as you know, there are three types of accounting changes, changes in accounting. Principal changes in accounting, estimate changes in accounting entity in our last class. We spoke about a change in accounting principle, and we know that all changes in the County principle get reported as a prior period adjustment.

Anytime we see a change in principal, we're going to go back redo statements and put the total impact the cumulative effect on all prior periods on the statement of retained earnings, not the income statement, the statement of retained earnings net of tax. Now in this far cpa review course, I want to talk about a change in accounting estimate.

I want to make sure you see the difference. Remember that a typical set of financial statements is loaded with estimates. You know, that where do you find estimates in a typical set of financial statements? Walton, a lot of places don't we estimate our bad debts. Don't we with fixed assets? Don't we estimate the useful life of a fixed asset.

Don't we estimate salvage value don't we sometimes estimate. How much of a cost to allocate to this period? How much of a cost to defer don't we sometimes have to estimate liabilities like a contingent liability. My point is estimates are all over the financial statements and estimates are a normal unavoidable essential part of the accounting process.

There's nothing wrong with estimates, but here's the problem. Not only is it normal to make estimates it's normal for estimates to keep changing. As we gain more experience with something, as we gain more information about something, as we gain more insight into something it's normal for estimates to keep changing.

Let me give you an example of a change in accounting estimate. Let's say that a company buys a machine. And as we said, with fixed assets, we make a lot of estimates. We estimate the useful life. Let's say we estimate the useful life of this machine is five years. We also estimate salvage value. Let's say in this case, we estimate there is no salvage value.

And let's say we use straight line depreciation. Well, if we use straight line depreciation, you know, what's going to happen here. We're going to take that $10,000 machine, no salvage over five straight line years. And in year one, we're going to take $2,000 depreciation in year two. We're going to take $2,000 depreciation and now let's assume.

That at the beginning of year three, now that we have worked with the machine for a couple of years, we've gained more experience with the machine, more information about the machine. And we realize that our original estimate of use of life was wrong. We now estimate this machine still has six more years of useful life.

Notice what changing the estimate of life. This is a change in estimate. Let me have you think about something when we change an estimate like this, when we changed the estimate of life, should we go back and redo statements? Should we handle this as a prior period? Adjustment? No, never, never. And this is an important point.

Please remember a change in estimate. Never affects any prior period. It's impossible. No, the FAR CPA Exam wants to know, you know, that. That a change in estimate, never. The word is never affects any prior period. No, I changed an estimate only affects the current period and future periods. If they're involved, what they call prospective only, never retroactive.

That's the quick way to say it. I change an estimate is always prospective, only, never retroactive. You'll never touch prior periods, just the current period and future periods. If they're involved prospective only. So with that in mind, here's how you handle a change in estimate in year three, when we make that change, all we have to do is take the original cost of the machine 10,000 minus the accumulated depreciation on that machine 4,000, when we made the change, can we agree that the book value of the machine, the carrying value of the machine when we made the change 6,000.

We're going to take that book value 6,000 divided by six straight line remaining years of life. And what we'll simply do is take $1,000 of depreciation every year for the last six years. That is a change in estimate prospective only, never retroactive. Notice it affects the current period and future periods here.

And notice that this, this is on the income statement. Notice we are altering. The depreciation for this year and four years, three and four and five and six and seven and eight. We're altering the depreciation expense on the income statement. It does affect the income statement. It's prospective only. Let me ask you this.

Would you footnote a change in accounting estimate? Yes. Yes. That's assuming. It has a material effect on the statements. And I want you to listen to me carefully in the CPA exam, you always assume materiality in the CPA exam. You always assume materiality. I'll put it another way. The only time in that exam you'll ever treat something as immaterial is when they say this is immaterial.

I hope that's clear. Only time you'd ever treat something as immaterial in the CPA exam is if they state this is in material. If they're silent, You always assume it's your reality. So if they ask them in the FAR CPA Exam, would you footnote a change in estimate? Yes. Cause I have to assume it would have a material back on the statements.

Let's talk about a change in estimate effected by a change in principle. Now we're going to talk about a change in estimate effected by a change in principle. Let me just give you an example. Let's say for example, a company has a cost, a promotion costs. And historically what the company has always done with these promotion costs, they've deferred them and allocated these promotion costs for the different accounting periods they felt would benefit from the promotion costs.

Well, this year they've changed their mind this year. They've decided that these promotion costs don't really benefit future periods from now on this company is going to expense the promotion costs as they're incurred. Well, would that example in mind? What I just described in that example, isn't that a change in principal?

Because the old principal was deferral and allocation. The new principal is immediate recognition. It is a change in principal, but it's also a change in estimate because they used to estimate that this cost benefit several periods. Now they estimate it only benefits the current period. See, the point is it's really both.

It's really what they would call a change in estimate. Effected by a change in principals really bolt now listen carefully. If this comes up in the FAR CPA Exam, if you see a change in estimate effected by a change in principle, it is always treated, always treated as a change in estimate prospective only, never retroactive.

That's the rule. Anytime there is a change in estimate effected by a change in principal, it is always treated as a change in estimate. Prospective only, never retroactive. And since we're into this, I hope you're listening very carefully. There is one huge example of a change in estimate effected by a change in principle.

And that is a change in depreciation methods. Watch out for that. If a company changes their method of depreciation, Say from straight line to double declining balance or double declining balance to straight line or straight line to some of the year's digits or some of the years, digits to double declining balance, whatever.

Anytime a company changes, depreciation methods. What is that? That is a change in estimate effected by a change in principle. So it is always treated as a change in estimate. You've got to know that one, anytime, a company changes depreciation methods, that is a change in estimate effected by a change in principle.

So it is always treated as a change in estimate prospective only, never retroactive. Let's do a couple of questions. In your viewers guide, look at number one. Number one says when a company changes from the straight line method of depreciation for previously recorded assets to the double declining balance method of depreciation, how would, how would this be reported while again, if you go from straight line.

If you go from the straight line method to the double declining balance method, that is a change in depreciation methods. That is a change in estimate effected by a change in principle. It's always treated as a change in estimate. So we're going to show the cumulative effect from this change in accounting principle, the first column where we're going to are we going to report the cumulative effect from a change in accounting principle?

It's not a change in accounting principle. It is a change in estimate. How about the second call? Do we have to show. Pro form effects of retroactive application. It's not that there's nothing retroactive here. It's prospective only, never retroactive. So it's double no answer a look at number two, when a company changes the expected service life of an asset because of additional information, additional information has been obtained.

Well, if you change the expected service life, aren't you changing the estimate of life. It's a change in estimate. We know a change in estimate is prospective only, never retroactive. So are we going to show a pro form effects of retroactive application? No, nothing's retroactive. It's prospective only. Are we going to show the cumulative effect from a change in principle?

It's not a change in principle. It's a change in estimate double. No, again, answer D number three on January five. To better reflect the variable use of its only machine Holly elected to change its method of depreciation from the straight line method to the units of production method, Hollywood report, this accounting change in the financial statements is what you change in accounting.

If you change your depreciation methods, what is that? You change your depreciation methods. That's always treated as a change in estimate. And the answer is B. Now before you do the next class, I'm going, I'm going to assign five more questions. So you're going to see that for the next class. There are five questions that have to be done.

Get those five questions done before you start the class. Promise me, you'll do that. You want to get your answers to those five questions and then we'll do the questions together and I'll look to see you in the next class.

Welcome back. You remember that in our last class, I wanted you to do five questions before coming to FAR cpa review course. So let's start by going through those five questions in number one, they say on January one, year three, Pell purchased the machine for 700,000. Having an estimated useful life of 10 years. No salvage.

The machine was depreciated using double declining balance for both financial statement and income tax reporting. I know you understand, and these classes, we're not really looking at what a company is doing on their intake, on their income tax return on their income tax return. They're probably using makers or some method that Congress dreams up.

That's a different issue, but we'll get to what a company is doing on their tax return. In another class when we get into inter period tax allocation. But remember in these classes we're talking about in trough period tax allocation. So we're just looking at what we're doing within the period. We're looking at what we're doing in the financial statements.

Only it says on January one year six Pell changed from the double declining balance to the straight line method of depreciation. So we have it change in depreciation methods and they say they do this for both financial statement. And income tax reporting. But again, what they're doing on their income tax return is a different issue.

Accumulated depreciation at December 31 year five prior periods comes out to three 41 six. If the straight line method, if the new method had been used all those years, accumulated depreciation would have been 210,000. The amount shown at December 31 year six for accumulated depreciation was how much.

Well, of course the first question is this, is this a change in accounting principle or is it a change in accounting estimate? That's right. It's a change in estimate when you change depreciation methods, tactically, that is a change in estimate effected by a change in principle, but it is always treated as a change in estimate prospective only.

So here's how you solve this. The machine had an original cost of 700,000. Accumulated depreciation when we made the change was three 41 six. So that means that the book value of the machine, the carrying value of the machine when I made the change was 700,000 minus three 41 six, three 58, four. Remember with a change in estimate and a change in depreciation methods is always treated as a change in estimate.

And, you know, with a change in estimate, we ignore prior periods. It's prospective only. So all we have to do is take that. Book value of the machine. When we made the change three 58, four divided by its remaining life. W what is, what is, what is its remaining life? Well, the machine has an estimated life of 10 years, three years have already passed.

So aren't there seven more years of remaining life. I'll just take that book value. Three 58, four divided by seven straight line remaining years of life. And what they'll simply do is take $51,200 depreciation every year for the last seven years, prospective only, never retroactive. So I'll take $51,200 depreciation for year six.

Add that to the accumulated depreciation at the beginning of year six, three 41 six. So accumulated depreciation at the end of year six would be answer B. Three 92 eight and notice I don't care what accumulated depreciation would have been. If the new method straight line have been used all those years, that 210,000.

That means nothing. I ignore prior periods. It's prospective only, never retroactive. Number two. Milton began operations January one, year one, then on January one year to change their method of pricing inventory from last in first out to first in, first out, let me ask you, is this a change in estimate or change in principle?

That's right principle. Now we're changing a method with changing our method of pricing inventory. From life Oak to Five-O. It is a change in accounting principle. We know that all changes in accounting principle treated as a prior period adjustment. Let's go to the bottom. They say, what amount would Milton report as the cumulative effect from this change on their income statement?

Once you circle income statement, what's on the income statement, nothing. You're not going to fall for that. Right? The answer is a, there's nothing on the income statement. No, we're going to show the total impact on all prior periods. The cumulative effect on all prior periods on the statement of retained earnings, net of tax, not the income statement.

We go back and redo statements and show the total impact the cumulative effect on all prior periods on the statement of retained earnings, net of tax, not the income state, nothing's on the income statement. Number three, January 2nd year one union purchased the machine, but 264,000. The machine by the straight line method using a useful life of eight years with no salvage.

So let's work out the depreciation. They were originally taken. Originally. They go out by a machine for 264,000. Originally the estimate there is no salvage, right? Originally they estimate the useful life is eight years. So they would have started off by taking that 264,000. No salvage over eight straight line years.

Didn't they start off by taking $33,000 depreciation every year. And they would have taken $33,000 depreciation for year one, year two, year three. So in year four, when they make the changes. What would be accumulated depreciation 99,000. So what was the book value of the machine when they made the changes take the original costs 265,000 minus the accumulated depreciation, 99,000.

Can we agree that the book value of the machine when they made the changes 165,000? Well, what are the changes? Well, now they estimate the risks themselves. Now they change the estimate of life. You know what you're dealing with here. So change in estimate, and we know that what makes a change in estimate a lot easier is that when you change estimates, you ignore prior periods, it's prospective only, never retroactive.

You don't care about prior periods. All you had to worry about is this, the book value the machine when they made the changes 165,000. If I now think there is salvage, I just back it out. So back out that 24,000 salvage. So my new depreciable amount would be 165,000 minus 24,000 141,000. You know, under gap, you cannot depreciate below salvage.

You can not knowingly depreciate below salvage. So if you now think the salvage is just back it out. So my new depreciable amount is 141,000, but notice I also changed the estimate of life. What do I think the estimate of life is now six years. But did you notice from the date of acquisition, a lot of students miss that.

Now we think the useful life is six years from the date of acquisition and three years of already passed. So how many remaining years of life are there? Three with a change in estimate I ignore prior periods. I'll just take that new depression, depreciable amount, 141,000 over three straight line remaining years of life.

And what I'll simply do is take $47,000 depreciation every year for the last three years. So I'll take $47,000 depreciation for year four. Add that to the accumulated depreciation at the beginning of year four 99,000. So accumulated depreciation at the end of year four, answer D 146,000. And I hope you did well on that question because I'll tell you that that's about as difficult as a change in estimate is going to be in the FAR CPA Exam.

Will you change a couple of estimates like this and then make you do the calculations? If you understand number three, I think you're in very good shape on a change in estimate, let's do four and five in four and five. They say during the current year Orca company changed their inventory pricing method.

From first in first out to weighted average, you know, this is a change in accounting principle. When you change your method of pricing inventory from five, all the way to the average. It is a change in accounting principle. Now we know that all change is an accounting principle. There are no exceptions, all changes in the County principal have to be treated as a PPA.

A prior period adjustments let's go right down to number five. Number five says Orca would report the total impact of cumulative effect from this change as what you know what to answer a, gotta be a PPA, gotta be a prior period adjustment. Now in number four, they're asking you, what is that cumulative effect?

Now, you know what prior period adjustment means, it means we go back and redo statements and put the total impact on all prior periods. The cumulative effect on all prior periods on our statement of retained earnings, net of tax, and a number four, they're asking you, what is that cumulative effect? What is that total impact on all prior periods?

And I want you to dry this question, because I know that inventory changes bother people, and they're really not that bad. There's a little trick to these. And once you see it, I think you'll find these a lot easier. Just remember that when you make an inventory change, when you make an inventory change and you want to work out the cumulative effect, all you have to do is look at the change in inventory at the beginning of the period that you made the change.

I'll say it again. If you make an inventory change and you try it and you'll want it, and you want to calculate the total impact or the cumulative effect on all prior periods caused by making that change, all you have to do. Is looking at the change in inventory at the beginning of the period that you made the change.

So let's think about this problem. When did they make the change during the current year? So I'm going to look at what beginning inventory, January one. I'm gonna look at what beginning inventory. January one was under the old method. First in first out 71,000. Once you circle that number, now, if the new method weighted average had been used.

Beginning inventory would have been 77,000 circle that number. And if you think about it, that's $6,000 difference between 70 1070 7,000, that would reflect the total impact on all prior periods caused by making that change. I mean, just think about it for a minute. Doesn't the ending inventory at the end of the, of the previous year become the beginning inventory.

For the current year, right? Isn't that true? Isn't that the normal flow that the ending inventory from the previous year becomes the beginning inventory for the current year. And if you think about it, that's $6,000 difference between 70 1070 7,000, that would reflect the total impact on all prior periods caused by making this change.

But, you know, it's not answered D. Don't forget in Trump period tax allocation. So we're going to take out 30% tax that leaves 70% and that's answer safe, but I've got to ask the answer is C, but I want to ask you a question. Why would it be wrong to look at the $4,000 difference between 79,080 3000? And I'm asking you this because a lot of students do that.

Believe me, the person who wrote this question, they knew that a lot of students taking the CPA exam. What they would do is look at the $4,000 difference between 79,080 3000. And that's what answers a and B are about. So why is that wrong? Why does that not work? Why is it wrong to look at the $4,000 difference?

That's right, because that includes the current period. And I want the cumulative effect on the net income of. Prior periods. So that's why you can't look at the $4,000 difference, because that would include the current period. And I want the total impact on the net income of prior periods. That's what goes on my statement of retained earnings, net of tax.

So try to remember that about inventory changes, you make an inventory change and you want to work out cumulative effect. All you have to do is look at the change in inventory at the beginning of the period that you made the change. All right now, to this point, we've talked about a change in accounting principle.

We've talked about a change in accounting estimate, but remember there is a third type of accounting change and that is a change in accounting entity. Sometimes they call it a change in the reporting entity. Well, this is really not too bad. Just remember if you see a change in accounting entity in that exam, a change in entity is always treated.

As a prior period adjustment, I change an entity is always a change in accounting entity reflects on automatic prior period adjustment. Well, the change in entity, you have to go back and redo statements. Automatic PPA change, change in entity, automatic prior period adjustment. Let me give you what you're looking for.

There's a couple of exams. There's a couple of the FAR CPA Exam, really light. Let's say that a parent in a subsidiary company I've always issued separate financial statements. All right. Parent subsidiary company have always issued separate financial statements. This year. They'd like to start issuing consent.

Solidated financial statements. That is a change in entity, a change in the reporting entity, automatic PPA, automatic prior period adjustment. You've got to go back. And redo all prior statements as consolidated and you know, what a change network is all about compatibility. It's really about compatibility.

Here's the other one. They like, let's say a parent prepares consolidated statements with several subsidiaries. All right. So we have a parent company that prepares consolidated statements with several subsidiaries, but let's say that the parent has a sub that has always been excluded from the consolidated statements for whatever reason.

Parent has a sub that has always been excluded from the consolidated statements this year. They'd like to include the sub in the consolidated statements. That would be a change in entity. That's a change in the accounting entity. I change in the reporting entity, automatic prior period adjustment. You got to go back redo statements.

And put the sub in the consolidated statements. That's what you'd have to do. Automatic, prior period adjustment. You'd have to go back, redo all prior statements as consolidated with that sub included in the consolidated statements. As I said, what a change in entity is all about is compare ability. Let's do a couple of questions.

Number 6 cents. Which of the following statements is correct regarding an accounting change, that results in financial statements that are in effect the statements of a different reporting entity. Well, if it's a different entity, the answers date, the financial statements of all prior periods have to be restated.

It's an automatic PA number seven, Matt included a foreign subsidiary. And it's current year consolidated statements. The Saab was acquired six years ago and was excluded from previous consolidations. Notice we have a sub that was excluded from previous consolidations. Now the parent would like to include the sub in the consolidated statements.

That is a change in entity. The change was caused by the elimination of foreign exchange controls. Doesn't really matter why they're doing it. Including the sub in the consolidated statements, results in an accounting change that gets reported how answer D again by restating all prior years statements, because the change in entity is an automatic PPA on automatic, prior period adjustment.

Now, what I'd like you to do for the next class is a simulation on this topic. So you'll find it in your viewers guide, do the simulation before you come to the next class and in the next class, we'll go through it together. I'll see you then

welcome back in this far cpa review course. We're going to be doing the simulation on quot incorporated, and hopefully you've already done this simulation before coming to FAR cpa review course, you have your answers to all these questions. And now we'll go through this together. And in this simulation, we're given 10 transactions analyze and we have to pick our answers from list a and list B enlist day.

We have to decide for each case. Is it a change in accounting principle? Is it be a change in accounting estimate? Is it C correction of an error or is it D neither an accounting change nor on error correction. And then we also have to decide from list B what's the accounting treatment. Is it ex retrospective restatement, or is it Y.

Prospective only prospective approach. So let's go to the cases. Number one, they say quo manufacturers, heavy equipment to customer specifications on a contract basis on the basis that is preferable accounting for these long-term contracts was switched from the completed contract method to the percentage of completion method.

Well, you know, if you change your method of accounting for long-term contracts, from the completed contract method, To the percentage of completion method, that is a change in accounting principle. So it is a change in accounting principle and all changes in accounting. Principle are treated as a prior period adjustments.

So it would be for the next, for the next part of it. Let her ex retrospective restate it. You have to go back and redo statements. You know that number two, as a result of a production breakthrough. Quote determined that manufacturing equipment previously depreciated over 15 years would not be depreciated over 20 years.

Well, here you're changing the estimate of life. So it is be a change in estimate. And if it's a change in estimate, you know, that's prospective only, never retroactive. So it would be letter Y. That would be B. And why number three? The equipment that quo manufacturers is sold with a three-year warranty because of a production baked through a breakthrough quo reduced its computation and warranty costs from 3% of sales to 1% of sales.

So you used to estimate that 3% of your customers would want to refund. Now there's been a breakthrough. Now you think only 1% of your customers are going to want to refund. That is again, let her be a change in estimate and anytime it's a change in estimate prospective only let her why that's B and Y number four, quote, changed from last in first out to first in first out to account for finished goods, you go from Lightfair to Five-O you change your method of pricing inventory, you know, that's letter a.

That's a change in accounting principle. And if it's a change in accounting principle, it's X, you have to go back and redo statements, retrospective, reallocation, retrospective restatement. You have to go back and redo statements. So that's a and X. Number five quote changed from first in first out to weighted average for working process.

Well, if you go from Five-O to weighted average for work in process, you're changing the method of pricing inventory. Again, it's a change in accounting principle it's letter a and anytime you change, the principle, all changes in principle are an automatic prior period adjustment. So again, it's letter X retrospective restatement.

You have to go back and redo statements a and X again, number six, quotes sells extended service contracts on its products because related services are performed over several years in year three, quote changed from the cash method to the accrual method of accounting to recognize income from these service contracts.

Well, if you go from the cash basis to the grow basis, aren't you changing? From an unacceptable accounting principle to an acceptable accounting principle. And if you go from an unacceptable principle to an acceptable principle, that's not a change in principle that is letter C correction of an error.

And when you correct an error, automatic prior period adjustment, and again, it's letter X retrospective restatement. You got to go back and redo statements. So that's C and X number seven during year three, quote, determined that an insurance premium. Paid and entirely expensed in year two really covered the periods two and three, right to January 1st, year four.

So you expensed it all. What you should have done is set up prepaid insurance and allocate the expense over the periods of coverage. So again, it's letter C correction of an error corrected correcting an error, automatic prior period, adjustment, retrospective restatement again. So once again, number seven C.

And X number eight, quote, change their method of depreciating office equipment from an accelerated method to straight line. You change a method of depreciation. You know what that is? That's a change in estimate effected by a change in principle, always treated as letter B. I changed an estimate and we changed an estimate also letter Y prospective only, never retroactive.

So that would be let her be and why. Number nine quo instituted a pension plan for all employees in year three, they adopted all the current pronouncements in accounting for pensions. They had never had a pension plan before. Is this a change in principle? No, we're not going from an old gap to a new gap for the same transactions.

We never had a pension plan before. Now what we're doing here is adopting a new principal because our circumstances have changed. We're just adopting. A generally accepted accounting principle to account for our pension plan, which started this year. So that's not a change in principle. It's not a change in estimate.

It's certainly not correcting an error. It is letter D neither. It's neither an accounting change or correction of an error. And of course it would be prospective only. You wouldn't touch prior periods. It would be letter wide, D and Y prospective only just going forward. And then finally, number 10 during year three.

Quo increased their investment in worth from a 10% interest that was purchased in year two to a 30% interest. And also they got a seat on warts board of directors. So think what's happened here before they used to own less than 20% of worth stock. They did not have significant influence. They'd be under the cost method.

And they say, as a result of this increased investment, they changed their method of accounting. For this investment from the cost method to the equity method. So before when qual on 10% of worth, they did not have significant influence over worth, they'd be under the cost method to account for that investment.

Well, now they've gone up to 30%. They're on the board of directors of the, of the subsidiary. Now there's evidence of significant influence. So they switched over to the equity method. Is that a change in accounting principle? It's not. No, it's not remit. What is a change in principle? When you go from an old generally accepted accounting principle to a new generally accepted accounting principle for the same transactions, the same set of circumstances here, the circumstances have changed before they did not have significant influence over the subsidiary.

Now they do. They're adopting a new principle to react to new circumstances. That is not what we mean by a change in accounting principle. When you adopt a new principal. To react to new circumstances. It's not letter a, it's not a change in principle. It's not let her be. It's not a change in estimate.

It's certainly not see correcting an error. It is neither. It is letter D. Again, it is neither. And you may remember this is a step-by-step acquisition and you do have to retroactively apply the equity method all the way back to the first purchase of stock. So it is letter X retrospective. Restatement approach because in a step-by-step acquisition, when you do switch over to the equity method, you have to retroactively apply the equity method all the way back to the first purchase of stocks.

What would be D and X? I know you did well on that simulation. And I look to see when the next class keeps studying.

Welcome back in this far cpa review course. We're going to continue our discussion on income statement issues. And we know that on an income statement, a corporation's net income is divided into three components. We know there's net income from continuing operations. We know there's. Discontinued operations. And we know there's extraordinary items.

And we also know that's the proper order of presentation. It's alphabetical, it's C D E continuing operations, discontinued operations, extraordinary items. Let's talk about discontinued operations. First thing we have to get into. When do we use this part of the income statement called discontinued operations?

Well, we're going to use. Discontinued operations. When a corporation is selling off a clearly defined component of their business. That's when we use discontinued operations. When a corporation is selling off a clearly defined component of their business, they're selling off a subsidiary, a branch, a division that's selling off a whole product line.

It's a big deal. That's when we use discontinued operations. Now listen carefully. There are two things that go into discontinued operations. The first thing you put into discontinued operations is the results of operations for that component. In the period in which those operations occurred. Again, you have to put in discontinued operations, the results of operations for that component in the period in which those operations occurred.

And also what goes into discontinued operations is any gain or loss on the disposal of the assets. And he gained her loss from the disposal of the assets. Also goes into discontinued operations. Let me give you an example. Let's say on September 1st, 2011, a company enters into a formal plan to sell off their computer division.

Now they expect to complete the sale on April 1st, 2012. So they're not going to complete the sale to April 1st, 2012. So again, September 1st, 2011, they entered into a formal plan to sell off their computer division, but they don't expect to complete the sale until April 1st, 2012. Now a couple of things.

This computer division has consistently been generating operating losses of 10,000 every month. That's why we want to get rid of it also on the date of sale, April 1st, 2012, we're expecting a hundred thousand dollar, a hundred thousand dollar loss on the sale of assets. We're expecting a hundred thousand dollar loss on disposal, and let's assume that this company has a 30% tax rate.

Those are the facts we're dealing with. And now let's say we're doing an income statement for the year ended December 31st, 2011. You have to kind of picture it when we do our income statement for the year ended December 31st, 2011, just below income from continuing operations. We now put in another section to our income statement called discontinued operations.

So that's where it belongs just below income from continuing operations. We're now going to add another section to our income statement called discontinued operations. Now, what are we going to put in there? Well, we have to put in the results of operations for this component in the period in which those operations occurred.

So we know that in my example, this computer division has been generating operating losses of 10,000 every month. So what do you think we're going to do here? Are we going to take those operating losses of 10,000 a month times all 12 months of 2011 or just September, October, November, and December of 2011.

That's the question. We know the results of operations of this discontinued component has to be, we'll have to be put under discontinued operations now, but I'm going to take those 10,000 of operating losses. Every month times what all 12 months of 2011, or just September, October, November, December now it's all 12 months in the period in which those operations occurred.

And that's what you have to do. The results of operations of a discontinued component have to be put under discontinued operations in the period in which those operations occurred. So if you're with me, we're going to have to put 120,000 of operating losses in discontinued operations. Now let's talk about this.

What about the a hundred thousand dollar loss on disposal, the hundred thousand dollar loss on the sale of assets. I'd like you to think about something. When will that loss be realized? That's right. Not until April 1st, 2012, because that's the date of sale. So here's the question since that loss on disposal of assets of a hundred thousand.

Won't be realized until the date of sale. April 1st, 2012. Am I going to put that a hundred thousand dollar loss on disposal on the income statement in 2011 or 2012, and it's 2011. Why? Because when a loss is probable and you can reasonably estimate the amount, you must accrue the loss. When a loss is probable, as it certainly is here.

We've entered into a formal plan. We signed a purchase and sale agreement with the buyer when the loss is probable and we can reasonably estimate the amount we book it. We must accrue the loss. Always remember that you make shareholders and creditors and other interested parties aware of losses at the earliest possible point.

So even though that loss on a sale of assets, won't be realized until through till 2012, it's going to be reported on our income statement in 2011. So. Here's what our 2011 income statement would look like just below income from continuing operations. We now add discontinued operations and under discontinued operations.

We're going to have loss. From dispo loss from discontinued operations of our computer division, including that loss on disposal of assets. So what do we have under there? That's 10,000 of operating losses for all 12 months of 2011. That's 120,000 of operating losses. Plus the a hundred thousand dollar loss on disposal of assets.

In total, it's a $220,000 loss. It's a $220,000 loss from discontinued operations, but don't forget in tra period tax allocation, we're going to take out 30% tax, which is 66,000. So the net loss from discontinued operations would be 154,000. Don't forget in Trump period tax allocation. Each of the three components to net income must be reported with a related tax effect.

Now, let me ask you this. Well, maybe I should make you think about this for a moment. Does it bother you that I'm taking tax out of a loss? Well, don't let that bother you because the assumption in the FAR CPA Exam always is that if it's a gain, you have to pay tax on it. If it's a loss, it'll save you taxes.

That's the assumption in the FAR CPA Exam that if it's a game you're going to have to pay tax on it. If it's a loss. It's going to save you taxes. So just leave it in your mind, whether it's gain a loss, take tax out, but let me ask you something else. Now let's say we're doing our income statement for the year ended December 31, 2012.

My question is when we do our income statement for the year ended December 31, 2012. Well, that income statement have discontinued operations. It will. And all I'll put under discontinued operations in 2012 is the results of operations for that component for January, February, and March 10,000 of operating losses per month.

That's 30,000 of operating losses. Minus 9,000 taxes. 30% leaves me a net loss from discontinued operations in 2012 of 21,000. I have to put the results of operations. Have a discontinued component under discontinued operations in the period in which those operations occurred, always in the period in which those operations occurred.

So even in 2012, we are going to have discontinued operations and all we'll show are the results of operations for that component for January, February, March, net of tax in the period in which those operations occurred. Let me ask you this. Let's do the same problem. Same problem. September one, 2011 company enters into a formal plan to sell off their computer division.

The computer division has been consistently generating operating losses of 10,000 every month. Corporations tax rate, 30%. Everything is exactly the same, except one difference. Now let's say we're projecting a hundred thousand dollar gain from the sale of assets. What if we're projecting a hundred thousand dollar gain?

On disposal when we complete the sale on April 1st, 2012. Well, let's think about it. When we do our income statement for the year ended December 31st, 2011, we'll still have discontinued operations. And I should also mention that. Once a component is classified as held for sale, you have to set up discontinued operations and remember held for sale means sale is probable within 12 months.

They might try to get you on that point. Notice, even though the sale won't be till 2012. My in both of my examples in my 2011 income statement, I have discontinued operations because this component is now classified as held for sale. Meaning sale is probable within 12 months. Once that component is classified as held for sale sale is probable within 12 months.

You have to report discontinued operations, but getting back to my point, When we do our income statement for the year ended December 31st, 2011, just below income from continuing operations. We now add another section to our income statement called discontinued operations. Now what's going to be under discontinued operations, but notice this now under discontinued operations in 2011, all I have are the results of operations for this component.

10,000 of operating losses for all 12 months of 2011. That's 120,000 of operating losses in the period in which those operations occurred, less 30% tax, 36,000 leads me with a net loss of 84,000. All I have on are discontinued operations now in 2011, because this component is now classified as held for sale are the operating losses for all 12 months of 2011 in the period in which those operations occurred.

Why don't I include. The gain on the sale of assets, the gain on disposal, because I don't report gains until they realized. See, that's the difference when a loss is probable and you can reasonably estimate a loss from the sale of assets, you accrue losses, you don't accrue gains. Generally we don't recognize gains until they're realized if a loss is probable and you can reasonably estimate losses, you book them.

You make shareholders, creditors, other interested parties, aware of losses at the earliest possible point, but generally you don't recognize gains until they're realized. So notice now in 2011, I would have discontinued operations, but all I show are the results of operations for 2011, for that component in the period, when those operations occurred, net of tax.

And how about when I do my income statement for the year ended December 31, 2012. Well, we have discontinued operations on that income statement. Yeah. Yes. And now we're going to have a gain from discontinued operations. Won't I, because what I'll have under discontinued operations on my income statement in 2012 is the a hundred thousand dollars gain from the sale of assets.

That's now been realized. Plus I'd have to include the 10,000 of operating losses for January, February, and March in the period in which those operations occurred. So it's a net gain from discontinued operations of 70,000, but of course, net of tax, I take out 30% tax or 21,000 leads me up a net gain from discontinued operations of 49,000.

Don't forget in draw period tax allocation. I know you, won't always important that you're thinking of that as well. Let me ask you another question. Let's say that the same company. Is going to show their 2010 financial statements for comparison purposes. If they show their 2010 financial statements for comparison purposes.

Here's my question. Will their 2010 income statement have discontinued operations on it? Yes, it will. What I'm, if I'm going to show my 2010 income statement, I'm going to pull out the results of operations for that component for 2010 net of tax. And the pyramids was operations occurred under discontinued operations.

If I show 2009 financial statements for comparison purposes, I'm going to have to show the results of operations for that component for all 12 months of 2009 net of tax under discontinued operations. Why do we do this compare ability? Makes sense. If you think about it, when somebody sits down with my statements, they want to compare what operations that are going to continue with operations that are going to continue.

The component is gone. This computer division is no longer part of my business,

so I no longer get no people just not interested in it really. Somebody sits down with my statements. They want to compare operations that are going to continue with operations that are going to continue. The component is gone. It's all. It's about compatibility and it's really about the going concern concept.

So the statement you present for comparison purposes, we'll now pull out the results of operations for that component net of tax and show it under discontinued operations, allowing people to compare operations that are going to continue with operations that are going to continue. Now, before I see you in the next class, I want you to do for mobile choice.

They will be four multiple choice questions. I'd like you to get done on discontinued operations. Before you come to the next class, please get those questions done. And then I'll look to see you in the next class. Keep studying. Welcome back in our last class. I assigned four questions for you to get done before coming to FAR cpa review course.

And now let's go through them together. And number one, they say on February 2nd Flynn's board of directors voted to discontinue operations of their frozen food division and to sell the divisions assets in the open market as soon as possible. The division reported net operating losses of 20,000 in January 30,000 in February.

Then on February 26th, they sold all the assets and that resulted in a gain of 90,000. What amount of gain from disposal of a business component would Flint recognize on their income statement? For the three months ended March 31. Well, if you're doing an income statement for the three months ended March 31, you are going to have discontinued operations, the sales been completed.

And what are you going to have on a discontinued operations? You're going to have the 20,000 of operating losses for January the 30,000 of operating losses for February in the period in which those operations occurred. So you've got. 50,000 of operating losses. Plus you also have the $90,000 gain from the sale of assets it's been realized.

So it's a net gain from discontinued operations of 40,000 answer be. And of course it would be net of tax, but they didn't give us a tax rate. But of course you would be looking for that just in case number two on October 1st year three wand. Committed itself to a formal plan to sell off the cam division.

Juan estimated that the loss from disposal of the assets in February of Oh four. So they don't expect to complete the sale to February till February of Oh four. There'd be a loss from the disposal of assets of 25,001. Also estimated that the cam division would incur operating losses of a hundred thousand from January one through December 31 year three and 50,000 of operating losses.

From January one to February 28th year for these estimates were materially, correct disregarding income taxes, which will always, we're always happy to do. What would wand report as loss from discontinued operations in the year three income statement in the year four income statement? Well, when you do you, would you, when you do your year three income statement, would you have discontinued operations?

The sale's not going to be completed. Till February of Oh four. So again, when you do your year three income statement, would it have discontinued operations? It would because this component is now classified as held for sale sale is probable within 12 months. So we are going to have discontinued operations in the year three income statement, and what's going to be under discontinued operations.

Well, you're going to have the a hundred thousand of operating losses for year three in the period in which those operations occurred. Plus you'd also have the 25,000 of loss from the sale of assets. It's probable. You can estimate it you'd accrue it. So in your year three income statement under discontinued operations, you'd have 125,000 of losses, $125,000 loss from discontinued operations.

Now, when you do a year for income statement, you'd also have discontinued operations and all you'd show are the 50,000 of operating losses. For January and February in the period in which those operations occurred. So the answer is B and of course, all of this would be net of tax, but they said disregard taxes.

Now three and four are set December 30, one of the current year, the board of directors of Macs, committed to a plan to discontinue operations of its alpha division. The following year. Max estimated that alphas following year operating losses would be 500,000. The facilities would be sold for 300,000 less than the carrying amounts.

So they were expecting a $300,000 loss from the disposal of the assets. Alpha's current year operating loss was 1,000,004 before any consideration of an impairment loss, the effective tax rates, 30% in number three. They want to know what you'd have in the current year income statement. And once again, we know in the current year income statement, they would be discontinued operations because this component is now classified as held for sale sale is probable within 12 months.

What's going to be under discontinued operations. Well, you're going to have the 1,400,000 of operating losses for the current year in the period, which those operations occurred. Also the $300,000 loss from the sale of assets, even though it's not realized to the following year, it's, it's a loss it's probable, you can estimate it.

You have to accrue it. You provide for losses. So under discontinued operations in the current year, you'd have a $1,700,000 loss, but don't forget in Trop period tax allocation, we're going to take out 30% tax that leaves 70% of 1,000,007 answer a. Number four says the following year income statement, what would you have on a discontinued operations?

All you'd have are the results of operations. The following year, 500,000 operating loss net of tax take out 30% of that 30% tax. That leaves 70% answer a because that's the period in which those operations occurred. You know, once a component is classified as held for sale, the results of operations of that component will be reported under discontinued operations.

In the period in which those operations occurred. Well, now that we've talked about discontinued operations, let's talk about extraordinary items because we know these are the three components to net income, continuing operations, discontinued operations, extraordinary items, let's get into extraordinary items.

And of course the issue is when would we allow a corporation? To take a gain or a loss that's a gain or loss out of their continuing operations report it separately. So they can say to the world, this gain or loss is not normal for us. This gain or loss is an extraordinary event. When do we allow corporations to do that?

Well, let's start with the basic criteria. Cause you have to know it. Here's the basic criteria to be considered extraordinary. A gain or a loss that's a gain or loss must be both, must be both on usual and big and there. And infrequent the gain. A loss must be both unusual, which means very abnormal and infrequent, which means.

Not likely to happen again, considering the environment the entity operates within that's the criteria to be considered extraordinary. The gain of loss must be both, must be both on usual, which means very abnormal and infrequent, which means not likely to happen again, considering the environment, the end of the operates within I'd like you to think about something.

Let's say that we run a company. And one day the environmental protection agency, the EPA knocks on our front door, you know, it's good news. And they say, listen, we've discovered toxic waste on your property. We require you to clean it up. We estimate the cleanup costs are going to be $8 billion. My question to you is the $8 billion in cleanup costs.

Would that for our company being an extraordinary loss. They found toxic waste on our property. They required a weekly nut up. We estimate the cleanup costs are going to be $8 billion with a B with the $8 billion of cleanup costs. Be an extraordinary loss for us. It depends. Doesn't it? It depends. If we're a chemical company, listen very carefully.

If we're a chemical company. We deal with toxic waste all the time. That's a normal part of our environment. That is an ordinary loss, but if we make ice cream, we're working on a new and exciting flavor. If we make ice cream and toxic waste is unheard of in our industry, that's an extraordinary item. So you don't forget.

There's that environment constraint, the gain of loss must be both unusual and infrequent considering the geographic environment, considering the economic environment, the entity operates within. You know the criteria isn't, what's generally unusual. What's generally infrequent. No, the criteria is what's unusual for this company and infrequent for this company, considering the economic environment, the geographic environment, this company operates within.

So that's why I say we're a chemical company. We deal with toxic waste all the time. It's a normal part of our environment that cleanup costs would be just an ordinary loss. But we make ice cream. We've never dealt with toxic waste before. It's unheard of in our industry that billions, the billions in cleanup costs be an extraordinary loss.

So just don't forget. There is that environment constraint. Now there are some gains and losses that are in the FAR CPA Exam. These come up a lot and these are never extraordinary. Okay. So I'd like to just, I want you to just have them in your mind. So you don't waste time on them in the FAR CPA Exam. There are gains and losses that just in the FAR CPA Exam all the time, they never extraordinary.

Let's go over them. A loss due to an employee, strike a loss due to an employee strike. That's never extraordinary. Never. Now the one gains or losses gains or losses from changes in monetary exchange rates, never extraordinary, never gains or losses from fluctuations and monetary exchange rates. Never extraordinary.

Another one. Loss from abandoning assets, never extraordinary a loss from abandoning assets that would never be extraordinary. And one more a gain or a loss gain or loss from selling off a whole component of your business, like a subsidiary, a gain, or loss from selling off a whole component of your business.

Like a subsidiary. There's no way that could ever be extraordinary. And you know why there's another part of the income statement just for that. Discontinued operations. And I just think they kind of hope you forget that no, a gain a loss from selling off a whole component of your business. That can't be extraordinary because there's another part of the income statement just for that discontinued operations.

So these items, they never extraordinary don't waste time on them, you know, they just, they're not going to be yeah, extraordinary. Now there are, there, there are some items that, that they would want you to assume are extraordinary. All right. So kind of classify these in your mind, assume extraordinary.

What would you assume is extraordinary hurricane damage? You know, cause sometimes in the FAR CPA Exam they don't give you a lot of information. They'll just say there's been a hurricane, you know, would you have to assume it's extraordinary. You would, if that's all they say there's been a hurricane, you'd have to assume.

It's extraordinary. What if they said this? What if they said in the FAR CPA Exam, there's a hurricane every eight minutes in this geographic area. And they can be, you know, ridiculous like that. They say there's a hurricane every eight minutes in this geographic area. Well, you know, for God's sakes movie warehouse, but you know, in that case it would be an ordinary loss because of the geographic environment.

But if you're in the FAR CPA Exam and all they say there's been a hurricane, yeah. You'd have to assume it's extraordinary earthquake damage, same thing, because they don't sometimes the FAR CPA Exam. They don't say a lot. There's been an earthquake. You'd have to assume it's extraordinary. And another one, you know, volcano damage.

No. Yeah. If a volcano destroys a warehouse, you'd have to assume it's extraordinary. Now I know, you know, this next point, but I want to say it. Remember this, once you decide that something is extraordinary, it's net attacks. So you don't forget that extraordinary items are one of our three components, net income, right?

Continuing operations, discontinued operations, extraordinary items. Those three components are all net of tax. So if you're in the FAR CPA Exam and you see a gain or loss in a question goal, yet it's hurricane damage extraordinary. If there's a tax rate in that problem, it's automatically net of tax. They won't say anything but extraordinary items require in tra period tax allocation.

One more thing. What if a corporation has a gain or a loss, you know, gain or loss? That's considered unusual, but not infrequent or they have a gain or loss that's considered infrequent. It doesn't happen every day, but it's not unusual. It's not abnormal. In other words, what if a corporation has a gain or loss that meets one of the criteria, but not both.

Well, let me ask this. Is there any way it could be extraordinary? Will you know, it cannot be right. We know it's not extraordinary because to be extraordinary, the gain or loss must be both on usual and infrequent. So we know it's not extraordinary. All right. So what do we do with these things? Listen carefully.

These are called in frequent charges or infrequent gains. So get, at least get used to the language. You know, you have a gain, a loss that's considered infrequent. You know, it doesn't happen every day. But it's not unusual. It's not abnormal.

It's called an infrequent charge or an infrequent infrequent game. Just remember these infrequent items are a separate line item up and operations. That's where they belong, you know, other gains and losses, but these infrequent items are just going to be a separate line item up and operations and not net of tax, not net of tax.

Let's do a couple of questions. Number five. During the current year, Kurt company sold a parcel of land used as a plant site. The amount curve received was a hundred thousand in excess of the land's carrying amount. So there's a a hundred thousand dollar gain here. Car's income tax rate is 30% in the current year income statement.

How would they report the gain? Well, you know, what's going to come down to see your day. If you think you take the tax out, you go for C. If you don't think you'd take the tax out, you'd go for D and it is D this is an infrequent item. So that if this is what one looks like, I think what happened here, a company had a piece of land, right?

They thought they were going to build a plant on it. They held that land for 180 years. This year. They changed their mind. They sell it off at a game. Well, that doesn't happen every day. It's certainly infrequent, but it's not unusual. It's not abnormal. It's normal part of business. See, that's what, that's an infrequent item right there.

Company had a piece of land. They thought they were going to build a plant on it. They assumed they were going to build a plant on it. They held that land for 8,000 years have this year, they changed their mind. They sell it at a gain. Well, it certainly infrequent, but it's not abnormal. It's not unusual.

It's a normal part of business. That's an infrequent item. So that belongs up and continuing operations. Other gains are the losses, not net of tax. The answer is D now N income from continuing operations, all, you know, all of the continuing operation items. Will be finally NetApp packs. That's true. But each item in continuing operations is not net of tax.

That's just other gains and losses up and continuing operations, not net of tax. Number six during the current year, both rain and cane have flood losses due to flooding of the Mississippi river. Rain is two miles in the river has flood losses all the time. Because of the geographic environment for rain, it's an ordinary loss.

Cain is 50 miles in the river has never had a flood loss of their history. Well, for Kane, it's an extraordinary item. And the answer is a just don't forget that environment constraint, you must consider the geographic environment, the economic environment that a company operates within because that's the issue what's unusual and infrequent for this company.

Depending on the geographic environment, the economic environment, this entity operates within. I'll be looking for you in the next class. Keep studying don't fall behind. I'll see you that.

Welcome back in this far cpa review course. We're going to talk about comprehensive income. As you know, all corporations are required to report what is called. Total comprehensive income. So let's define that because it really is definitional. Just remember that comprehensive income is defined as anything that affects stockholders' equity, as long as long as it doesn't come from the owners like issuing shares or go to the owners dividend.

Let me say it again. Comprehensive income is always defined as anything. It's very broad. Anything that affects equity. As long as it doesn't come from the owners like issuing shares or go to the owners like a dividend, that's the definition of comprehensive income. Also keep in mind that for most companies, the biggest single part of comprehensive income is the net income right off their income statement, never lose sight of that.

That for the vast majority of companies, the biggest single part of comprehensive income is the net income right off their income statement. So, let me make a couple of points. First of all, I want you to be confident that comprehensive income does not affect any of the notes that I've given you so far about the income statement.

We're going to do our income statement the way we've always done it, but I think, you know, the problem there are gains and losses that are not on the income statement. There are gains and losses that go directly to stockholders' equity. As items of other comprehensive income items of OCI. So that's the problem.

Again, we're going to do our income statement the way we've always done it. And that's the biggest part of comprehensive income for most, most companies, but there are gains and losses, as you know, that are simply not on the income statement, the gains and losses flow directly to stockholders' equity as items of other comprehensive income items of OCI.

So let's just talk about this for a minute. What are these gains and losses that are not on the income statement that go directly to stockholders' equity as items of other comprehensive income? Well, there's really three big areas to worry about. First in the area of investments. If a company has any unrealized holding gains or losses, any unrealized holding gains or losses from available for sale securities, any unrealized holding gains or losses.

From available for sale securities. These gains and losses are not on the income statement. They go directly to stockholders equity. As items of OCI. Also, hedging comes into this as well. If a company has an unrealized gain from an effective hedge, from an effective cashflow, hedge security, any time a company has an unrealized gain from an effective cash flow, hedge security.

That game's not on the income statement. It goes directly to stockholders' equity as an item of OCI. Now, the second area you want to be careful about is foreign operations. If a company has any unrealized gains or losses from translating a foreign subsidiaries financial statements back to us dollars again, if the company has any unrealized gains or losses from translating a foreign subsidiaries financial statement.

Back to U S dollars. Those gains and losses are not on the income state. They go directly to stockholders' equity as items of other comprehensive income. Also hedging comes into this as well, and he unrealized holding gains or losses from a hedge of a net investment in foreign operations. Any unrealized holding gains or losses from a hedge of a net investment in foreign operations.

Those gains and losses would go directly to stockholders' equity as items of OCI. And then the other big area to be careful about is pensions. When a company has a defined benefit pension plan at year end, they have to evaluate the funding status of the plan ERN. And at year end, if they're overfunded, that's really a game.

If they're overfunded. But that game wouldn't go to the income statement. It goes directly to stockholders' equity as an item of OCI. If they're underfunded, I mean, it's really a loss and not that loss wouldn't be on the income statement goes directly to stockholders equity as an item of other comprehensive income, an item of OCI.

So I think you see our basic problem here. Corporations are required to report what is called total comprehensive income. And that's made up of. The net income on the income statement, that's the biggest part of comprehensive income, but we've got also gains and losses that are not on the income statement.

So I think, you know, what I'm getting at since corporations are required to report totally comprehensive income, how do they do it? Well, there are two approaches to acceptable approaches. First, there is what they call the one statement approach. When a corporation reports comprehensive income under the one statement approach.

Again, they'll do their income statement the way we, the way they've always done it. So they'll have income from continuing operations, discontinued operations, extraordinary items, but then after they get down to net income below net income, they show all the items of OCI for the period and that lets them show the bottom line.

Total comprehensive income. So that's what we mean by the one statement approach, because we're doing a combined, a combined statement of income and the comprehensive income. That's the one statement approach. Do your income statement the way you've always done it. But after you have income from continuing operations, discontinued operations, extraordinary items, you get down to net income.

Then below net income, you show the items of OCI for the period. By the way, the items of OCI would be net of tax. Don't forget that items of OCI. Require in tra period tax allocation. So they would be shown net of tax. And then that would allow you to show the bottom line, total comprehensive income.

That's what we mean by the one statement approach where you do a combined statement of income and comprehensive income. Now, also, what is acceptable is the two statement approach. Now, when a corporation reports comprehensive income under the two statement approach, again, they do their income statement the way they've always done it.

And that didn't the income statement, reports, net income for the period. But then in the two statement approach, the company not only has an income statement, they have a separate statement of comprehensive income. That's the two statement approach, and you see why it's called the two statement approach, because there's an income statement and a separate statement of comprehensive income.

Now, if you're going to do a separate statement of comprehensive income, you start off that statement with net income right off your income statement, because that's the biggest part of conference of income. So on a separate statement of comprehensive income, you'd start with a net income right off the income statement, and then add the items of OCI for the period net of tax, allowing you to report total comprehensive income.

So just remember those are the two approaches of reporting. Total comprehensive income. There is the one statement approach, a combined statement of income and comprehensive income. And there's the two statement approach where you do an income statement and a separate statement. Of comprehensive income.

Let's do a couple of questions. Question number one, rock company's financial statements have the following balances. They have an extraordinary gain, a foreign currency translation gain an unrealized gain from available for sale securities and report reported net income for the year 400,000 and in a multiple trades like this, they give you this information and then just ask you.

What is total comprehensive income for the year ended December 31. Well, here again, you know that the biggest single pot of comprehensive income is the net income on the income statement. So we'll pick up that 400,000. How about the extraordinary game? No, that's already in the 400,000 member discontinued operations, extraordinary items are components of net income.

So that 50,000 of extraordinary game should already event already be in the 400,000 of net income. Don't double count it. So we have the net income. Now we'll just add the items of OCI for the period. The foreign currency translation gain of a hundred. The unrealized gain on AFS securities of 20 comprehensive income for the year would be 520,000 answers.

See number two says, what is the purpose of reporting? Comprehensive income. ACE says, well, the purpose would be to summarize all changes in equity from non-owner sources. That's pretty much it isn't it. Anything that affects equity, as long as it doesn't come from the owners like issuing stock or go to the owners like a dividend, it does summarize all changes in equity from non-owner sources.

Number three, which of the following statements is correct regarding reporting comprehensive income. ACE says accumulated OCI accumulated other comprehensive income is reported in stockholders' equity on the balance sheet. That's true. Remember the gains and losses that are not on the income statement, they flow directly to stockholders' equity as items of OCI down in stockholders' equity.

Those gains and losses are accumulate. They accumulate. So in stockholders' equity, we now have accumulated OCI. It's like having a retained earnings account. In stockholders' equity for all these gains and losses that are not on the income statement to accumulate. So answer a is correct. Now, in terms of the income statement itself, you may remember that there were basically two formats for an income statement.

There is the mobile step format and there was the single-step format. And I just want to make sure that, you know, the basic difference because they sometimes ask, if you look in your viewers guide, You'll see an example of a multiple step format, income statement. Now the multiple step format, not going to bother you because it's the format you see most often noticing the multiple step format.

You start with a sales. You take out cost of goods sold. That gives you gross margin. Might want to circle that. All right, there's gross margin. After gross margin, have selling general administrative expenses. And you get down to income income from operations. You might want to circle that then there's other gains are the losses are their income there's rental income interest in dividend income gain on sale of machinery.

So other gains and losses add up to 17,200, then there's other revenues, interest revenue, a loss on the sale of investments. Well, my point is you finally work down to income for operations before tax. So you see why it's called the multiple step format. It's called the molded step format because you're working out income from continuing operations before taxes in multiple steps.

You know, first you work out gross margin, then income from operations, then other gains or the losses you're working out income from continuing operations before tax in several steps. Now on the next page, in your, in your viewers guide. You'll see the single-step format and you see the difference in the single-step format.

We take all our revenues and gains minus all our expenses and losses. And we work out income from continuing operations before tax in one single one single step. That's what we mean by the single step format where a company takes all their revenues and gains minus all their expenses and losses and calculates income from continuing operations before tax in one single step.

But notice in both cases. You still don't get away from continuing operations, discontinued operations, extraordinary items, C D E that never changes. All of it's different between the single step format and the modal step format is how we calculate income from continuing operations before tax it's either done in several steps or one single step button in both formats.

Once you get down to income from continuing operations, then below there you have. Discontinued operations, extraordinary items. You never get away from C D E just to show you how they could hit the same concepts in a multiple choice. Let's look at number four, bear food company, their current year single step income statement.

Single step for me, that is titled revenues, you know, revenues and gains. So they give us, they give us a list. And what they're asking me is if you're doing a single step income statement, For bare foods. What would you report under revenues and gains while you pick up the sales revenue? 187,000, that's a revenue or gain.

How about the loss from operations of a segment, the gain on disposal of a segment. Now that goes below, write that book that goes below income from continuing operations, then there's discontinued operations. Extraordinary items. As I, as I say, the only difference between the single steps format and the multiple step format is how you calculate income from continuing operations before tax.

Then below there it's all the same. Then you'd still have discontinued operations, extraordinary items. So discontinued operations goes below. So we don't pick that up interest revenue. Yeah, that's a revenue or gain. Pick it up, gain on sale of equipment. That's a revenue or gain pick that up. And the answer is D 201,900.

That's revenues and gain, keep studying, and I'll look to see you in the next class.

Welcome back in this far cpa review course, we're going to begin our discussion of earnings per share a calculation, a formula that you're going to have to be very comfortable with for the FAR CPA Exam. Not only did they test this with multiple choice, but earnings per share would make a pretty good simulation as well. And if you've studied this before, and I know you have, it could be that you're a little bit ahead of me right now.

You're thinking all Bob, I know where this is going basic and diluted earnings per share. I know that's, what's coming. Basic and diluted earnings per share. And Bob, I know diluted is more complicated than basic, and let's be honest. the FAR CPA Exam is going to test diluted earnings per share. So let's get to it, Bob.

Let's let's let's not worry about the basics let's get to diluted. Well, it may surprise you that often often what the FAR CPA Exam will test you on is basic earnings per share. Which as you may remember is not that basic. It's a little tricky and that's going to be my advice to you. The secret to earnings per share.

If there is one is to slow down and master basic earnings per share, don't take it too fast. Just slow down, master basic earnings per share. And then later we'll do dilute it. Now, starting with the formula. For basic earnings per share. When you calculate basic earnings per share in the numerator, you don't just put the company's net income.

A lot of students do that. It's not just the company's net income. No. In the numerator you want net income applicable to common stockholders. Remember earnings per share is earnings per common share. It's nothing to do with your earnings per share preferred stock, nothing like that. Earnings per share is earnings per common share.

And. In the numerator. You don't just want the company's net income. No, you want net income applicable to common stockholders in the numerator. You want net income applicable to common stockholders. Let me define that net income applicable to common stockholders is defined as the company's net income minus the current year's preferred dividend.

Take the company's net income minus. The current year is before a dividend and listen carefully. You're going to back out that current years for dividend, if preferred stock is cumulative, which it almost always is you'll back out that current year's preferred dividend, whether it's declared or not.

Don't forget that. So it's the company's net income minus the current year's preferred dividend and a preferred stock is cumulative. You're going to back out that current years before a dividend, whether it's declared or not. Now the divisor. You don't just divide by the number of common shares.

Outstanding. A lot of students do that. No, you divide by the weighted average common shares. Outstanding for the period. Don't forget in the divisor. You've got a weight, the shares by how many months they've been outstanding. You've got to weight the shares. By how many months they've been outstanding.

Let's go to a problem and we'll do it together. Problem says Rand had 20,000 shares of common outstanding January one, year six. Then on May 1st year six, they issued another 10,500 shares of common shares for four for cash. Presumably outstanding all year were 10,000 shares of non-convertible preferred stock on which dividend of $4 a share was paid.

In December of year six, net income for your six 96,700 and what's earnings per share for the year. Notice they just want basic earnings per share. As I say, often all the FAR CPA Exam Watson's basic earnings per share. So let's work it out. We've memorized the formula and we know in the numerator we want net income applicable to common stockholders.

So let's get that. We're going to take Rand's net income. 96,700 minus the current use for a dividend current years before a dividend would be $4 a share times 10,000 preferred shares outstanding $40,000. So let's agree if I back out that 40,000 from the net income net income applicable to common stockholders is 56,700.

So we have that. Now let's work on the divisor. As I say in basic earnings per share, you're dividing by the weighted average common shares, outstanding for the period and the divisor. You've got to weight the common shares by how many months they've been outstanding now in terms of waiting chairs, there's a long approach and there's a shortcut.

Just want to show you the shortcut, the fastest way to do it. They said that Rand had 20,000 shares of common stock outstanding January 1st. So since those shares. Were outstanding for all of your six, the full year. We give those shares a full weight of one since they were outstanding for the full year of year six, you're going to give those shares a weight of one, a full weight of one.

So multiply 20,000 shares times one that's 20,000 weighted shares. Then they should another 10, 10,500 chairs May 1st. Well, those shares have been outstanding for what may June, July, August, September, October, November, December eight months. So we're going to give those shares a weight of eight twelfths or two thirds.

That's 10,500 times two thirds. That's another 7,000 way to chairs. So add the 20,000 shares and the 7,000 chairs. The weighted average common shares outstanding for the period 27,000. Now we can solve it. If I take the net income applicable to common stockholders, 56,700, and I divide by the 56,000 by by the 27,000 weighted shares.

Outstanding for the period. Basic earnings per share comes out to answer B $2 and 10 cents. That's basic earnings per share. It's taking. The net income applicable to common stockholders, the 56,700 dividing by the 27,000 weighted shares outstanding for the period. And that will give you basic earnings per share, $2 and 10 cents a share.

Let's do another problem.

The second problem says that Fe corporations. Capital structure December 31 year one was as follows. There's 200,000 common shares outstanding, and there's another 50,000 shares of non convertible preferred on October 1st, they issued a 10% stock dividend on the common shares and paid a hundred thousand cash dividend on the preferred net income for the year ended December 31 year to 960,000.

Phase year two earnings per share would be what, well, again, they're not asking for a diluted, they just want basic earnings per share. So you've memorized the formula, you know, in the numerator you want net income ethical to common stockholders. So you're going to take the company's net income 960,000 back out the current years before a dividend, a hundred thousand.

Let's agree that in the numerator net income applicable to common stockholders is 860,000. Now we're going to divide by the way to chairs. Now, since they had 200,000 shares outstanding for the full year, those years going to full weight of one or 200,000 weighted shares. And you know why I am making us do this problem because of the stock dividend.

That's the complication here October 1st. They should have 10% stock dividend. Now, you know what that means? That means they literally increased their shares outstanding by 10%, they set out another 10%, another 20,000 shares. And since those shares outstanding for October, November, December three months, give those a weight of three 12.

So one quarter that's 5,000 way to chairs. And if you take the net income applicable to common stockholders, 860,000. Divide by 205,000 weighted shares. There's no answer there for you. Notice it doesn't work and this is why it doesn't work. Listen very carefully. This is extremely important. Don't forget when you calculate basic or diluted earnings per share, either one, we'll get to diluted later, but when you calculate basic or diluted earnings per share stock dividends.

And stock splits are retro, actively weighted stock dividends and stock splits are retro, actively weighted. You will always bring a stock dividend or split back to the beginning of the year, usually January one it's calendar year, but always bring a stock dividend or split back to the beginning of the year.

And you'll be fine. So in other words, the way I'm supposed to look at this, I'm supposed to look at this as if. They had 220,000 shares outstanding for the full year with a full weight of one. So if I take the net income applicable to common stockholders, 860,000 divided by 220,000 shares, the answer is a, but don't forget that that's one of their favorite tricks in the FAR CPA Exam, stock dividends and splits.

They are retroactively weighted. As I say, you will always bring a stock dividend or split back to the beginning of the year and it'll work out. It should always work out. So be careful. And let me emphasize again, that would be whether you're doing basic or diluted earnings per share, and I want to make sure that you're comfortable with this idea of how we handle stock dividends and splits.

So let's do another problem together. Let's say as a hypothetical, let's say a corporation had a hundred thousand common shares outstanding on January one. Issued another 50,000 common shares on July one and issued another 50,000 common shares on October one. So that's the situation. Accompany issues. A company had a hundred thousand shares outstanding.

January one issued another 50, another 50,000 common shares on July 1st and issued another 50,000 common shares on October 1st. What would be the weighted average common shares for the period? Well, let's work it out. We know that the a hundred thousand common shares were outstanding for the full year.

They get a full weight of one, that's a hundred thousand way to chairs. They should another 50,000 shares on July one. Well, they've been outstanding for six months or a half a year, so they would get a weight of a half that's 25,000 weighted shares. Now the other 50,000 shares that were issued on October 1st, they've been outstanding for three months, October, November, December three, twelves, a one quarter of a year.

So we give those away to the quarter that's 12,500 way to cheer. So let's add it up. What's the way average, common shares outstanding for the period, a hundred thousand plus 25,000 plus 12,500, 137,500. I hope you with me, that's the weighted average common shares outstanding for the period. We have to wait the common shares by how many months did an outstanding, and in this case, it comes out to 137,500 way to chairs.

Let's do the same problem again, but I'll add one more thing. Let's say there's a two for one split, a hundred percent stock dividend, a two for one split on September 1st. Same problem. But now there's a hundred percent stock dividend, a two for one split on September 1st. Now what would be the weighted average common shares for the period?

Well, remember I said. Stock dividends and splits are retroactively weighted. You always bring a stock to the under split back to January one back to the beginning of the year. So let's do that if I bring that split. So a hundred percent stock dividend, a two for one split back to January one, not the way I look at it now, instead of having a hundred thousand common shares outstanding on January one, they would have 200,000 common shares, outstanding and standing in January one.

I hope that makes sense to you. I bring that up. A hundred percent stock dividend that two for one split back to January one. Now, instead of having a hundred thousand common shares outstanding on January one, there would have been 200,000 common shares outstanding on January one, outstanding for the entire year.

We'll give those shares a full weight of one that's 200,000 weighted shares. Now the 50,000 shares that were issued on July one. Well, now it would be as if they issued a hundred thousand shares on, on July one. Excuse me. Right. They issued another 50,000 shares on July one, but I'm retroactively applying the stock split.

So now I'd look at that as if they issued a hundred thousand shares, not 50, a hundred thousand shares on July one. Those shares were outstanding for six months. If you give those away to the half, cause they all standing for a half a year. That's 50,000 weighted shares. How about the 50,000 shares they issued on October 1st?

Would I double those? No, no. The split was on September 1st. So the a hundred percent stock dividend, the split wouldn't be on the, on the 50,000 shares. You should, you should an October 1st. So that would still be 50,000 shares weighted at a quarter that would still be 12,500 weighted shares. So we'll add it up.

Add up 200,000 plus 50,000 plus 12,500. Now the way that average common shares for the P for this period would be 262,500. 200,000 shares weighted at one a hundred thousand shares weighted at a half and 12,000 and 50,000 shares weighted at a quarter 12,500. The answer would be 262,500. I hope you see my point.

Yes. Stock dividends or splits are retroactively weighted. That's true. You always bring a stock dividend or split back to the beginning of the year. You'll be fine, but just be careful. That you don't have to watch out for dates because as in this case, any shares issued after the split, the split wouldn't be on those shares.

The split wouldn't be on those 50,000 shares. They issued on October 1st after the split. So just be very careful and watch out for dates, but you've gotta be able to deal with stock dividends and splits with earnings per share. Because as I said, it's one of their favorite tricks in the FAR CPA Exam. And you may have to deal with it, whether it's basic or diluted earnings per share.

Now, before I see you in the next class, there are three, there are two problems. I want you to have done two problems. I want you to have done before you start the next class and I'll look to see you then

welcome back in this far cpa review course. We're going to continue our discussion of earnings per share, and there were two problems. That I wanted you to answer before coming to FAR cpa review course. And I didn't know you've done that. So let's look at them. First question says a company had the following outstanding shares as of January 1st year two preferred stocks, $60 par 4% to cumulative 10,000 shares.

Outstanding common $3 par that's 50,000 shares. Outstanding. Then on April 1st year, two companies sold 8,000 shares of previously. Unissued common. No dividends were in arrears January 1st year, too. And no dividends were declared or paid during year two net income for a year to 236,000. And they want to know what is basic earnings per share?

Well, you've memorized the formula. That's always where you start, you know, when the numerator. You want net in a couple of a couple of common stockholders? Well, that's a matter of taking the company's net income 236,000 and backing out the current years, but for a dividend, does it matter that no dividends were in arrears January 1st year to no dividends were declared in year two, but we ignore them.

No, remember I said, you're going to back out the current years before a dividend, whether it's declared or not. If the preferred stock is cumulative, which it is almost always is in the FAR CPA Exam. So that's the point back out the current is, but for a dividend, whether it's declared or not. So what's the current year for a dividend take 4% of $60.

Remember with preferred stock, the dividend is a fixed rate on par. So take the 4% times $60 annual, but for a dividend is $2 and 40 cents times 10,000 refrigerators outstanding $24,000. So if I take the company's net income, 236,000 back out the current year for a dividend 24,000. Let's agree that net income applicable to common stockholders is 212,000.

Now we're going to divide by the weighted average common shares, outstanding for the period. And since they had 50,000 shares outstanding for the full year, those years get a full weight of one 50,000 way to chairs. Then they issued another 8,000 shares. On April 1st, she's been outstanding for nine months, three quarters, nine, 12, three quarters of a year.

So they get away to three quarters, 6,000 way to chairs. So add the 50 plus the six, the way that average common shares outstanding for the period, 56,000. So now we can solve it. If you take the net income applicable to common stockholders, 212,000 divided by the weighted average commentaries for the period, 56,000.

The answer is B that's basic earnings per share in the next question, Rand, I'm sorry. Ute Ute company you'd company had the following capital structure years, one and two. They have preferred stock, $10 power, 4% cumulative 25,000 shares issued. Outstanding. With a total power of 250,000 common $5 bar, 200,000 shares issued in outstanding total power of a million.

You reported net income of 500,000 for the year ended December 31 year two. You paid no dividends during the year during year one, and then paid 16,000 in for dividends in year two in the December 31 year to income statement, what would be earnings per share? Now, once again, they just want basic earnings per share.

So let's work it out. In the numerator, we want net income applicable to common stockholders. So if you take the company's net income, which is 500,000 back out, the preferred dividend of 16,000 net income applicable to common stockholders is 484,000 divided by way to cheers. Since they had 200,000 common shares outstanding for the full year, those shares get a full weight of one.

You take 484,000 divided by 200,000 shares. You get answer a $2 and 42 cents a share and a is wrong. A is very tempting, but a is wrong. This is a mistake that a lot of students make. And I worry about a lot. It's not answer a all right. Now, if you did pick answer, right. And I'm not, I'm not accusing you, but if he did pick answer, right, where did you go wrong?

Well, let's go back to the beginning of our discussion. When we first started discussing basic earnings per share. How did I define net income applicable to common stockholders? Didn't I say that net income applicable to common stockholders is the company's net income minus what the current year's prefer a dividend back out.

What you always back out is the current years, but for a dividend what's the current use for a dividend 4% of 250,000. 10,000. It doesn't matter what they paid. The fact that they paid 16,000 is irrelevant. They're paying off some arrears there. Now what you always back out in this calculation or in any calculation on earnings per share, whether it's basic or dilute diluted, you're going to back out the current year's preferred dividend every year.

You back out 4% of two 50 last year, you backed out 4% of two 50. So don't let a rears messy up there. It doesn't matter what no one said, it's what they paid for preferred dividends, which you always back out is the current user for a dividend every single year. You're going to back out 4% of two 50, whether it's paid or not, or how it's paid, it doesn't matter.

All right. So if you back out the current isn't for a dividend 10,000 net income applicable to common stockholders is 490,000 divided by 200,000 way to chairs. Basic earnings per shares answered be $2 and 45 cents. It's a very important lesson to learn. Now, keep in mind that up to this point, all we've talked about his basic earnings per share, and essentially we only use basic earnings per share.

When a corporation has a simple capital structure. Let me say that again. We only use basic earnings per share. When a corporation has. A simple capital structure. Now, what do I mean by a simple capital structure? I'm saying that it's a corporation that only has common shares. Outstanding. Only has common shares.

Outstanding does not have any other securities outstanding that could become common chairs. No. A simple capital structure for earnings per share purposes means the corporation only has common shares outstanding. And when a corporation only has common shares, outstanding, we simply calculate. Basic earnings per share.

But now what I want to talk about is what we do with earnings per share. When a corporation has a complex capital structure, now listen carefully for earnings per share purposes. A corporation has a complex capital structure when in addition to common shares, outstanding, in addition to common shares, outstanding, the corporation has other securities outstanding.

That are not legally common stock, but, but they have the potential to become common stock. They have potentially dilutive securities outstanding. That's what makes a complex capital structure for earnings per share purposes. One more time. It's a corporation that in addition to common shares, outstanding, in addition to common shares, outstanding, the corporation has other securities outstanding that are not legally common stock, but have the potential.

To become common stock. So these securities are potentially diluted. And when a corporation has potentially dilutive securities outstanding, that corporation has a complex capital structure for earnings per share purposes. Now, what I'm going to give you next is the, is the main point. And that is this.

When a corporation does have a complex capital structure. Now earnings per share becomes the dual presentation. Now the corporation must present both, both basic earnings per share and diluted earnings per share. That's the bottom line. When a corporation has a capital, a complex capital structure, a complex capital structure, and we know what that means.

Now. Now earnings per share becomes the dual presentation. Now the corporation is required to present both basic, basic and diluted. Earnings per share. Let me give you the formula for a diluted earnings per share. It's going to seem pretty familiar when you calculate diluted earnings per share in the numerator.

We still want net income applicable to common stockholders by the way, defined exactly as we did before. No debt, no difference. It's the company's net income minus the current use for a dividend. So in the numerator, we still want. Net income applicable to common stockholders. Notice we still divide by the weighted average common shares.

Outstanding for the period. Don't forget in diluted. You still in the Nevada in the divisor have to weight the common shares by how many months they've been outstanding, but notice what's different. Also in the divisor, we would add any of these dilute of securities. So also in the divisor now we're adding.

These potentially dilutive securities. If they are diluted now listen carefully. Understand what I just said? Only put these potentially diluted securities in the calculation. If they're diluted, what does diluted mean? It causes earnings per share to go down down. Diluted means down the DS go together.

That's what diluted means down. But listen, if you put these potentially potentially dilutive securities in the calculation and they cause earnings per share to go up. They cause earnings per share to go up. Then they are anti diluted. They don't belong in the calculation if they're anti diluted. All right.

So with that in mind, what are these potentially dilutive securities? I'll give you list this for you. Gotta look out for number one, watch out for stock options. Or stock warrants, a warrant is an option. It's the same thing. Watch out for stock options or stock warrants. You see what I'm saying? When a corporation has stock options or warrants outstanding are stock options, a warrants legally common stock.

No, but they have the potential to become common stock. The potentially diluted number two, watch out for convertible preferred stock. You know what that is? It's preferred stock that can be converted into common. Number three. Convertible bonds. You know, those are, those are bonds that can be converted into common stock.

So you see the analysis are convertible preferred shares, convertible bonds, legally common stock. No, but they have the potential to become common stock. They avoid, therefore they are potentially dilutive. And then finally number four would be contingent shares. And we'll get to that later. Let's start with.

Stock options and stock warrants. And here's my question for you. When a corporation has stock options or warrants outstanding, are they automatically diluted? Are they automatically diluted? I hear you. You're saying no, Bob they're potentially diluted. They're potentially dilutive. So your job in the FAR CPA Exam is to test the options or warrants to see if they dilute it or not.

Remember that they're not automatically diluted, they're potentially diluted. So your job in the FAR CPA Exam, when you see stock options, warrants is to test the options or the warrants, see if they dilute them or not. How do you do that? The, if what, what you use is the treasury stock method. If you want to test options warrants, to see if they'd load or not, we use the treasury stock method, and that's what I want to show you.

Let's go to the next. Set up problems, three and four, man Inc had 200,000 shares of common stock issued outstanding, December 31 year two, then July 1st year, December 31st year one. Excuse me, man had 300,000 shares of common stock issued an outstanding December 31 year. One that on July one year two. An additional 50,000 shares of common issued for cash.

Man also had on exercise stock options to purchase 40,000 additional shares of common at $15 a share that's the option price. Notice that 15. So if you're holding these options, you can buy the shares at that fixed price, $15 a share, and they were outstanding at the beginning. And the end of year two,

the average market price of the common stock. Was $20 during year two, number three says, what is the number of shares that would be used in computing? Basic earnings per share. Number four says what is number of shares that would be used in computing, diluted earnings per share. So let's work on number three.

We should know how to do that. No problem. Right? How do we work out? The number of shares that we would use in the divisor calculating basic earnings per share while since they had 300,000 common shares, outstanding. For the entire year for the full year, those years get a full weight of one, 300,000 weighted to chairs.

Then, then they issued another 50,000 shares on July. One will. They've been outstanding for six months or half a year. So this year, those years would get a weight of a half that's 25,000 way to chairs. And the answer is a that's the number of shares we use in the divisor. If we were calculating basic earnings per share notice in basic, I ignore the stock options.

I just ignore that. They're irrelevant. All right now, number four says, what is the number of shares that would be used in computing diluted? Now let's do it. If we're going to do diluted earnings per share, we start exactly the same way we say, well, there was 300,000 shares outstanding for the full year.

Those years get a full weight of one that's 300,000 way to chairs. They issued another 50,000 shares on. July one they've been outstanding for six months or a half a year. Those years get a weight of a half. That's 25,000, where to cheers. Notice you start exactly the same way, but the difference is in diluted, we have to consider the stock options.

Now, as now, as I said before, those options are not automatically dilutive. They're potentially diluted. Our job in the FAR CPA Exam is to test those options, to see if they diluted. How do I do that? The treasury stock method. Now with the treasury stock method, there's a long approach and there's a short approach.

I'll just show you the shortcut. It's a really fast, here's a short way to do it. Notice the exercise price. As I pointed out before $15 a share, people are holding. These options can buy the stock for $15 a share. Then they said the average market price. Of the common stock for the period was $20 a year.

Here's the quick way to do the treasury stock method. Take the average market price for the period 20 minus the exercise price 15. Again, I took the average market price for the period 20 minus the exercise price 15 that's five over the market price 20 it's the average market price. Minus the exercise price over the market price.

So I took the average market price 20 minus the exercise price 15 that's five. Over the average market price. 25. Over 20 is one quarter. One quarter of those 40,000 options would be diluted or 10,000 dilutive shares at 10,000 diluted shares to what we already had. Three 25. The answer is, is B the number shares you'd use in the divisor for diluted is 335,000.

I'm adding another 10,000. Dilutive shares. Now make sure you know that shortcut, but a couple of points. Notice we use the average market price here in the treasury stock method. And I want you to know when you're applying the treasury stock method, you always use the average market price for the period, always.

And I mentioned that because they could throw in the ending market price and mess a lot of people up. No, no. In the treasury stock method, we always use the average market price for the period. Another thing I want to make sure you notice noticing this problem. The average market price 20 was above the exercise price 15.

And I want you to know this. As long as the average market price is higher than the exercise price as it is here. You know, this as long as the average market price is higher than the exercise price, they're automatically diluted. I just want you to know that little shortcut, the average market price is above the exercise price.

You know, those options are automatically diluted. Go through the calculation. But if the average market price is below the exercise price, and they might do that. If the average market price is below the exercise price, those options are anti diluted, ignore them. So you should be aware of that. If the average market price is below the exercise price, those options are anti diluted.

Just go right by it. All right. So if you see stock options or warrants member warrants, or just options, If you see stock options in the FAR CPA Exam, you use the treasury stock method to see if they diluted or not. Now getting back to our list. How about convertible preferred stock convertible bonds? Well, here again, convertible preferred stock convertible bonds are not automatically diluted.

They are potentially diluted. Your job in the FAR CPA Exam is to test convertible preferred stock test convertible bonds, to see if they had alluded or not. How do you do that? The, if converted method, we have to use the, if converted methods. That's what I want to show you next. If you go to question five, it says done had 200,000 shares of $20.

Par common and 20,000 shares of a hundred dollar par 6% cumulative. Convertible preferred notice convertible preferred outstanding for the entire career ended December 31. Each preferred share is convertible into five shares of common. Let's stop right there. Once you write something down. Don't we know that if each preferred share was convertible into five shares of common, there are 20,000 convertible preferred shares.

Outstanding times five. That means the preferred is convertible into a hundred thousand shares of common. I think you had to write that down. Yeah, I did notice that, that there are 20,000 shares of controllable convertible preferred each year. Preferred is convertible into five shares of common take 20,000 convertible preferred shares, times five.

You want to notice right away that the preferred is convertible into a hundred thousand shares of common Dunn's net income for the year ended was 840,000. For the current year and the December 31. What is diluted earnings per share? Well, just to get us grounded, let's start with basic. If I were doing basic earnings per share for done, how would I do it?

You know, it, hopefully you're getting very comfortable with basic well, if I was doing basic, I would take the company's net income, 840,000 minus the current year's preferred dividend. What's the current year for a dividend, isn't it? 6% of a hundred or $6 a share. But with preferred stock, The annual dividends, a fixed rate on par.

So take that fixed dividend rate, 6% times the power of a hundred annual preferred dividend is $6 a share times 20,000 outstanding preferred shares. Let's agree. The current year for dividend is $6 times 20,000 preferred shares outstanding 120,000. So I would take the company's net income, 840,000 back out the current years before a dividend of 120.

So net income applicable to common stockholders would be 720,000 divided by weighted shares. And since they had 200,000 common shares outstanding for the entire year, give those a full weight of one divided by 200,000 way to chairs. Notice that to answer. C might just want to write scribbled next answer.

Say basic that's basic earnings per share. Now I know you're with me. They don't want basic. They want diluted. They want diluted. Now in this problem, we have one potentially dilutive security, outstanding, the convertible preferred. And as I've been saying that preferred is not automatically diluted. It is potentially diluted.

And our job is to test this preferred, to see if it's diluted or not. And the way we do that is with the, if converted method. Here we go. Under the, if converted myth, we just assume, we just assume that the preferred was converted into common at the earliest possible point. Again, under the converted method, we just assume the preferred was converted into common at the earliest possible point.

That would be January one, cause it was outstanding all year, but you just make an assumption. The preferred was converted into common. At the earliest possible point, that would be January one here. So let's think about it. If the preferred was converted into common back on January one, wouldn't it be another hundred thousand shares and the divisor a hundred thousand shares.

I was sending all year weighted at one for a full, a full weight of one. They were outstanding all year. If the preferred was converted into common, that would have been another under thousand common shares issued on January one. Outstanding all year weighted at one wouldn't my devise, a go from the okay.

200,000 up 100,000 to 300,000. Hope you see that my device was going to go from 200,000 up a hundred thousand way to chairs up to 300,000. Now, would anything else change? Sure. Now there wouldn't be a preferred dividend. Right. You've got to be consistent. If the preferred stock was converted into common back on January one, I don't have to pay anybody a preferred dividend.

There is no preferred dividend. So when the numerator I'm just back to net income, 840,000 hope you see that you've got to be consistent. It can't be common and preferred at the same time. It's either preferred or it's common. If it's now common, there is no preferred dividend. So in the numerator, I'm just back to net income, 840,000, because I don't have to pay anybody a preferred dividend.

And if you take the net income, 840,000 divided by 300,000 way to chairs that comes down to $2 and 80 cents a share. All right. So where are we? Well, think it through with me, what was earnings per share before I considered the preferred $3 and 60 cents a share the basic answer. See what's earnings per share.

When I consider the preferred $2 and 80 cents a share what we just proved about this preferred. It's diluted. It caused earnings per share to go down. Dilute of means down. And the answer is B the answer is B that's diluted earnings per share. Cause it costs money, but you got to go down. It is a diluted security.

It stays in the calculation. Now something just happened here and I don't want it to be subtle because I don't do subtlety well. I don't, I don't try to be subtle ever ITV. I always, my goal as a teacher always is to be about as subtle as a train wreck and it believe it's something that's important to me.

I, if I ever do a subtlety it's by accident, but that's something that just happened here and I'm afraid it could be subtle. What is dilutive mean to you? What if we said dilutive means down, right? Dilutive means down causes. Don't even try to go down down for what. Basic, right. Here's my point. If I were you in the FAR CPA Exam and I had a problem like this, I would always do basic first.

Cause I want to know my starting point. In other words, if in this problem, I did the calculation with a preferred and it came out to $3 and 65 cents a share. I ignore the preferred. Because it's anti dilutive, right. Basic was three 60. So if I did the calculation with the preferred and it came out to $3 and 68 cents a share, I'd ignore it.

I'd ignore the preferred it's anti dilutive makes earnings per share to go up and diluted would be three. The answer to diluted would be $3 and 60 cents a share. Hope you followed that giving you good advice here. Always do basic first. Some students say to me, Bob, I don't have time. Oh, I don't think that's true.

You know, w if you get really comfortable with basic, just takes a few seconds. Just you want to know your starting point, because if I'm working on diluted, I have to know what BR what, what makes what's what makes earnings per share go down, down really from basic. So I just think it's good advice now, have they, have they ever done that in a problem in the FAR CPA Exam?

Have the security be antediluvian? So the answer just would be. Basic. I'm not sure. I don't, I don't know, but I don't. I know I don't trust them and if I don't trust them, you shouldn't trust them. So always do basic first just to make sure now, before you go to the next class, there's a problem. I want you to get done before you come to the next class.

And here's what I want you to do. Take the problem and just do basic. Okay. Just do basic. Cause the problem asks were basic and alluded. I just want you to do basic and you'll see in the problem, there's two potentially dilutive securities, this convertible preferred stock, this convertible bonds also, I'd like you to test the preferred, see if it's diluted or not.

That's all I want you to do. We'll do the bonds together because we haven't talked about that yet, but calculate basic for me, get that. And with the convertible preferred stock, that's in the problem. Just test it, see if it's diluted or not. And then I'll look to see you in the next class.

Welcome back now, you know that in this glass, we're going to finish our discussion on earnings per share. And there's a problem I asked you to, to try before coming to FAR cpa review course, let's take a look at it. We have a set of two questions and the first question they want to know basic earnings per share.

And then the second question. They want to know diluted earnings per share. And what I asked you to do before coming to FAR cpa review course is get the basic for me. So hopefully you got that with no problem. Let's get the basic earnings per share. We know for basic in the numerator, we want net income applicable to common stockholders, and that's the company's net income, 980,000 minus the current years before a dividend.

45,000. I think we can agree that net income applicable to common stockholders is 935,000. Now we divide by way to chairs and since they had 90,000 common shares outstanding for the entire year, those years get a full weight of one. So it's 90,000 way to chairs and basic comes out to answer B. $10 and 39 cents a share noticed in basic, we don't even consider the convertible preferred the convertible bonds they're ignored and it's simply $10 and 39 cents.

Now, before we move on to dilute it, notice that all through our classes on this topic, all we've worked on is earnings per share earnings per share. Let's just say a couple of words about what you're doing. If it's a loss per share, there was a couple of tricky things. If a company's reporting a loss per share the, like, for example, in this problem, if they were doing a loss per share, well, don't forget if it's a loss per share.

If the loss was 980,000, not in not income, it was a net loss of nine 80. The current is preferred dividend would be added to the loss. I hope you follow that. If, if it's a low, if the company has a net loss for the year and you're doing loss per common share the preferred dividend 45,000 would be added to the loss because the preferred dividend is bad for the common share.

It makes, makes the situation worse for the common shareholders. So that gets added to the law loss. Now how about the divisor? For loss per share. What do we do with potentially dilutive securities? Ignore them, ignore them now. Why, why are all potentially dilutive securities ignored with a loss per share?

Because if I put more shares in the divisor loss per share shrinks, it improves the picture. It makes things look better. Does that make sense? If I put more shares in divisor with potentially dilutive securities, then loss per share would go down. That makes things look better. In other words, potentially dilutive securities are anti diluted to a loss per share.

Aren't they potentially dilutive securities are anti diluted to a loss per share. Ignore them just in case it comes up. All right. Now in the second question, they want to know, all right, what's diluted earnings per share, and I'm sure you notice that. In this problem, we have to potentially dilutive securities.

We have convertible preferred stock. We have convertible bonds, and I asked you to test the preferred, see if it's diluted or not. So let's do that. Let's test the preferred hope he did this. Notice the preferred is convertible into 30,000 shares of common and the way we test convertible preferred convertible bonds.

Is with the, if converted method. So let's do it under the, if converted method, we'll just assume, just assume the preferred was converted to common at the earliest possible point. And that would be January one because it was outstanding all year. If the preferred was converted into common at the earliest possible point B January one was outstanding all year.

Wouldn't it be another 30,000 shares in the divisor weighted at one 'cause th th they would be outstanding for the full year. Given a full weight of one. So would my divisor go from 90,000, the device ID, the divisor I used in basic, wouldn't it go up 30,000 to 120,000. If that makes sense to you, there'd be another 30,000 shares in the divisor.

So the divisor that I use for basic 90,000 would go up 30,000 to 120,000 with anything else change. Sure. Now there's no preferred dividend to pay anybody. It can't be common and preferred at the same time. It's either common or it's preferred. If the preferred was converted into common back on January one, I don't have to pay anybody a preferred dividend.

So in the numerator, I just have net income, 980,000. And if you take 980,000 divided by 120,000 weighted shares, it comes out to $8 and 17 cents a share. So, you know, my thought process, what was earnings per share before I consider the preferred $10 and 39 cents a share what's earnings per share. When I.

Factor in the preferred eight, seven, $8 and 17 cents a share what we just proved about that preferred it's diluted. It's diluted. Isn't it? It caused earnings per share to go down. So it would stay in the calculation. It would S it, the preferred stock is diluted. It stays in the calculation. Now our job now is to test the convertible bonds, see if they're diluted or not.

And I want to make sure you understand something. My new, my new measuring point now is $8 and 17 cents a share, not $10 and 39 cents a year. In other words, once I have tested that preferred and it is diluted, I'm going to test the bonds to see if they bring me below $8 and 17 cents a share not below 10 39.

Hope that makes sense to you. My new marketing point now is $8 and 17 cents a share. I'm going to test those bonds to see if they bring me below eight 17, not below 10 39. Does it matter what order you do? The securities? It shouldn't. I would always just do them in the, in the order. They're listed, just do them in the order.

They're listed. It should work out fine. It shouldn't really matter the order you test them. But now I want to test the bonds to see if they bring me below $8 and 17 cents a share. See if they dilute it or not paint even a worse picture. And it's all about conservatism. Isn't it. That's what diluted earnings per share is all about conservatism.

We want to show shareholders how bad it could get, how bad could it get? Let's do the, if converted method under the, if converted method, we're just going to assume that the bonds were converted into stock at the earliest possible point. Now that would be January one because they were outstanding all year.

So you know where I'm going with this. If the bonds were converted into stock back on January one, wouldn't it be another 20,000 shares? And the advisor would my divisor go from the 120,000. I used with the preferred up 20,000 to 140,000, they'd be another 20,000 to chairs. And the divisor, my device would go from 120,000 where I left off up to 140,000.

I hope that makes sense to you. Would anything else change? Sure. If the bonds were converted into stock back on January one, I don't have to pay any bond interest, right? It can't be bonds and stock at the same time. You've got to be consistent. If the bonds were now converted into stock, I don't have to pay the bond holders, any interest.

So what I have to do is add the interest back to the net income, and I add it back net of tax, because interest is deductible for tax purposes. Notice the tax rate here is 40%, so let's work it out. I'm going to take the interest rate on the bonds. 10% times the million. The bonds pay a hundred thousand of interest since they have a 40% tax rate.

I add back 60% of the interest. That's always a function of a hundred. If it's a 35% tax rate, add back 65% of the interest. If it's a, if it's a 30% tax rate, add back 70% of the interest, it's always a function of a hundred. So since it's a 40% tax rate, add back 60% of the interest or 60,000. If I add 60,000 back to the net income, nine 80.

Net income now becomes 1,000,040 thousand divided by 140,000 shares that comes out to $7 and 43 cents a share. You know what? I'm going to ask you what was earnings per share. Before I considered the bonds, $8 and 17 cents a share what's earnings per share. When I consider the bonds $7 and 43 cents a share what we just proved about those bonds they're diluted.

They caused earnings per share to go down. They stay in the calculation and the answer to the second question. Is D now there is something else I've been saying that might be subtle and I never want to be subtle. Never want to be subtle, but it might be Mike B, maybe it wasn't, but it might be. So let me double check.

Haven't I haven't I been saying time and again, assume the bonds are converted to stock at the earliest. Possible point soon, the preferred is converted into common at the earliest possible point at the earliest possible point. So I want to make sure you understand what that means. Let's say these convertible bonds had been issued on July 1st.

When's the earliest. They could have been converted July 1st. So the extra 20,000 shares in the divisor would have to be weighted at a half. Careful. Right. You assume the bonds are converted into stock at the earliest possible point. If the bonds were actually issued on July 1st, the earliest they could have been converted is July 1st.

So those 10,000 additional share, excuse me, those 20,000 additional shares would have to be weighted at a half and become 10,000 weighted shares. And don't forget in the numerator only add back a half a year's interest right at the earliest possible. Point now there is one more. Oh, maybe I should mention the earlier problem we did on the stock options when we did the gift converted method and we talked the average market price 20 minus the exercise price 15, that was five over 21 quarter of the shares.

One quarter of the 40,000 shares will be diluted. Remember that we're 10,000 dilutive shares? Well, I said at the earliest possible point, those options were outstanding all year. So I just added another 10,000 shares. To the divisor, but if those options had been issued on July one, if stock options were destroyed, were issued on July one, the earliest they could have been converted, the earliest they could have been exercised, excuse me, would be July one.

So the extra 10,000 shares would be weighted at a half. Same thing, same thing. So I keep saying that phrase earliest possible point. Now there is one more potentially dilute of share one more potentially of security. And that is contingent shares. Let's just talk, let's just talk about them. Briefly.

Contingent shares are shares that will be issued. If some contingency occurs. If some condition is met, some contingency is met. That's what contingent shares are. And with contingent shares, there are basically just rules that you follow. First of all, it's pretty simple with basic earnings per share with basic earnings per share.

Only put. Contingent shares in the divisor. If the contingency has been met, I was very simple with basic earnings per share. You only going to put the contingent shares in the divisor. If the contingency has the conditions been met, the contingency has occurred. And of course, again at, you know, basically the earliest possible point, you know, if July one, the corporation promised to issue shares.

You know, ma made some commitment to issue shares July 15th, right? Or they, they made some promise to issue shares August 1st. Well, the, the shares, you know, if it's now past August 1st, you treat them as if they were issued at that date. The earliest possible point. When you do your earnings per share December 31 tweet as if those shares were issued on August 1st, even if they haven't been quite, you know, issued yet, there was a promise made the contingent the condition has been met.

So it's a very simple thing with basic only put the shares in the divisor. If the contingent contingency has been met now with diluted earnings per share, what do you do with contingent shares? Well, it depends on what kind of contingency it is. If the contingency is just time. All right. If the contingency is just time, corporation makes a commitment to issue shares 18 months from now.

Well, time has to pass to pass. So put the shares in the divisor now for diluted again at the earliest possible point as if you actually issued them. Now, in other words, corporation makes a commitment. Th there's a commitment, a solid legal commitment to issue shares two years from now. Well time has to pass.

So you gotta treat it as if they sh they issue the shares. Now at the earliest possible point, put the shares in the divisor now for, for a diluted earnings per share. Next possibility. If the contingency is a market price of stock or earnings contingency, okay. If the contingency is a market price of stock or earnings contingency, in other words, the corporation says we'll issue so many shares.

If our stock hits a certain market price or we'll issue a certain number of shares if we hit a certain level of earnings. All right. So if the contingency is a market price of stock contingency or earnings contingency, the corporation says we'll issue so many shares. If our stock hits a certain market price will issue so many shares.

If we do a certain level of earnings, only put the shares in the divisor for diluted. If the contingency has occurred, they've hit that market price. They've hit that level of earnings only put the shares in the divisor if the contingency has been met. And then finally, number three, third level, any other contingency you can think of corporation says we'll issue a hundred thousand shares.

If Bob Annette wears a pink shirt, well assume that will be met with any other contingency. Just assume it will be met and put the shares in the divisor again at the earliest possible point. You know, when the promise was made. Any other contingency, just assume it will be met. Put the shares in the divisor at the earliest possible point.

You know, when the promise was made, keep studying don't fall behind. I'll see you in the next class.

Welcome back in this far cpa review course. We're going to discuss segment reporting and to get us into this topic. I want you to imagine. A big multinational corporation, a corporation where besides their main line of business, they're involved in several industry segments. This corporation has activities in pharmaceuticals, toy, manufacturing, agriculture, soft, where development.

So it's a corporation that has several operating segments. And what is required is that a corporation like this disclose information about operating segments? Now, the first thing that comes up in the FAR CPA Exam is this. How do you identify the operating segments? What is an operating segment? Well, an operating segment is a segment of your business with its own assets, its own customers.

It's own results of operations and those results of operations are reported to a decision maker. Those results of operations are reported to the chief executive officer, the chief financial officer for the whole enterprise for the whole company. And make sure you remember this that's called the management approach of identifying operating segments.

The idea that the results of operations of an operating segment must be reported to a decision maker. The chief executive officer, the chief financial officer of the whole company. Again, that's called the management approach of identifying your operating segments. Now, since a corporation like this is required.

To disclose information about operating segments. What do they have to disclose? Well, they have to disclose assets by segment sales, by segment results of operations by segment. So again, they have to disclose assets by segment sales, by segment results of operations by segment, they are not required, not required.

To disclose liabilities by segment. That's not required. They're not required to disclose cash flows by segment. That's not required. Another point, they must also disclose a reconciliation. They have to disclose a reconciliation where the company reconciles from all the profits and losses from their operating segments back.

To the profit or loss for the company as a whole. So they have to also disclose that reconciliation where the company reconciles from the profits and losses from all their operating segments, back to the profit or loss for the company as a whole, another point, a company like this has to disclose information about operating segments in both annual statements.

And interim statements, quarterly statements. So it's required for both. You have to disclose information about operating segments, not only in annual statements, but also interim statements, quarterly statements. Now there's one more thing the FAR CPA Exam loves to get into with this. Let's say that a company starts to dabble in software development.

They just start kind of dabbling in software development. Does that. Automatically mean that, that is an operating segment. And the corporation has to disclose information about that operating segments. In other words, how do you know if an operating segment is significant enough important enough that you have to disclose information about it?

In other words, you have to disclose information about. Material significant operating segments. So how do you know if an operating segment is significant enough material enough? So it is required that you disclose information about it? Well, there's a guideline and it's called the 10% test and you have to know it.

And I'll just tell you, the FAR CPA Exam has asked more questions about the 10% test than any other single thing about segment reporting. So you have to remember. The 10% test let's go through it. It works like this. If a segments, assets, if a segments, assets are equal to or greater than notice, equal to, or greater than 10% of the combined assets from all segments, that indicates it is a reportable segment.

It is a significant material segment. You must disclose information about this segment. So if a segment's assets are equal to, or greater than 10% of the combined assets from all segments, it is a reportable segment or, or if a segment sale are equal to, or greater than 10% of the combined sales from all segments that would indicate it is a reportable segment.

If a segment sales are equal to, or greater than 10% of the combined sales from all segments. It indicates it is a reportable segment. And by the way, when you are applying this test on segment sales, you include bulk sales to outsiders and sales between segments. Let me say that again. When you are applying this test on sales, you include both sales to outsiders, external sales and sales between segments.

All sales are included or there's more. Or if a segment's profit is equal to, or greater than 10% of the combined profit from all segments that just reported profits. In other words, you'd knock out any segments that reported losses that would indicate. You have a reportable segment. If a segments, profit is equal to, or greater than 10% of the combined profit from all segments that reported profits you'd knock out any segments that reported losses, it indicates it is a significant reportable segment or one more, or if a segment's losses are equal to, or greater than 10% of the combined loss.

From all segments that just reported losses you'd knock out any segments that had profits that would indicate it is a reportable segment. So if a segments, losses are equal to, or greater than 10% of the combined loss from all segments that reported losses you'd knock out any segments that reported profits that would indicate it is a significant reportable segment.

You have to know that 10% test. And I know you're in the mood for the 75% sufficiency test. Now let's be careful here. Don't lose me now. What comes first? The 10% test, right? That that 10% test that's a guideline to help you identify all your reportable segments. Well, they want you to identify reportable segments so that your operating segments make up at least 75% of your sales to outsiders.

In other words, you use that 10% desks. And you want to keep identifying operating segments until operating segments make up at least 75% of your sales to outsiders. So you keep identifying operating segments until you have. You've identified segments that make up at least 75% of your sales to outsiders.

In other words, now you're not looking at entire segment sales, just sales to outsiders. And then one more point, they want you to keep your reporting to 10 segments or less. You should try to keep your reporting to 10 segments or less, even if you have to combine segments to do it. So you try to keep your reporting to 10 segments or less.

The argument would be that the benefit to the readers of financial statements starts to get lost. You know, if you have 15 segments, so you try to keep your reporting to 10 segments or less, even if you have to combine segments in order to do that, let's look at a couple of questions. Number one, which of the following.

Should be disclosed for each reportable operating segment. Do you have to report profit or loss by operating segment? Yes. Assets by operating segment? Yes. And the answer is a remember, you don't have to disclose information about liabilities by operating segment or cash flows by operating segment.

Number two. Tara company's total revenues from their operating segments are as follows. There are three operating segments, lion monk, and Navy, and they say which operating segment or segments would be deemed to be reportable. Well, you know, it's a little multiple choice about the 10% tests. And notice if you just look at sales to external customers, just look at that column.

If you just look at sales to external customers, Navy wouldn't wouldn't pass Navy's only 8%, 8,000 lion would be fine. Monk would be fine, but Navy would be FA would, would, would fail the test. Navy would not be a reportable segment in that 10% test. But of course, remember when you apply the test to sales, you include both.

Sales to outsiders, external sales and sales between segments. You do include both. So you want to look at the column to the far right total revenues, and now Navy would qualify making 20 making up 24,000 over one 50, clearly more than 10%. So now lion monk and Navy all passed the 10% test. When you look at all sales, including sales tax.

Between segments and the answer is D finally number three, which of the following qualifies as an operating segment? Well, I don't think you'd be tempted by a, it's not corporate headquarters. Corporate headquarters is not an operating segment. And I don't think that you'd be tempted by C because looking at all those measurements, 5%, 9%, 8% clearly.

You're not in the 10% test. So AA is not going to attempt. You see, is not going to attempt you, but I think a lot of students would be agonizing perhaps between B versus D D says there's an Eastern European segment, which reports its results directly to the manager of the European division and has 20% of the company's assets, 12% of revenues, 11% of profits.

So it's clearly within the 10% test. But it's not enough that the results of operations get reported directly to the manager of the European division. No, don't forget the management approach. We want these results of operations to be reported to a decision maker for the whole enterprise. That's why B is a better answer is a North of a North American segment whose assets are 12%.

So it means the 10% test and. Management reports to the chief executive officer, the CEO of the whole enterprise. Don't forget that management approach keep studying. Don't fall behind. I'll look to see you in the next call. Yes.

Welcome back in this far cpa review course, we're going to discuss foreign operations and in the area of foreign operations, there's a couple of things. the FAR CPA Exam likes to get into first. They may ask you how you convert a foreign subsidiaries financial statements back to us dollars. That's the first thing that comes up.

How do you convert a foreign subsidiaries financial statements back to us dollars while as you may know, there are two approaches. There are two methods. There is the translation method and there is the remeasure method. So that's what you're up against. There are two methods. Now listen carefully. Which method you use depends on what currency, the sub functions.

In what method you choose. Depends on what currency, the subsidiary functions in. Let me explain if the sub really functions in us dollars. In other words, most of their transactions are in us dollars. They get their financing from us banks. A lot of transactions with the U S parent, if the sub really functions in us dollars, then you have to use the measurement method.

But if the sub really functions in their local currency, you know, most of their transactions are in their local currency. They get their financing from local banks, very few transactions with the U S parent. If the sub really functions in their local currency. Then you use the translation method. Now going into the FAR CPA Exam, you have to have an idea of how these methods work.

So let's start with the remeasure method. Now, remember you're going to use the remeasure method when the sub really functions in us dollars. What do we mean by the remeasure method? Well, in the remeasure method, all monetary items get converted at the current exchange rate. Again, all monetary items. Will be converted at the current exchange rate.

And I think, you know what I mean by monetary items, when you look at a balance sheet, what are your monetary items? These items are fixed in terms of a currency by contract or otherwise again, monetary items are items whose amounts are fixed in terms of recurrency by contract or otherwise. So we're talking about cash, of course, accounts receivable.

Accounts payable notes, receivable notes payable, don't forget. Bonds payable held to maturity securities. These are your monetary items. And again, in the re measurement method, all monetary items get converted at the current exchange rate. In other words, the exchange rate on the date of the financial statements, the current, the exchange rate on say December 31, the date of your, the balance sheet.

Now all non-monetary items, all non-monetary items get converted at the historical exchange rate. So non-monetary items. What are those? Those are items whose amounts are not fixed in terms of a currency by contract or otherwise not fixed in terms of a currency by contract or otherwise. So we're talking about fixed assets inventory.

Again, these items are, these are items whose amounts are not fixed in terms of currency by contract or otherwise, but their values can change with changing prices. So as I say, fixed assets, inventory, tangible don't forget trading securities available for sale securities. These are non-monetary items and all non-monetary items.

Get converted at the historical exchange rate. In other words, what was the rate of exchange on the day you bought the inventory? What was the rate of exchange on the day you bought the equipment, use the historical historical exchange rate. Now how about the income statement? How about revenues expenses?

Well, on the income statement, revenues and expenses get converted at the weighted average exchange rate for the period weighted average exchange rate for the period, but be careful not depreciation. Depreciation would be the historical rate. The rate of exchange on the day you bought the equipment, not cost of goods sold, you have to use the historical rate, the rate of exchange on the day you bought the inventory.

So again, the revenues and expenses on the income statement get converted at the weighted average exchange rate for the period, but not depreciation. Use the historical rate, not cost of goods sold you as the historical rate. How about retained earnings? Well, th there's no exchange rate for retained earnings.

You just convert the revenues and expenses the way we've said and retain you back into retained earnings. And it builds over time. Hope that makes sense. There is no exchange rate for retained earnings. You just convert the revenues and expenses the way we've said and you back into retained earnings and it builds over time.

How about common stock, additional paid in capital, the historical exchange rate. How about dividends, always the exchange rate on the day of declaration, always the exchange rate on the date of declaration. All right, now follow me through this. Now we do all these conversions, right? We do all these conversions just the way we've said.

And what you end up with is a remeasure gain or loss, and remember a remeasure gain or loss belongs on the income statement. I remeasure meant gain or loss that was belong on the income statement it's included in earnings. Now how about the translation method? Now, remember, you're going to use the translation method when the sob is really functioning in their local currency, and it's actually a little easier.

You're not going to mind the translation method in the translation method. All assets, all liabilities get converted at the current exchange rate. The rate of exchange on December 31, the date of your balance sheet. So all assets, all liabilities get converted at the current exchange rate on the income statement.

All revenues, all expenses, no exceptions, all revenues, all expenses. Get converted at the weighted average exchange rate for the period. Retained earnings again, there's no exchange rate for retained earnings. We convert the revenues and expenses the way we S we've said, and we back into retained earnings.

It builds over time. Common stock, additional paid in capital. Same rule. Use the rate of exchange on the day that you issued the shares, the historical exchange rate, the rate of exchange on the day you issued the shares, dividends, same rule. Use the rate of exchange on the date of declaration. All right.

So we do all these conversions in the translation method. And what you end up with is a translation gain or loss, and you have to remember that a translation gain a loss does not go to the income statement. It's not included in earnings. It goes directly to stockholders equity as an item of OCI.

Remember that a translation gain or loss does not go to the income statement. It goes directly to stockholders equity as an item of other comprehensive income. Now there's one more thing they do get into, and that is how do you handle transactions that are denominated in a foreign currency? You have to know how to deal with this as well.

Before we get into that side of FAR cpa review course, why don't we just do a couple of questions? Look at number one. Number one says. A foreign subsidiaries, functional currency is its local currency. Stop right there. What method translation method. You have to know that if they're functioning in their local currency, it's the translation method.

And you know what the translation method means on the income statement. All revenues, all expenses are converted using the weighted average exchange rate for the period. So when they ask us the weighted average exchange rate, For the current year would be the appropriate exchange rate for sales to customers.

Yes. Wage expense. Yes. The answer is yes. Yes. Answer B because in the translation method, all revenues, all expenses get converted at the weighted average exchange rate for the period. Number two, certain balance sheet accounts of a foreign subsidiaries, a foreign subsidiary of Rowan Inc. Have been translated into us dollars as follows.

We're talking about a note receivable, that's longterm prepaid rent patent. We know translated at the current exchange rate. All of them that would add up to 475,000 at historical rates, 450,000. The subs functional currency is the currency of the country in which it is located. That's the key to the question.

If they're functioning in the local currency, you have to use the translation method and in the translation method, all assets, all liabilities get converted at the current exchange rate. So just look at the current column adds up to 475,000, and the answer is safe. Now, as I started to say, the other thing the FAR CPA Exam does get into is how to handle transactions that are denominated in a foreign currency.

Let's look at question number three. On September 22nd year for Umi corporation purchased merchandise from an unaffiliated foreign company for 10,000 units of the foreign companies, local currency, let's say it's a Euro on that date. The spot rate was 55 cents. I think entries always help here. So what entry was made on September 22nd year four, when the company goes out and purchases merchandise for 10,000 euros.

And euros are trading for 55 cents. Each. They're going to debit purchases for 10,000 euros times 55 cents, 5,500 and credit accounts payable, 5,500. Then they go on to say, you mean pay the bill in full March 20th year five when the spot rate was 65 cents per Euro, the spot rate was 70 cents per Euro, December 31 year four.

And they say at the bottom. What would you mean report as a foreign currency transaction loss in its income statement for year four, let's go to December 31 year four. When Yumi gets to December 31 year four. Now Euro's a trading for 70 cents each on December 31 year four. Now euros are trading for 70 cents each aren't euros now 15 cents more expensive.

So you have to adjust your payable. You're going to have to take 15 cents. Times 10,000 euros, you're going to have to show a transaction loss, debit, a transaction loss of 1500 and credit accounts payable, 1500. You're going to bring your accounts payable from 5,500 up to 7,000. Cause now euros at December 31 year four are trading for 70 cents each and notice I have to take a transaction loss of 1500 and that loss would go to the income statement.

And that's why the answer is D. Now I want to make sure you notice something, listen, very carefully notice a transaction gain or loss belongs on the income statement, not a translation gain a loss. Be very careful with that language. A translation gain or loss does not go to the income statement. It goes directly to stockholders equity as an item of OCI, but a transaction gain or loss belongs on the income statement.

Be very careful translation gains and losses go directly to stockholders equity as an item of OCI, but transaction gains and losses belong on the income statement. Be careful. All right, let's just carry this through what happens when they pay the bill on March 20th, year five, while on March 20th, year five, we're going to debit accounts payable, 7,000.

Right. The payable started at 5,500, but at year end, December 31 year four, we adjusted it by 1500, up to 7,000. So on March 20th, year five, when we pay the bill, we're going to debit accounts payable 7,000, but on March 20th, year five, what a Euro's trading for now that trading for 65 cents each. So I can go out and buy 10,000 euros for 65 cents.

Each I'm going to credit cash 6,500 and noticing your five. I have a transaction gain. 500. So credit transaction gain 500. And again, that gain would go to the income statement for your five because transaction gains and losses belong on the income statement, not translation gains and losses. Always be careful with that language.

Keep studying. I'll look to see you in the next class.

Welcome back in this far cpa review course. We're going to discuss. How to calculate a corporation's liability for taxes. And I think, you know that when you go to calculate a corporation's liability for taxes, the basic problem is that there are differences. There are differences between the income that the company has reported on their income statement, what the FAR CPA Exam calls, the book income and the income that the corporation has reported on their tax return.

Taxable income. Now these differences between what's on the income statement and what's on the tax return fall into two categories. It's either going to be a temporary difference or it's going to be a permanent difference. That's all there is. It's either going to be temporary differences or permanent differences.

Now we're going to begin with temporary differences. Now the first thing we want to get down. What causes temporary differences? Let's be clear on this. What causes all temporary differences? All of them is this situation. A company is using one method of accounting on their books, but another method of accounting on the tax return.

And that's what causes all temporary differences. Anytime a company is using one method of accounting on their books and another method of accounting on the attached return. That's what causes all temporary differences. Now stay with me when a company is using one method of accounting on their books and another method of accounting on their tax return, that results in two types of temporary differences.

So I want you to know there's only two types. Let's go over them type one. Type one would be this, there are revenue or expense items that belong on the income statement. Now gap says you must report these items now, but they won't be on your tax return till later that's type one and type two. I know you're ahead of me could be the opposite.

There are revenue and expense items that belong on the tax return. Now, tax law says you must report these items now, but they won't be on your income statement till later. So those are the only two types that exists revenue and expense items that belong on the income statement. Now. Won't be on the tax return to later or the opposite revenue and expense items that belong on the tax return.

Now won't be on the income statement until later. Now what I want to get into next are some examples of each type. And the good thing about the FAR CPA Exam is that the same temporary differences. Come up again and again and again and again, so that one of the things we want to do in these classes, Is make sure that the ones that are in there all the time, you're totally comfortable with you recognize them when you see them and you know how to handle them instantly.

Let's go over the common, temporary differences now, understand we're not going to go over every temporary difference that exists in the universe. We're going to go over the common ones. You see time and again in the FAR CPA Exam time. And again, you'll see, see these come up in your homework. Let's go over the first type we said.

Type one would be revenue and expense items that belong on the income statement now, but won't be on your tax return till later. So we're going to set up two columns books now tax later. So let's think this through how would it be possible to have revenue or profit on the income statement now, but it won't be on the tax return to later.

Here's one, the FAR CPA Exam loves. Let's say a company makes a lot of installment sales. So we have a company that's making on a routine basis. A lot of installment sales on their books. They're just using normal accrual accounting, but on the tax return, they using the installment sales method of accounting. Now notice right away, they're using one method of accounting on their books, normal accrual, accounting, another method of accounting on their tax return.

The installment sales method of accounting. Now just think what's going to happen here. This company goes out and makes a sale. When would all the profit from that sale beyond their income statement right away, they just using normal accrual accounting on their income statement. They're not doing anything fancy.

So if they go out and they make a sale, all the profits from that sale will be on their income statement right away. But you know this, if they using the installment sales method on their tax return, That profit won't be on the tax return till later when the installments come in, when the payments are received.

So you see the white that you see that the way I do, isn't that an example of how you can have income on the income statement now, but won't be on the tax return to later when the installments come in, when the payments come in. Now, this is very important. the FAR CPA Exam would call this a future taxable amount.

Get used to that phrase. the FAR CPA Exam would refer to this. As an FTA, a future taxable amount. Doesn't that make sense? Because the company is going to get taxed in the future. When the installments come in, when the payments are received, that the company is going to get taxed in the future. Think of this as a future taxable amount.

What would be another example of how a company could have revenue or profit on the income statement now? But won't be on the tax returns later. Here's another good one exam loves it. Let's say a company is involved with long-term contracts, long-term construction contracts on their books. They using the percentage of completion method, but on the tax return, they using the completed contract method.

Notice again, they're using one method of accounting on their books, another method of accounting on their tax return. That results. In all temporary differences. That's why we have them. Now think what's going to happen to this company. This company starts a five-year project. They get to the end of year one, they estimate the project is 18% complete.

You know, what's going to happen. If at the end of year one, you estimate the project is 18% complete on your books. You're going to recognize 18% of the estimated profit from that project on your income statement at the end of year one, because that's how the percentage of completion method works. We recognize a certain percent of the profit each year of the project.

As we earn the profit each year of the project. But, you know, this, there would be no profit from that project on their tax return until year five, when they finished the project. Cause under completed contract, we recognize no profit from a project until it's finished. So you see what we end up with. We end up with profit on our income statement.

Now you're one that won't be on our tax return until year five. When we complete the project. the FAR CPA Exam is going to refer to this as another example of a future taxable amount. Why? Because the company is going to get taxed in the future when they finished the project, it's got to make sense to you. These phrases have to make sense.

How about an expense, a deduction? How would it be possible to have an expense or a deduction on the income on the income statement now? But it's not going to be on the tax return until later. Well, what you're looking for here is any sort of estimated expenses. And the one we're going to discuss is the one that's in the FAR CPA Exam again.

And again, and again, let's talk about warranty expenses. I think, you know what happens with warranty expenses on our books? We have to estimate we have to accrue our want expense. In other words, if based on past experience, we estimate that 1% of our customers. I'm going to want to, I'm going to want to refund 1% of our customers based on past experience are going to demand a refund.

What are we supposed to do in gap? We're supposed to take 1% of our sales and set up an estimated or a crude warranty expense. IRS would disallow that IRS is not going to let you estimate your warranty expense on your tax return. The corporation can't take that warranty expense as a deduction on their tax return until they actually pay out the claims.

So you see my basic problem. Don't I end up with an expense, a deduction on my income statement. Now gap makes me accrue it gap makes me estimated I have no choice, but it won't be on my tax return. Till later when I pay out the claims. Now be careful the FAR CPA Exam would call this a future deductible amount.

Why is this a future deductible amount? Because isn't this a deduction that we can take on our tax return in the future. When we pay out the claims, this is not a future taxable amount. This is a future deductible amount, because this is a deduction we can take on our tax return in the future. When we pay out the claims, let me say something that is probably becoming pretty obvious already.

Let me just say this to you. If you go in that exam. And, you know, whether you're D whether you're dealing with a future deductible amount or a future taxable amount, this isn't going to be bad at all. That's why I want to spend so much time on that, because once you get that down, once you're in that exam and you know, Oh, that's a future deductible amount.

Oh, that's a future taxable amount. As I say this, isn't going to bother you a bit. Let's go to type two. What's the second type of temporary difference. Well, it's the opposite, right? There are revenue and expense items that belong on the tax return. Now. Tax law says you must report these items now, but they won't be on your income statement until later.

So let's get into revenue or profit. How would it be possible to have revenue or profit on the tax return? Now it's not going to be on the income statement until later. Now what you're looking for here is anything collected in advance. And the one we're going to put in our schedule is the one the FAR CPA Exam likes the most, and that is rental income.

Now, you know, what's going to happen for rental income on our tax return. It's going to get on the tax return as it's collected. It's not going to get on our books till we earn it. So think what happens here. Let's say I'm the landlord. You're my tenant. You rent out my warehouse. You give me a check.

That's meant to cover five year's rent in advance. You know, what's going to happen. If you give me a check, that's meant to cover five year's rent in a bit in advance, by the way, God bless you, but you'll give me a check. That's meant to cover five year's rent in advance. When I do my tax return, I have to put all five years rental income on my tax return now, because all IRS cares about is I got the money.

IRS does not care about the matching concept. IRS does not care about accrual accounting. All IRS and cares about is we got the money. So if you give me a check, that's meant to cover five year's rent in advance. When I do my tax return, I have to put all five years rental income on my tax return now, but you know, this, that rental income is not going to be on my income statement until I earn it evenly over the next five years.

Because under gap, we don't recognize the income when we collect it, we recognize income as we earn it. So. That income's not going to be on my income statement until I earn it evenly over the next five years. So you see what I end up with? Don't I end up with profit that's on my tax return now, but it won't be on my income statement until later over the next five years, as I earned it evenly over the next five years.

All right. It's time for a pop quiz. I want to see if you've been listening to me. What do you think the FAR CPA Exam would call this one? Is this a future deductible amount or a future taxable amount? What do you think it's right. It's a future deductible amount. Why I already paid the tax? I don't get taxed in the future here.

I already paid the tax. Now I can deduct this from my taxable income later. That's a future deductible amount. One more. How about an expense? A deduction. I can take on my tax return now, but I can't take on my income statement to later. Well, the best example of that, and you knew this was going to come up is accelerated depreciation.

Let's get into depreciation. You know what happens? You go out and buy a piece of equipment on your tax return. You use acres makers, whatever accelerated recovery, right off system Congress dreams up. We want to write it off as quickly as we possibly can for tax purposes. So on our tax return, we're going to use makers, the modified, accelerated cost recovery system.

We're going to write it off as fast as we possibly can for tax purposes. But let's say on our books, we using straight line depreciation. You see the effect that has don't. I take a big deduction on my tax return now that I won't take on my books until later, more slowly under straight line. So what do you think, what would the FAR CPA Exam call this one?

Is this a future deductible amount? Or a future taxable. Now this is a future taxable I'm out. I already took a big deduction on my tax return. This is not a deduction I can take in the future. It's gotta make sense to you. I already got a big deduction on my tax return. I got to pay the Piper later. It's a future taxable amount.

Now, before we leave temporary differences, I want you to notice something very important about temporary differences. Notice. What is unique about temporary differences? What is singular about temporary differences is that temporary differences reverse themselves. This is very important. Temporary differences.

Turn around. You can see it in what we've just done. The rental income that's on my tax return now will eventually get on my books in the future. As I earn it over the next five years, you know, if I wait long enough, the income statements will catch up to the tax returns. The tax returns will catch up to the income statements in the first examples.

But remember that about temporary differences, they turn around, they reverse themselves. Now, before we get into how to account for temporary differences, we haven't covered that yet. I mean, now we know what temporary differences are, what causes them. The difference between a future deductible amount, a future taxable amount.

All we need to discuss now is how to account for temporary differences. But before I get into that, let's talk about the permanent differences. I will say that there's not that many, that the FAR CPA Exam loves, but you've got to know them. When you see them, let's start this the same way. What causes permanent differences.

We already know what causes temporary differences. Anytime a company is using one method of accounting on their books and another method of accounting on the tax return. That's what causes all temporary differences as we know. So we'll start this the same way. What causes permanent differences we'll remember what causes all permanent differences is this situation.

The company has some item on their books, revenue, or expense, this some item on the company's books, revenue, or expense. That'll never be on the tax return. It'll never be on the tax return. It'll never reverse itself. That's why it's permanent. Permanent means what it always means. It's forever. You're stuck with it.

It never reverses itself. It's permanent. So remember that permanent differences never reverse themselves. They are permanent. Now, as I say, there aren't that many permanent differences, the FAR CPA Exam throws in again and again, but you got to know them when you see them. Here are the ones, the FAR CPA Exam likes, let's say a corporation.

Takes out a life insurance policy on the president of the corporation. And the corporation is the beneficiary of that policy. That's important. The corporation takes out a life insurance policy on the president of the corporation and the corporation is the beneficiary of the policy. Now, you know, what's going to happen.

The coup the corporation's gonna pay premiums on that policy. The corporation is the beneficiary of the policy. It's what they call a key person policy. So the corporations going to pay premiums on that policy, what do you think will those premium expenses beyond the company's income statement? Of course.

Why? Because they incurred them. It's all gap cares about those are expenses that were incurred. Will IRS let you take those premium expenses as a deduction. On the corporate tax return. No IRS will disallow that if the corporation is the beneficiary of the policy, if it's a key person, policy, IRS will disallow that.

So you see my problem. Don't I have an expense on my income statement. I have to report it. I incurred it gap makes me report it, but it'll never be on my tax return. That's never going to reverse itself. It's a permanent difference. Another one. Let's say the president of the corporation dies and the corporation collects a million dollars of life insurance proceeds.

Well, the million dollars of life insurance proceeds beyond the corporations income statement. Yes. Other income. Is it on the tax return? No life insurance proceeds are just not taxed. So you see my problem. I end up with income on my income statement. I have to report it because I earned it. But it's never going to be on my tax return.

It's not taxed. That's a permanent difference. That's never going to reverse itself. Another one, they like let's talk about interest, income on municipal bonds. Cooperation goes out and invests immunity, double bonds. You know, what's going to happen. They're going to earn interest income on those municipal bonds.

Will that interest income from municipal bonds beyond the income statement? Of course they earned it. So all gap cares about was earned. Is it on the tax return? No interest income from municipal obligations is just not taxed. So you see my problem. I end up with income on my income statement. I have to report it.

I earned it, but it's never going to be on my tax return. That's never going to reverse itself. It's a permanent difference. You're stuck with that difference. You see what really causes permanent differences gap and tax law. Just don't agree. It's another way to put it. Gap and tax law just don't agree on the item.

One more, one more permanent difference. And I have to mention it because in these classes, we're going to get into this. Don't forget this. When one domestic corporation pays another domestic corporation, a dividend 80% is non-taxable again. When one domestic corporation pays another domestic corporation, a dividend.

80% is non-taxable. Don't forget there's an 80% dividend received deduction, an 80% DRD. Now I know there's a 70% DRD. There's an 80% DRD. There's a hundred percent DRD, but for our purposes in these classes, we will stick with the 80% DRD. Now, maybe you don't see why I brought this up. Well, let's say you're a domestic corporation.

I am a domestic corporation and you send me a thousand dollars dividend. If you send me a thousand dollar dividend, you see the way that's going to play out on my income statement, I'm going to have a thousand dollars of dividend income, but on my tax return, I'm only going to have $200 of dividend income because there's that 80% exclusion.

And I want you to be confident that that $800 difference between book and tax never reverses itself. That is a permanent difference. And you have to be aware of that because that is going to come up. As we go through these classes, we will continue our discussion on how to account for a company's income taxes in our next class.

Don't fall behind, keep working hard and I'll see you in the next class.

Welcome back in this far cpa review course, we're going to continue our discussion on how to account for a company's taxes. And I want to start FAR cpa review course by doing a problem just on permanent differences, just on permanent differences. If you look in your viewers guide, you'll see the problem. Notice we have a corporation and the income on the books.

Is 150,000 and the income on the tax return is 150,000 before we put in the permanent differences. So notice down to this point, book and tax agree income on the books is 150,000 income on the tax returns, 150,000. But again, that's, before we put in the permanent differences, let's put in the permanent differences.

This corporation paid $18,000 in premium expenses on key person policy. So, you know, the way that plays out, they have to put the $18,000 premium expense on their income statement on their books because they incurred it. But IRS would disallow it. Notice there's nothing on the tax return. They would disallow it because if it's a key person policy, if the corporation is the beneficiary of the policy, IRS is not going to allow you to take that as a deduction on it, on the corporate tax return.

Next, this company earned $30,000 of interest income from municipal bonds. And, you know, the way that plays out, you've got to put the 30,000 of interest income on the books because it's earned. It's all gap cares about, but there's nothing on the tax return because interest income from municipal obligations is simply not taxed.

Next. This company received a $10,000 dividend. From a domestic corporation. So naturally there's 10,000 of dividend income on the income statement. But notice there's only 2000 of dividend income on the tax return because we have that 80% DRD that 80% dividend received deduction, 80% just not taxed. So if we add it up, here's the situation, this company's income on the books under gap under generally accepted accounting principles.

Their income on the income statement is 172,000, but on the tax return, their taxable income is only 152,000 together. Let's put down the journal entry to record tax for this company because that's, what's so important for you as a student, making sure you know, the entry to record taxes. That's really what these classes are about to make sure that, you know, the entries for taxes.

Because if, you know, if you can get the entries down for taxes, you're going to be strong on this. So what would be the entry to record tax for this company? Well, I have some advice for you any time you're putting down the entry to record tax for corporation, I think you should always start with, what's something that the FAR CPA Exam can't change, they can't play around with.

And that is what you owe the government, what you owe the government, your current federal tax liability. Is always based on taxable income, always, whether you're dealing with any type of problem in the FAR CPA Exam, they can't change that. What you owe the government, your current federal tax liability is always based on taxable income.

So let's say that the current tax rate is 30%. If I want to work out what I owe the government, I would simply take the taxable income 152,000. Times the current tax rate, which is 30% and notice I'm going to credit income tax payable, 45,600. That's what I owe the government. And it's always based on taxable income and notice I debit income tax expense, current portion 45 six.

That would be the entry for taxes, debit income tax expense, current portion, 45, six, and credit income tax payable, 45 six. That's what I owe the government. And it's always based on. Taxable income. Now I want you to notice something, notice this important point, as long as you're dealing with permanent differences, as long as it's only permanent differences, whatever you owe the government, your payable is also your expense.

In other words, you don't do any different tax accounting with permanent differences. Why because they never reversed themselves. I'll say that again. As long as you're only dealing with permanent differences, remember whatever you owe the government, that's also your expense. You don't do any different tax accounting with permanent differences because they're permanent.

They're forever. They never reverse themselves. So whatever you owe the government, that's also your expense. Now I want to tell you this. Also, I know from dealing with my students, that a lot of students. Get these wrong in the FAR CPA Exam. Not because they don't understand what's going on in the problem, but I will tell you, I've got to warn you on this terminology.

Messes people up here. I know it. I know from talking to my students, terminology can mess you up. So I want you to know before we go any further that there are three ways the FAR CPA Exam could ask you for what we just did. So let's, let's get this down three ways. They could ask this, this drives people crazy.

Number one, they could ask. What is the current federal tax liability. Now they ask you that what is the current federal tax liability? The answer is what you owe the government in this example, 45,600. And what they're talking about is the credit and that entry income tax payable. Number two, they could ask what is the current portion of income tax expense.

This really does drive people crazy. If they ask what is the current portion of income tax expense? Again, the answer is 45 six. In this problem, what you owe the government. And now they're talking about the debit in that entry. One more they could ask, what is the current provision for taxes. Now, if they ask you, what is the current provision for taxes?

Again, the answer is 45 six. It's what you owe the government. And what they're referring to is the debit in that entry. You have to get used to that language. Don't let the language mess you up. Now, what I want to show you next is there's a type of problem. That they've always had in the FAR CPA Exam on this. And they always will.

And my guess is you've probably seen something like this before the FAR CPA Exam loves a problem where they give you the income on the books. They give you that they give you the income on the books, and then they tell you the temporary differences and the permanent differences. And what they want you to be able to do is reconcile from book income, to taxable income.

This is a very common type of problem in the FAR CPA Exam. And I'm going to hammer on it because you can not go in that exam and not be absolutely comfortable with reconciling, from book income to taxable income. Let's do a question. And your viewers guide question number one. Number one says for the year ended December 31 year one Mont company's books showed income of 600,000.

Before the provision for tax expense. So book income is 600,000 before taxes to compute taxable income. The following items should be noted. So let's, let's do the reconciliation together. So we know the income on the books is 600,000 and you see the basic idea in all of these problems. The basic premise is if we tell you the income on the books and we give you the temporary differences and the permanent differences, well, then you should be able to infer then what taxable income must have been.

So let's go through the differences. First one income from municipal bonds. Let me ask you, is that 60,000 in the 600? Is it sure because you earned it it's in the 600, you earned it, but it wouldn't be on the tax return. Cause it's not taxed. So all by itself, it wouldn't be in the tax return. It's not taxed.

So all by itself, wouldn't that cause taxable income to be 60,000 less than book income, we're going to subtract that. And you know, that's a permanent difference, you know? So put a little P there, cause that's what I want my students to be good at, you know, go down a list of differences and right away, identify permanent differences, temporary differences.

That's a permanent difference. Now the next one's a temporary difference. Their favorite. Look at the wording depreciation deducted for tax in excess of what's on the books. Now think about it. If I take 120,000 more depreciation on the tax return over and above what I took on the books all by itself, that's going to cause taxable income to be 120,000 less than book income.

Right. If I take 120,000 extra depreciation on my tax return over and above what I took on the books all by myself, all by itself, that's going to cause taxable income to be 120,000 less than book income. Now we know that's a temporary difference, but I want you to think about this. Is that your, is that a future deductible amount or is that a future taxable amount?

That's a future taxable amount. That's an FTA get used to that one. That's a future taxable amount. I already took a big deduction. I already took a huge deduction on my tax return. I got to pay the Piper later. That is an FTA. That is a future taxable amount. Now the last one is a permanent difference.

Notice proceeds received from life insurance on the death of an officer is the a hundred thousand in the books. He asked the a hundred thousands in the 600,000 because it was earned other income it's on the books, other income. But it's not on the tax return because life insurance proceeds are just not taxed.

So all by itself, that's going to cause taxable income to be a hundred thousand less than book income. So now we can reconcile what is taxable income? It's the 600,000 minus the 60 minus the one 20 minus the a hundred, 320,000 that's taxable income. And my point is now we can solve it. Because what I owe the government is based on taxable income.

So I'm going to take the taxable income 320,000 times the tax rate. They say that's 30% and I'm going to make my entry. I'm going to debit income tax expense, current portion, 96,000. I'm going to credit income tax payable, 96,000. Get used to that entry. That's what I owe the government. And it's always based on taxable income.

I can't do anything with book income. I know you recognize that. I can't do anything with book income. I had no choice here, but to reconcile from book income to taxable income. So we'll go to the bottom. They say, what amount would Martin report at December 31 year one as their current federal tax liability?

I say to you again, if they want the current federal tax liability, it's what you owe the government. The answer is a, and they're talking about the credit and that entry income tax payable. Let's do number two. Kemp camps, income statement for the year ended December 31 year five shows pre-tax income known as pre-tax income, 500,000.

All right. So we know the income on the books, 500,000 and we have some items we have to reconcile with. And as I said, the basic premise in all these questions is that if we tell you the income on the books, And then we tell you the temporary differences and the permanent differences, you should be able to infer.

Then what taxable income must be. Let's go through the differences. The first one we've talked about it is a temporary difference. Rental income. They putting it on their tax return is as it's collected, they're putting it on the books as they earn it. So look at that rental income. There's 60,000 of rental income in the accounting records.

That's already in the 500,000, right? That's in the book income, there's only. 35,000 of rental income on the tax return. So think about it. If there's 25,000 less, 25,000 less rental income in the tax return than there is on the books all by itself, that's going to cause taxable income to be 25,000 less than book income.

We subtract that and that is an FTA. That's a future taxable amount will get taxed in the future. When we collect the money next, their favorite. Depreciation, they took 110,000 depreciation in the accounting records. That's reflected in the book income of 500,000. But I think we agree if you take 140,000 depreciation on the tax return, if you take an extra $30,000 depreciation on the tax return over and above what you took on the books all by itself, that's going to cause taxable income to be 30,000 less than book income.

So we subtract that also, and that's an FTA. That's a future taxable bow. We already took a big deduction on our tax return. We pay the Piper later future taxable amount. Now the last one is a permanent difference. They took a $45,000 premium expense on their income statement in their accounting records.

That's reflected in the book income, a 500,000 notice. IRS allowed none IRS disallowed it that tells you that the corporation must've been the beneficiary of the policy to key person policy. Now think now. Is that going to cause taxable income to be higher or lower than book hire right higher. If IRS disallows a deduction that causes taxable income to be higher than book, it's just like your personal tax return.

If IRS disallows a deduction, it causes taxable income to go up. Same thing here. It's going to cause taxable income to be higher than book. So now we can reconcile. What's taxable income. It's the 500,000 minus the 25 minus the 30 plus the 45 taxable income is 490,000 and now we can solve it because what we owe the government is based on taxable income.

I want you to recognize again, we can't do anything with book income. I had no choice here, but to reconcile from book income to taxable income. So I'm going to take the taxable income 490,000 times the tax rate. Which is in this case 40%. And I'm going to make my normal entry. I'm going to debit income tax expense, current portion, 196,000.

I'm going to credit income tax payable, 196,000. That's what I owe the government. And it's always based on taxable income. What do they want here at the bottom? It says, what is the current portion of Kemp's total income tax expense? See what you have to know the language when they want the current portion of income tax expense.

Again, it's what you owe the government. The answer is C. And what they're talking about is the debit in that entry. As I say, it's very important when you win the FAR CPA Exam that you can reconcile very quickly from book income, to taxable income. It's something they test a lot and I want you to be very, very good at it.

Now, there are two more questions in this module questions, three and four, you make sure and I'll promise me, you'll do those two questions before you come to the next class. Get those two questions. Dunn and pine, get those two done. And I'll look to see you in the next class.

Welcome back in this far cpa review course. We're going to continue our discussion of how to account for a company's taxes. And I asked you in the last class to do two questions before coming to FAR cpa review course, and I know you were good about that. So let's do let's look at the first one done company. And we have a problem again, where, what we have to do to solve this is reconcile from book income to taxable income.

In this problem, we know the income on the books is 90,000. And as I've said, the premise in all these questions is that if we tell you the income on the books, and then we give you the temporary differences, the permanent differences, we should be able to infer then what taxable income must be. So let's go through the differences first.

How about that rent received in advance that 16,000? Is that in the 90? Is it in the 90? No, because you haven't earned it yet. Remember in the books, you don't recognize income until you earn it. If you collected in advance, it wouldn't be in the book income. Cause it's not earned, but it would be on the tax return because it's taxed when you get the money.

So all by itself, that's going to cause taxable income to be higher than book. We add that. And what do you think is that a future taxable amount or a future deductible amount? That's right. It's a future deductible amount. We're going to pay the tax. Now we're not taxed in the future here. We're going to pay the tax now, and we can deduct this from our taxable income later.

That is a future deductible amount. Next, the income for municipal bonds, that 20,000. Is it in the 90? Yes. Are there income? It's on the books. But on the tax return, it's just not taxed interest income from municipal law obligations is just simply not taxed. So all by itself, that's going to cause taxable income to be lower than book.

So we'll back that one out. That's a permanent difference, as you know, and then the favorite depreciation deducted for tax in excess of what's on the books. You know what happens in this case, we take an extra 10,000 depreciation on the tax return. Over and above what we took on the books, that's going to cause taxable income to be lower than book income by 10,000, get used to it, memorize it.

If you have to, that is a future taxable amount and FTA. So now we can work it out. What's taxable income, 76,090 plus 16, minus 20 minus 10, 76,000. And my point again, and again is now we can solve it. Because what we owe the government is based on taxable income. We can't do anything based on book income.

So I'm going to take the taxable income, 76,000 times the tax rate, which is 30%. And I'm going to make my normal entry. I'm going to debit income tax expense, current portion, 22,800. I'm going to credit income tax payable, 22,800. That's what I owe the government. And it's always based on taxable income.

What do they want here at the bottom? They want to know the current federal tax liability. And as you know, when the FAR CPA Exam asks for the current federal tax liability, it's what you owe the government. The answer is B 22,800. And what they're talking about is the credit in that entry income tax payable.

Let's go to the other question I wanted you to do Pyne. Once again, we know the income on the books, 800,000. Let's go through the differences. They had a gain from an involuntary conversion. You might remember in our first class on this topic, we went over that the common, temporary differences that you see in the FAR CPA Exam.

But I want to emphasize, again, we didn't cover all of them. We didn't cover every temporary difference. That's in the universe. We just covered the ones that are in the FAR CPA Exam all the time. As you're doing your homework, you'll run into a couple of odd ones. Here's an odd one, a gain from an involuntary conversion.

What is that? Well say a fire destroys a machine and we get more from the insurance company than the carrying value of the machine. That would be a gain from an involuntary conversion. We didn't mean to do it as opposed to we go out and sell the machine of the gain. That would be voluntary. That's a gain from a voluntary action.

The main point is this gap doesn't care gap. Doesn't care. Whether gains and losses are voluntary, involuntary, they belong on your income statement. Again, gaps simply doesn't care about the issue. Gap doesn't care, what the gains or losses are voluntary, involuntary. They belong on your income statement. So that that gain is in the 800,000 book income it has to be, but IRS has a rule.

Where, if you go out and replace the property within a certain period on your tax return, they can defer the gain. And that's what they did. They replaced the property within the statutory period. So on the tax return, they can defer the gain. So all by itself, that's going to cause taxable income to be 350,000 less than book income, because that game's not on the tax return.

And that is an FTA. That is a future taxable amount because we're going to get taxed in the future because what we now do is adjust. The tax basis of the asset for any unrecognized gain. So it eventually it does reverse itself. Eventually we pay the tax in the future, but that is a future taxable amount.

And then their favorite. I know you getting used to it, Bob, I can do this one blindfold. That's good. That's what I want. Should be automatic depreciation deducted for tax in excess of what's on the books, you take an extra $10,000, excuse me, an extra 50,000 depreciation on the tax return. That's going to cause taxable income to be lower than book by 50,000.

Now we know taxable income, 400,800 minus three, 50 minus 50. Taxable income is 400,000. So now we can solve it. What I owe the government is based on taxable income. So I'm going to take that taxable income, 400,000 times the tax rate, 30%. And I booked my entry. I'm going to debit income tax expense, current portion, 120,000.

I'm going to credit income tax payable, 120,000. That's what I owe the government. And it's always based on taxable income. What do they want here at the bottom? It says, what amount would pine report as their current federal tax liability? You know what that language means? If they want the current federal tax liability, it's what you owe the government.

They're talking about that income tax payable. So the answer is C right? No, it's Nazi. That's why I wanted you to do this one because they made estimated tax payments notice that, that they made 70,000 of estimated tax payments. So let me just show you what you do when you see that. If they've made estimated tax payments, it just means they've made another entry where they've debited income tax payable, 70,000 and credit cash, 70,000.

So that's how you handle estimated payments. If they, if they've made estimated tax payments, it's simply me. It simply means that they've made another entry where they debit income tax payable, 70,000 and credit cash, 70,000. So when they asked me at the bottom, what is my current federal tax liability will that income tax payable used to be 120,000, but I've made 70,000 in payments.

So it's now 50,000 answer a. So watch out for those estimated tax payments. Let me ask you this. What if they ask the same problem and they wanted the current portion of income tax expense? Well, if they want the current portion of income tax expense, now it's C because when they want the current portion of income tax expense, that's what I owe the government.

But now they're talking about the debit net entry and the estimated payments don't affect the debit. See, I want you to know that it matters a lot in that exam, whether they're asking you for the debit or the credit and that first entry. Stay with me. Same problem. What if they wanted the current provision for taxes?

If they asked you for the current provision for taxes a or C now C because yes, if they want the current provision for taxes, it's what you owe the government. But now they're talking about the debit and that first entry, the debit and the estimated payments don't affect the debit. The estimated payments affect the debit income affect the credit income tax payable.

The estimated payments don't affect the debit. Current portion of income tax expense, current provision for taxes. It only affects the credit income tax payable. That's why I say in the FAR CPA Exam, it matters a lot. Whether they want the debit or the credit from that first entry, that's why you have to be right on that language.

And I know you are now. I want to go back now that we are experts on reconciling from book income to taxable income. I want to go back to temporary differences. And how we account for temporary differences. And I want you to listen carefully. The way we account for temporary differences is the liability method.

That's what the CPA exam calls. This, what we apply to temporary differences in order to account for temporary differences is the liability method. The liability method. Is a so-called asset and liability approach. That's what it is. The liability method itself is an asset and liability approach of accounting for temporary differences.

That's what we're going to use here, an asset and liability approach of accounting for temporary differences. But as I say, it's what the CPA exam always calls the liability method. And I think the only way to understand the liability method is to go right to a problem. And you'll notice in your viewers guide, we have an illustrated problem.

We know the book income for year one, 800,000, and we have some differences. There were premiums paid on key person, life insurance policies of 260,000 interest income from municipal bonds. A hundred thousand depreciation for tax more than what's on the books. 600,000 and accrued warranty expenses of 50,000.

Now we're also told that the warranty liability. Is expected to actually be paid in year four. We know the tax rates for year one, two, three, and four. We know the depreciation difference is going to reverse 400,000 in year to 200,000 in year three, before we do anything else, let's take this problem. And let's reconcile from book income to taxable income.

This is why you have to be good at this because it's really your starting point. So let's take this problem. Let's reconcile from book income to taxable income. We know the income on the books. 800,000. Let's go through the differences. They pay 260,000 of premium expenses on key person policies while, you know, the way that plays out that expense is in the books because you incurred it, but it wouldn't be on the tax return because IRS would disallow it.

If the corporation is the beneficiary of the policy, IRS is going to disallow that. So that's going to cause taxable income to be higher than book by 260,000. We add that. Interest income on municipal bonds? Well, you know, the a hundred thousand is in the 800,000 it's in the book income because you earned it, but it's not on the tax return.

It's not taxed. So that's not, that's going to cause taxable income to be a hundred thousand less than book income. We subtract that their favorite depreciation. For tax in excess of what's on the books, you know, the way that plays out, you take an extra 600,000 depreciation on the tax return over and above what you took on the books.

That's going to cause taxable income to be less than book income by 600,000. And then finally the warranty expense, the 50,000 on our books. We follow gap we have to, and gap makes us estimate makes us a crew, our warranty expense, but IRS would just allow that IRS is not going to let you take that as a deduction on your tax return.

And you're one, you're not going to be able to take that as a deduction on your tax return until year four, when you pay out the claims. So as you know, if IRS disallows a deduction, that's going to cause in year one taxable income to be higher than book by 50,000. So now we can reconcile what's taxable income.

It's 800,000 plus two 60 minus a hundred minus 600,000 plus 50,000 taxable income is 410,000. So let's work out what we owe the government. We are, we know that what we owe the government is based on taxable income. So I'm going to take the taxable income 410,000 times what tax rate the year one tax rate, which is 35%.

And I'm going to make my normal entry. I'm going to debit income tax expense, current portion, 143,500. And I'm going to credit income tax payable, 143,500. That's what I owe the government. And it's always based on taxable income. Now let's look at these differences, the. Key person, life insurance premiums.

We know that's a permanent difference. How about the municipal bond interest? We know that's a permanent difference. Those are never going to reverse themselves. Now the accelerated depreciation, that's a temporary difference, but let me ask you this. Is that a future deductible amount and a few or a future taxable amount?

What is it, Bob? I can't stand that question anymore. It's a future taxable amount. That's good. I want you to be like that. It's gotta be automatic. You see that accelerated depreciation, hots and FTA. I want that reverberating in your head tonight when you're trying to sleep. So a future taxable amount. How about the second one, the warranty deduction.

While we took a big deduction on our income statement. Now we estimate it. We can't take it on our tax return until later when we pay out the claims, isn't that a deduction we can take on our tax return in the future. When we pay out the claims, that's a future deductible amount. So we know the accelerated depreciation is a future taxable amount.

We know the. Warranty expense is that future deductible amount? Let me ask you this. Are we going to set up deferred taxes for the municipal bond interest for the life insurance premiums? No. Remember this will ring a bell with permanent differences, whatever we owe the government. That's also our expense.

We don't do any different tax accounting with permanent differences because they never reversed themselves. So that first entry you would put what we, that we put down when I debit in, I don't want my students to think like this. When I debit income tax expense, current portion, one 43, five, and I credit income tax payable, one 43 five.

When we worked out what we owe the government that automatically takes care of all permanent differences. You never have to think about them again. I like my students to think like that, you know, once you work out what you owe the government that automatically takes care of all permanent differences, you never have to worry about them again, get that, that first entry down for taxes, what you owe the government you're done with permanent differences.

Of course, now what we have to work out is the temporary differences. And we'll do that in our next class. We'll continue this problem in the next class and we'll get to the. Temporary differences. I'll see you then

welcome back. The first thing we're going to do in this far cpa review course is finish the problem that we started in the last class on temporary differences. And you remember that in that illustrated problem, we have already reconciled from book income to taxable income. We've worked out what we owe the government.

It's 143,500. And we know that's always based on taxable income. And when we left off, we were saying that we do, I would apply the liability method to permanent differences because once you figure out what you owe the government, once you debit income tax expense, current portion, credit income tax payable, 143,500, that's what you owe the government.

And that automatically takes care of all permanent differences. You'll never have to worry about them again. Now we're going to apply the liability method to the temporary differences. And remember the liability method is an asset and liability approach. It's an asset and liability approach of accounting for temporary differences.

And what does that mean? It means that you have to be able to calculate a deferred tax asset and you have to be able to calculate a deferred tax liability. So let's start. By calculating our deferred tax asset. And what we're going to go over now is the formula for deferred tax assets. And you have to memorize it.

There's no way out of this. You've got to memorize this and I think we're going to work with this quite a bit. So I think you'll probably have it memorized right away, but let's get it down the way you calculate deferred tax assets is by taking. Future deductible amounts. You see why it's important to know what these phrases mean.

We're going to take future deductible amounts, times future tax rates. If you take future deductible amounts, times future tax rates, that'll always give you your deferred income tax asset. So let's work it out in this problem. The warranty expense, as we talked about in the last class that represents a future deductible amount because.

The warranty expense is a deduction that we can take on our tax return out in year four. It's a future deductible amount. So let's work out our deferred tax asset. We're expecting a future deductible amount, the warranty expense to reverse out in year four when the enacted tax rate is 20%. So we're going to have to set up a $10,000 defer income tax asset for that reversal.

Deferred tax assets are always based on future deductible amounts, times, future tax rates. And we do have to worry about these future tax rates. If, and only if they've been enacted in the law. Again, you, you are supposed to use future tax rates. If, and only if they've been enacted in the law, are we supposed to estimate future tax rates?

No. No, we're not required to do that. What's the tax rate going to be in 2071, who knows? We're not asked to estimate future tax rates. We're not going down that path. No, we'll use future tax rates if, and only if they've been enacted in the law, but deferred tax assets are always based on future deductible amounts, times, future tax rates.

So we're going to have to set up a $10,000 deferred tax asset for the reversal. Of those warranty expenses. Now let's get into how you calculate a deferred tax liability. Deferred tax liabilities are always based on future taxable amounts, times, future tax rates. And again, you use future tax rates if, and only if they've been enacted into law.

So let's look at our future taxable amount, the accelerated depreciation. Think what, think what happened in this problem. We took an extra $600,000 depreciation on our tax return over and above what we took on the books. Now notice how that's going to reverse and the FAR CPA Exam will give you these reversals.

So don't get nervous about that. We're told that 400,000 of that future taxable amount is going to reverse in year to 200,000 of that future taxable amount is going to reverse in year three. So let's work out our deferred tax liability. We're expecting a $400,000 future taxable amount to reverse in year two, when the enacted tax rate is 30%, we're going to have to set up $120,000 deferred tax liability.

For that reversal let's move on. We're expecting a $200,000 future taxable amount to reverse in year three. When the inactive tax rate is 25%, we're going to have to set up a $50,000 deferred tax liability for that reversal. What is your deferred tax liability? 120,000 plus 50,000, 170,000 deferred tax liabilities are always based on future taxable amounts, times future tax rates.

If those future tax rates have been enacted into law, but let's, let's be honest in an exam. They're going to have to give you the future tax rates anyway. All right now, let's get back to where we left off. You know, in our last class, we reconciled from book income to taxable income. We worked out what we owed the government.

We debit it, income tax expense, current portion, 143,500. We credited income tax payable, 143,500. Right. That's what we owe the government. It's always based on taxable income. Now let's put down the second entry for taxes. I hope it makes sense. We're going to. Credit deferred income tax liability, 170,000.

We're going to debit deferred income tax asset, 10,000 notice it's an asset and liability approach of accounting for temporary differences. So again, I'm going to debit deferred income tax asset, 10,000. I'm going to credit deferred income tax liability, 170,000. Now the entry doesn't balance, of course.

This next number is a plug. I simply need $160,000 debit to balance the entry out that's income tax expense, deferred portion, 160,000. This is how we account for a corporation's taxes. We make one entry for the current portion of expense, what you owe the government and a second entry for the deferred portion of expense because of temporary differences.

It always takes two entries to record taxes, one entry for the current portion, what you owe the government and the second entry for the deferred portion, because you have temporary differences. Let me ask you this. In this case, the deferred portion, I need a debit to balance the entry out 160,000. That was the deferred part of expense.

Could the deferred portion be a credit? Yes, it's possible. Now, listen, you know, what? If the asset had been one 70, the liability 10 will, if the asset had been one 70 in the liability 10, well, now I need a credit of one 60. Listen carefully. If you need a credit to balance the entry out, that's called deferred tax benefit, you have to now the FAR CPA Exam talks.

So let me say it again. If you need a debit to balance the entry out, it's the deferred portion of expense. If you need a credit it's deferred tax benefit. All right now, if you would be down to there, what we're going to get into next is how we report all of this in our financial statements. I'm going to start with income statement presentation on an income statement.

Remember that income tax expense, as far as a corporation is concerned, it's just another expense of doing business. That's how corporations look at income tax expenses. Just another expense of doing business. And income tax expense belongs up and continuing operations on the income statement. And you have to divide it into two parts.

It's not going to surprise you a bit. We have to show the current portion of expense, what we owe the government in this case, 143,500 plus or minus deferred portion here. It's a plus because it's a debit. So I have plus deferred portion, 160,000. Add it up. That gives me my total income tax expense. My total provision for taxes, which the FAR CPA Exam could ask you for 303,500 that's income statement, presentation up and continuing operations.

You show income tax expense in those two parts, the current portion, what you owe the government plus or minus deferred portion here it's plus because the deferred portion was a debit. So my total provision for taxes, my total income tax expense, which again, they could ask you for is 303,500. Now what we're going to get into is balance sheet presentation.

If you look at the entry that we made, we have a deferred income tax asset of 10,000. We have a deferred income tax liability of 170,000. You know what the FAR CPA Exam's going to ask you is that asset a current asset or a non-current asset. Is that liability, a current liability or a non-current liability listen carefully.

This is very important. How you classify deferred tax assets and deferred tax liabilities depends on what causes them. Look at that deferred income tax liability of 170,000. What caused it? What caused that deferred income tax liability of 170,000 that's right. Accelerated depreciation, which is related to fixed assets since a non-current asset caused that liability.

All of it is non-current that deferred tax liability was caused by accelerated depreciation, which is related to fixed assets since non-current assets. Cause that liability, all of it is non-current. So let's agree. This company has a noncurrent deferred tax liability of 170,000. What caused that $10,000 deferred income tax asset?

That's right. The non-current warranty liability. Remember the claims aren't going to be paid out for years. A non-current warranty liability caused that asset. So the asset is non-current. So here's balance sheet presentation. Since they have a noncurrent deferred tax liability of 170,000, and they have a noncurrent deferred tax asset of 10,000 since they have both non-current you can net them.

And this company will report a net noncurrent liability of 160,000. That's what they want on a balance sheet, net, current amount, net noncurrent amount. I'll say it again. What you're supposed to report on a balance sheet is net current amount. Net noncurrent amount since they're both non-current in this case, I can net them and they report on their balance sheet net noncurrent liability, 160,000.

Oh, you can net current amounts and you can net noncurrent amounts. But listen to me, you can't net current with non-current. Don't let them talk you into that. You can't net a current deferred tax asset and a noncurrent deferred tax liability. No, the right of offset does not exist. So don't let them talk you into that.

You can't net current with non-current, but what they want on a balance sheet is net current amount net noncurrent amount. You can net current amounts. You can net noncurrent amounts, but you can net current with non-current. Remember that? Let's do a problem. See how we're doing on this question. Number one, fry fry, a construction company appropriately uses the completed contract method.

For tax purposes. However, they use the percentage of completion method on their books. And, you know, anytime you're using one method of accounting on your books and another method of accounting and your tax return, that's what causes temporary differences. And it's one we talked about now here's the information, December 31 year to the close of Frye's first year.

Now you look at the first two contracts. Notice the first two contracts they've recognized 600,000 plus 300,900,000 to profit from those first two contracts on their books. Under a percentage of completion in year two. When does that profit going to go on their tax return? Year three, when they finish the projects, look at the look at the last two contracts, the 200,000 and the 100,000 haven't they recognized 300,000 of profit.

From long-term contracts for the last two contracts on their income statement for year two, under percentage of completion, but that profit won't be on the tax return until they complete the project. And that's in year four. Now, very important question for you. The list they gave us their numbers, six hundred thousand three hundred thousand two hundred thousand one hundred thousand.

Are those future deductible amounts? Or future taxable amounts. Remember, that's the key to the FAR CPA Exam, knowing whether you're dealing with a future deductible amount or a future taxable amount, what do those represent? That's right. Aren't those future taxable mounts, because won't, they get taxed in the future when they finished the projects, those are definitely future taxable amounts, and we know the way you get a deferred tax liability.

We know the formula is based on future taxable amounts, times, future tax rates, and what they're asking at the bottom. Is what would be the deferred tax liability December 31 year two? Well, let's work it out. Aren't we expecting $900,000, 600,000 plus 300,000. Aren't we expecting 900,000 of future taxable amounts to reverse in year three when the enacted tax rate is 25%.

So they're going to have to set up a $225,000 deferred tax liability for that reversal notice, we were given the tax rates. For the current year, 30%. And for years for year three, 25% and year four, 20% 20 for year four, 20%, we were given the future tax rates. As I said, realistically, in the FAR CPA Exam, they're gonna have to give you the tax rates.

But as I say, we know that deferred tax liabilities are always based on future taxable amount of times, future tax rates. So I say for those first two contracts, I'm expecting $900,000 of future taxable amounts to reverse in year three. When the NACA tax rate, they tell me will be 25%. I'm going to have to set up a $225,000 deferred tax liability for those reversals, let's go to the other two contracts, the 200,000 and the 100,000 we're expecting 300,000.

Of future taxable amounts to reverse in year four when the inactive tax rate is 20%, we're going to have to set up a $60,000 deferred tax liability for those reversals added up. What's my deferred tax liability, 225,000 plus 60,000. Answer C 285,000 deferred tax liabilities are always based on future taxable amounts, times future tax rates.

If those future tax rates have been enacted into law. Let's look at question number two, black company organized on January 2nd year two had pre-tax financial statement, income of 500,000. So we know the income on the books. Pre-tax financial statement, income 500,000, but notice taxable income, 800,000.

And they say the only temporary difference is a crude warranty costs. Now we've talked about this. On your books, you follow gap, you have to, and gap makes you estimate or accrue you aren't expense for the year. So they did, they must've accrued estimated 300,000 of estimated warranty expenses. IRS disallows it because IRS will not let you take that as a deduction on the tax return until you actually pay out the claims.

And apparently the way you're going to play out the claims is a hundred thousand, 50,000, 50,000, a hundred thousand over years, three, four, five, and six. Then they say the enacted tax rates, 25% for year two 30% for years, three, four, and five and 35% for year six. And then at the bottom they say in the December 31 year, two balance sheet, what amount would black report as a deferred tax asset?

Now I have a very important question for you. The list they gave us their a hundred thousand, 50,000. Hundred thousand. What do those represent future taxable amounts or future deductible amounts? You know, their future deductible amounts, because both they represent deductions that the company can take on their tax return in the future when they pay out the claims, those definitely represent future deductible amounts.

And we know deferred tax assets are always based on future deductible outs, times, future tax rates. So let's work it out. We're expecting a future deductible amount of a hundred thousand to reverse in year three. When the enacted tax rate is 30%, we're going to have to set up a $30,000 different tax asset for that reversal we're expecting $50,000 of future deductible amounts to reverse in year four.

When the NACA tax rate is 30%, we'll set up a $15,000 deferred tax asset for that reversal, we're expecting another $50,000. Future deductible amount to reverse in year five when the enacted tax rate is still 30%. So we have to set up another $15,000 for a tax asset, but that reversal and we're expecting a hundred thousand future deductible amount out in year six to reverse when the NACA tax rate is 35%, we're going to have to set up a $35,000.

Deferred tax asset for that reversal. What's the deferred tax asset on the balance sheet, 30,000 plus 15,000 plus 15,000 plus 35,095,000. Answer D remember deferred income tax assets are always based on future deductible amounts, times, future tax rates, if, and only if the future tax rates have been enacted into law.

Now, before you come to the next class, You'll notice there's two more questions in this module. We have two more questions on Corey and on Clark. Your assignment is promise me now you'll do these do Corey and Clark. Before you come to the next class and in the next class, we'll go through them together.

I'll see you then

welcome back in our last class. I asked you to do two problems before coming to FAR cpa review course. And I know you did them. So let's look at the first one. Corey, if you remember the facts, Corey recognized 250,000 of profit from installment sales on their income statement on their income statement. They just using normal accrual accounting, but on their tax return, they're using the installment sales method.

And, you know, in the installment sales method, They defer the recognition of profit until the installments come in until the payments are collected. And apparently the way that profits going to go on the tax return is 25,000, 50,075,000, a hundred thousand over years, two, three, four, and five. Now, you know what, I'm going to ask those numbers.

They gave you the 25,000 to 50,000 to 75,000, a hundred thousand. One of those represent. Are those future deductible amounts or future taxable amounts, you know, their future taxable amounts because Corey's not going to get taxed until the future. When the installments come in, those definitely represent future taxable amounts.

Now, what do they want here at the bottom? It says what would be the deferred tax liability now be careful defer tax liability. That's a balance sheet account, so dates matter and they want the balance in deferred tax deferred tax liability, December 31 year two. Make sure you notice that date. They want the balance in deferred tax liability, December 31 year two.

So think about this with me. If I want to work out the balance in deferred tax liability, December 31 year two, I only look at what reverses after that date. So let's look at it. I'm expecting a future taxable amount of 50,000 to reverse in year three. When the enacted tax rate is 30%, we're going to have to set up a $15,000 deferred tax liability.

For that reversal, we're expecting a $75,000 future taxable amount to reverse in year four. When the enacted tax rate is still 30%, we're going to have to set up a $22,500 deferred tax liability for that reversal. And then finally in year five, we're expecting a hundred thousand dollars future taxable amount to reverse when the NACTA tax rate is 25%.

We're going to have to set up a $25,000 deferred tax liability for that reversal. What's the deferred tax liability, 15,000 plus 22,500 plus twenty five thousand sixty two thousand five hundred answer a. Now, you know what they were hoping you do. They were hoping you just do the whole list. If you do the whole list, you get B I hope you see how some student could yet be Bob.

I see it all too painfully. Maybe you did get this wrong. And if you did, I don't think you will. Again, I don't think you will, because this question teaches you a very important lesson. Why didn't I worry about the 25,000 cause it's already reversed. Remember you only look at what reverses after the balance sheet date.

In other words, if they had wanted the balance of deferred tax liability, December 31 year three, I would have just looked at the year four and five reversal. You only look at what reverses after the balance sheet date, and if that's still bothering you another way to look at it. Hey, what's the formula for deferred tax liabilities?

It's future taxable amounts times future tax rates. Well, the 25,000 is no longer in the future. Is it? It's already reversed. Remember, it's future taxable amounts, times future tax rates. You have to look at, what's going to go on in the future. And the 25,000 by December 31 year two has already reversed.

It's no longer in the future. It's a lesson you really have to learn about deferred taxes because they catch a lot of students on that. Let's look at the other question I asked you to do, which is Clark. Now in Clark, we have two temporary differences to think about. First of all. On their tax return, they took $500,000 of depreciation, but on their books, they took just 300,000.

They took 200,000 more depreciation on the tax return than they did on their books. And, you know, that represents an FDA. That's a future taxable amount. And how that, how is that going to reverse notice? They gave you the reversals 80,000 of that is going to reverse in year three. 70,000 of that's going to reverse in year four, 50,000 of that's going to reverse in your five.

So by the end of year five, that temporary difference will have come Wheatley reversed. Now, you know, that that list of names, the 80,000, the 70,000 and the 50,000, those ones present future taxable mounts. We already took them big deduction on our tax return. We've got to pay the Piper in the future.

Those are future taxable amounts, and we know the way you work out a deferred tax liability. Is based on future taxable amounts, times future tax rates let's work it out. I'm expecting an $80,000 future taxable amount to reverse in year three. When the enacted tax rate is 30%, I'm going to have to set up a $24,000 deferred tax liability for that reversal, I'm expecting a $70,000 future taxable amount to reverse in year four.

When the enacted tax rate is 25%, I'm expecting 50,000. Of a $50,000 deferred to a $50,000 future taxable amount to reverse in year five when the enacted tax rate is still 25%. So I'm going to add up the 70,000 and the 50,000 for years, four and five because the tax rate, the same is the same. I'm expecting 120,000.

Future taxable amounts to reverse in years four and five. When the inactive tax rate is 25%, I'm going to have to set up a $30,000 deferred tax liability for those reversals. What's my deferred tax liability, 24,000 plus 30,054,000. That's my deferred tax liability. Now I also have another temporary difference to worry about the warranty expense on their books.

They accrued 50,000 of estimated warranty expenses. IRS would just allow it. They're not going to let them take that as a deduction on the tax return till they pay out the claims. And apparently they're going to pay out the claims 10,000, 15,000, 25,000, over years, three, four, and five. And don't those represent future deductible amounts, because those are deductions that Clark can take on their tax return in the future when they pay out the claims.

So we know the way we calculate a deferred tax asset. Is based on those future deductible amounts times, future tax rates. So let's work it out. We're expecting, expecting a future deductible amount of 10,000 to reverse in year three. When the inactive tax rate is 30%, we're going to have to set up a $3,000 deferred tax asset for that reversal.

Again, I'll combine years four and five because the tax rates the same, we're expecting 40,000 of. Future deductible amounts, 15 plus 25, 40,000 future deductible amounts to reverse in years four and five. When the NACA tax rate is 25%, we're going to have to set up a $10,000 for a tax asset. For those reversals.

My deferred tax asset is 3000 plus 10,013,000. Now let's make our S our deferred entry for taxes. We're going to debit defer income tax asset 13,000. We're going to credit deferred income tax liability, 54,000. Remember, it's an asset and liability approach of accounting for temporary differences. You have to calculate your deferred tax asset.

You've got to calculate your deferred tax liability. So that's what we've done. We've debited deferred income tax asset 13,000. We credit deferred income tax liability, 54,000. Now what do they want here at the bottom? They say in Clark's year to income statement, what is the deferred portion of expense number?

That's a plug to balance the entry out. I need a $41,000 debit just to plug the balance, the entry out that's income tax expense, deferred portion. So the answer is C that's what they wanted. The deferred part of expense entries. Usually help you. Let's do another question. Let's do this one together. Let's look at the first question in this module.

Question number one on shin company. It says on in the current year, in the current year, December 31 balance sheet shin had income tax payable of 13,000. Let's stop right there. If at December 31 on the balance sheet, they're showing income tax payable of 13,000. We have to infer that this must have been their first entry for taxes.

They must have debited income tax expense, current portion, 13,000 and credit income tax payable, 13,001 thing that makes this question a little bit more difficult is you have to infer some things. So if they showing income tax payable of 13,000 on the December 31 balance sheet, we had to infer that that must've been their first entry for taxes.

They must have debited income tax expense, current portion for that 13,000 and credit income tax payable, 13,000 let's read on. They also have a current deferred tax asset of 20,000 before determining the need for any valuation account, which we'll talk about in a minute. Shin had reported a current deferred tax asset of 15,000 a year ago, December 31, the previous year stop right there.

Here's another thing you have to think about. Notice December 30, one of the previous year, they had a deferred tax asset of 15,000. What's the balance and deferred tax asset at the end of the current year 20. See, what they're making you think about is year to year adjustments. So if a year ago in the previous year deferred tax asset was 15,000 and now we need 20, let's make another entry.

We're going to debit deferred income tax asset 5,000. Again, what they're making you do when this problem is year to year adjustments in the previous year, deferred tax asset was 15,000. Now they need 20. So I'm going to debit deferred income tax asset 5,000. And what do I credit? Remember deferred tax benefit.

Remember if you need a credit to balance that deferred entry out, that's called deferred tax benefit here, they have a benefit. Now let's read on, they say at December 30, one of the current year, shin determined that it's more likely than not that 10% of that deferred tax asset is never going to be realized.

Now, this is why we're getting into this problem. Now listen carefully for deferred tax assets. Only not liabilities. For deferred tax assets only, never liabilities. You may have to set up a valuation allowance account, and I want to show you how to do this. They said it's more likely than not that 10% of that deferred tax asset is never going to be realized.

So I'm going to take 10% of the balance in our deferred tax asset. Then when we brought that from 15,000 up to 20,000, I'm going to take 10%. Of the balance of our deferred tax asset, 10% of 20,000, which is 2000, I'm going to credit valuation allowance, 2000 notice. I actually set up an account valuation allowance.

It's a credit of 2000. That's a Contra asset on the balance sheet. What do I debit? I lower the benefit. I'm going to debit deferred tax benefit for 2000. I want you to notice that if you have to set up a, a valuation allowance account, this is handled through the deferred portion of expense. Don't touch the current portion.

Anytime he set up a valuation allowance for deferred tax asset and only affects the deferred portion. So notice that either it either, when you set up a valuation allowance, it will either increase the different part of expense or in this case, lower the benefit here. I had a lower the benefit 2000. Now we're not done yet at the bottom.

It says in the current year income statement, what amount would shin report as total. Income tax expense. So to make matters worse. Now they ask for total income tax expense. Remember we talked about this earlier, we talked about this in another class on an income statement. How do you show your total provision for taxes?

How do you show total income tax expense? Remember it's the current portion in this case? 13,000. Plus or minus deferred portion here. It's a minus because it's a benefit. The benefit used to be 5,000, but we load it by two. Now the benefit is 3000. So what's the total income tax expense, the total provision for taxes, 13,000 minus the benefit again, that's the current portion, 13,000 minus the benefit three.

Again, the benefit used to be five, but I load it by two because the evaluation allowance account. So I take the current portion of expense. 13,000. What I owe the government minus the benefit 3000, my total provision for taxes, my total income tax expense, 10,000 answer C let's do another problem.

Number two, Bart, a newly organized corporation uses the equity method of accounting for its 30% investment in Rex. During the year, the sob recs pay dividends of 300,000 and reported earnings of 900,000 move. Before we do anything else, let's apply the equity method. Cause I know you know it well, we know under the equity method, Bart would automatically pick up this year of Rex's income.

Now Rex, his income for the year 900,000 Bart would automatically pick up this year 30%. So take 30% of 900,000. Remember the entry Bart's going to debit investment in Rex. 270,000, the carrying value investment would rise 270,000 and credit equity and suburb things or investment income, 270,000. But the point is that's investment income for bar that would go to the parents' income statement.

They have no choice. It's generally accepted accounting principles. Now let's deal with the dividend. During the year, the sob Rex paid Bart, a three paid Bart paid, excuse me. The sub recs pay total dividends of 300,000. Well, you've got to assume that if Bart owns 30% of Rex's shares bought when it got 30% of that dividend or 90,000 let's handle that Bart would have debited cash 90,000 and you know what they would credit the investment account because under the equity method, parent treats any dividends from the sob as a return of capital.

Now I know you might say, well, Bob, why are we back to the equity method? Because there's one more thing you've got to know about the equity method. And that is that the equity method itself causes a temporary difference. You have to know this about the equity method, that the equity method itself causes a temporary difference.

And if you look at the entries that we just did, you can really see what the problem is. Look at those two entries that we just did in this problem, how much income is on Bart's income statement? 270,000. They have no choice. It's generally accepted accounting principles. It's the equity method. Parent has got to pick up their sheriffs I've income.

And that 270,000 is on Bart's income statement as investment income equity in the earnings of a subsidiary. But is that what's on Bart's tax return? No, IRS only taxes. The parent on what they actually got from the sub Bart is only taxed on the 90,000. So there's the temporary difference right there. Now let's read on the other information.

It says the dividends received from Rex are eligible for the 80% DRD. The 80% dividend received deduction. All on distributed earnings of Rex will eventually be distributed in future years. There were no other temporary differences. Notice the current income tax rate is 30%. The future tax rate is 25%.

Now we're going to do this. With the way we've, we've really done these problems all through these classes. We're going to make one entry for the current portion of expense, what we owe the government and another entry for the different portion. Let's w let's work out what we owe the government. You know, that what we owe the government is based on what's on the tax return.

What's on Bart's tax return is the 90,000. The parent is only taxed on what they've, what they've actually received from the sub the 90,000. So how do I work out? What I owe the government? Well, what you've got to work into this is that one, one domestic corporation pays another domestic corporation. A dividend 80% is non-taxable.

So you've got to take the 90,000 that's on Bart's tax return. 80% will never be taxed. Only 20%. Only 18,000 will be taxed at the current rate, which is 30%. In other words, you have to take 90,000 times, 20%, times 30%. You're going to debit income tax expense, current portion, 5,400. And you're going to credit income tax payable, 5,400.

That's what you owe the government. And notice that to answer. See, that's not the answer here, but you know, if they won what we owed the government, if they wanted our current federal tax liability, it would be C. But again, that's what you have to do. Take the 90,000 it's on the tax return. Times 20%, 80% will never be taxed.

There's an 80% dividend received deduction. Only 20%, only 18,000 gets taxed at that current rate, 30%. So we owe the government 5,400 debit income tax expense, current portion, 5,400 and credit income tax payable, 5,400. Now, when you do a problem like this, you really are making an assumption. Look, there's 270,000 of income from this sub.

On Bart's income statement, only 90,000 on the parents' tax return. You know what you have to assume. You have to assume that if Bart waits long enough, they'll eventually get all 270,000 in the form of dividends. That's the assumption we're going to make here that if the parent, if Bart waits long enough, they'll eventually get all 270,000.

They'll get the other hundred and 80,000. In the form of dividends and isn't that other 180,000, a future taxable amount because won't Bart get tack won't Bart get taxed in the future when the dividends come in. So let's work out our deferred portion. I'm going to take that 180,000. Again, I'm going to look at that as a future taxable amount bought it's going to get taxed in the future when those dividends eventually come in, but remember, 80% never gets taxed.

Only 20%, only 36,000 gets taxed at the future rate. 25%. We're going to debit income tax expense, deferred portion, 9,000 and credit deferred income tax liability, 9,000. That's what they wanted. They wanted the balance in deferred tax liability. And the answer is B. I look at that other 180,000 as an FTA, a future taxable amount.

Cause Bart, the parent is going to get taxed in the future when the dividends come in, but 80% never gets taxed. Only 20%, only eight, only 36,000 gets taxed at that future rate, future tax rates, if a knackered in the law twenty-five percent. So I'm going to debit income tax expense, deferred portion, 9,000 credit deferred income tax liability, 9,000.

That's what they wanted the balance and deferred tax liability. And the answer is B let's do another question. Number three, Lear corporations pre-tax income for the current year, 100,000. So we know the income on the books, a hundred thousand. And here are the temporary differences. And at the bottom, we know the effective tax rate is 30% in the current year income statement.

What would be the current provision for taxes now? You know, the language, if they want the current provision for taxes, it's what we owe the government. And what we owe the government is based on taxable income. I can't do anything with book income. I know the income on the books. Pre-tax book income, a hundred thousand, but I can't do anything with book income.

What I owe the government is based on taxable income. So once again, We have no choice, but to reconcile from book income, the taxable income. So let's do that. We know the income on the books, a hundred thousand let's look at the differences. First depreciation in the financial statements was 8,000 more than tax.

So it's a little bit different here. We're so used to being the opposite. We're so used to more depreciation on the tax return here. They say depreciation in the financial statements was 8,000 more than. What's on the tax return. So think about it. If I take 8,000 less depreciation on the tax return than I do the books, that's going to cause taxable income to be 8,000 higher than book income.

Again, if I take 8,000 less depreciation on the tax return than I did on the books, that's going to cause that's going to cause taxable income to be 8,000 higher than book income. I'm going to add that now look at the second thing. The equity method of accounting. Resulted in financial statement, income of 35,000.

Let me ask you, is that 35,000 in the a hundred? Sure. You have no choice it's gap. Under the equity method, the parent is required to pick up their sheriffs of income. So that 35,000 is in the a hundred thousand, but notice they got a $25,000 dividend from the sob and they are eligible for the 80% DRD. So what's on the tax return.

Just 20% of 25, 5,000. Again, what's on the tax return is not 25,000, just 5080% never gets there just 20, just 20% of 25,005,000 on the tax return. So think about it. If there's 35,000 of sub income in the a hundred thousand. In the book income only 5,000, 20% of 25,000 on the tax return all by itself.

That's going to cause taxable income to be 30,000 less than book income. So subtract 30,000 taxable income is 78,100,000 plus eight minus 30. Taxable income is 78,000 and now we can solve it. What we owe the government is based on that taxable income. I take the taxable income, 78,000 times the tax rate, 30%.

I'm going to debit income tax expense, current portion, 23,400. I'm going to credit income tax payable, 23,400. They ask what is the current provision for taxes? You know what that language means? The current provision for taxes is what I owe the government. And what they're talking about is that debit net entry and the answer is B 23,400.

Keep studying don't fall behind and I'll see you in the next class. Yes.

Welcome back in this far cpa review course. We're going to talk about how to prepare a statement of cash flows. And I want to mention right away that statement of cash flows. Is a great area for multiple choice. It's a great area for a simulation and it's a heavily tested area. So there's no way you can win the FAR CPA Exam and not know how to prepare a statement of cash flows.

So let's dive right into it. A statement of cash flows has three separate and distinct sections. Let's go over them. Section number one. He is cash flows from operating activities, cash flows from operating activities. Now in your mind, think of this as your income statement section, in other words, as you're doing a problem, if you see any item that affects revenues, expenses, gains losses right away, you think of the section because it is your income statement, section cash flows from operating activities.

Now there's also one more thing that goes in this section. If a company buys or sells trading securities that's cash flows from operating activities. You see how it works. If a company goes out and buys trading securities that's cash used in an operating activity. If they sell off trading securities, that's cash provided by an operating activity.

So that goes in there as well. Section number two is cash flows from investing activities. Now, several things go, go in here first. If a company buys or sells, held to maturity investments, buys or sells available for sale investments, that's cash flows from investing activities. So a company goes out and buys, held to maturity available for sale securities.

That's cash used in an investing activity. If they sell off held to maturity or available for sale securities, that's cash provided by investing activities. How about investment income? How about that? How about investment income? Well, that's operating activity. Remember that's on the income statement.

That's operating activity. Investment income don't make a sloppy mistake. No, but if a company buys or sells, held to maturity buys or sells available for sale securities, that's cash flows from investing activities, but there's more, if a company buys or sells property plant or equipment that's cash flows from investing activities.

And one more thing, if a company buys or sells equity investments. That's cash flows from investing activities. Now what I'm going to say next, I think you'd probably guess anyway. And that is that when you do your homework, you're going to see that very often in multiple choice questions, especially what they're really testing is whether or not a student understands where cash belongs in the statement.

And one of my goals in this far cpa review course is that I want to make that as automatic as possible. So I'm going to give you. A memory tool when you're in the FAR CPA Exam, just remember investing makes you happy. It makes you happy. H a P P E. It makes you happy. You see where I got that? If I buy yoursel H held to maturity by herself, a available for sale, buy or sell PP and E buy or sell equity investments.

That's when I go to that section, investing always makes me happy. The third section, the third section is cash flows from financing activities. Now several things go in here. First thing is debt principal. If a company goes out and borrows debt, principal, that's cash provided by a financing activity. If they pay down debt, principal, that's cash used in a financing activity.

How about the interest? How about the interest? Well, that's on the income statement. That's operating. Don't make a sloppy mistake. But if a company borrows debt, principal cash provided by a financing activity, if they pay down debt, principal cash use in a financing activity. Also, if a company pays a dividend, I don't care if they pay a dividend on common shares, preferred shares, that's cash used in a financing activity.

There's more, if a company issues stock, if they issue common stock, if they issue preferred stock that's cash provided by a financing activity. And one more thing. Don't forget treasury stock transactions. If a company goes out and buys treasury shares, that's cash used in a financing activity. If they sell off treasury shares, that's cash provided by a financing activity.

Now I'm going to give you a memory tool on this also. So when my students were in the FAR CPA Exam, what they're thinking is investing always makes me happy by herself, held to maturity by herself, old for sale by herself P E buy or sell equity investments. We're always thinking that. And just remember that I'm always financing for Prince divots.

Prince divots. Prince is debt. Principal, give pay dividends. I issue stock in TSS, treasury stock transactions. That's really what it comes down to investing makes you happy, but you're always financing for Prince divots. Now you're going to see once you really get sorted out in your mind where cash belongs in the statement.

Now we are ready to attack a problem. Now before we attack a problem, let me say something first. You have to be aware of this. There are two acceptable methods of preparing a statement of cash flows. There is the direct method and there is the indirect method. And I want you to remember that the direct method is theoretically preferred.

They could ask you that the direct method is theoretically preferred, but this is something you have to get used to. Even though the direct method is theoretically preferred because it is the CPA exam has tested the indirect method far more often. That's just the reality of the test. Yes. The direct method is theoretically preferred, but as I say, the CPA exam has tested the indirect method far more heavily.

And I want you to understand why tell you why they let, this is really the case. What you're going to, I hope learn in these classes is that the direct method. It's not really a different method. There's really only one method of breaking down statement of cash flows problems. And that is the indirect method.

When they talk about the direct method, I think of it as not really a different method, it's a presentation difference. One of the sections operating gets presented differently in, in really in any real sense. It's not a different method. It's a presentation difference. As I say, one of the, one of the sections operating just gets presented differently.

So the bottom line is there's only one method of breaking down statement of cash flows problems, and that is the indirect method. Now does the CPA exam ever test ever test the direct method they do, but let me get to my point when you're in that exam, only worry about the direct method if they specify.

In other words, if they're, if they, if they're silent, You solved the question under the indirect method. I'll say again, when you're in that test, only worry about the direct method. Only give it a thought. If they specify, solve this problem under the direct method. Other than that, you really always going to be thinking in terms of the indirect methods.

So that's what we're going to start in this far cpa review course We're going to start with the indirect method. If you go to your viewers guide, you'll see a, a set of multiple choice questions, dice corporation. Let's take a look at it. Dice corporation's balance sheet accounts as of December 31 year two and year one and additional information follow.

So we're given comparative balance sheets at the end of year one at the end of year two, this some additional information I noticed there are three questions. They only want three little things. Number one, they want cash flows. From operating activities. Question number two, they want cash flows from investing activities and question number three, they want cash flows from financing activities.

They just want three little things. There is a lot to do here. All right. Now we've looked at this set of multiple choice. What method are we going to use? Well, notice they didn't specify if they don't specify, we use the indirect method. Now, the reason we're going to do this. Set of questions together is that I want to show you a technique and I'm not exaggerating.

When I tell you that this technique is foolproof. It really is. And once you get it down, it'll take a little time to learn it. But once you get this technique, technique down, I don't care how the FAR CPA Exam tests this. I don't care if it's multiple choice. I don't care if it's a case-based simulation. With this technique, you know, you can break it down.

And my technique involves two things. In fact, it involves my two favorite things, journal entries, and T accounts. That's how we're going to approach this. So let's look at this question. Let's go right to the comparative balance sheets. Notice at the end of year one, go right to cash. At the end of year one, the cash balance was a hundred thousand dollars at the end of year two, when year later cash balance is 230,000.

So the first thing you notice is that in the last year, cash has increased by $130,000 debit. Make sure you make a little note of that. So that's, we start by knowing that that in the last year, cash has increased by $130,000 debit. And I want to make sure you understand. When we do our statement of cash flows, our statement has to prove why cash increased by $130,000 debit.

In other words, this is one of those odd accounting problems where you start by knowing the answer. So we already know the bottom line, our statement of cash flows. It has to explain why cash increased by $130,000 debit. Now, as I say, the technique we're going to use involves two things, journal entries, and T accounts.

The first thing we're going to do. It's set up three big T accounts. We're going to set up a T account for operating activity. And remember, that's your income statement section. You see any items that affect revenues, expenses, gains losses. You go right to that section. It's the income statement. Section cash flows from operating activities set the second T account investing activities.

And we can put right in the, in the heading happy. It always makes me happy. By herself held to maturity by herself, ill for sale by herself, PP and E buy or sell equity investments going to go through that section. And then the third T account financing activity. And you can put right in the heading Prince divots Prince is dead.

Principal. Dave has paid dividends. I is issued stock. Ts is treasury stock transactions. We know what goes there. So we have our three main T accounts. Now the next step. Now we put down a small T account for every account. They give us in the balance sheet. Except for cash and put the net change in each one of those accounts.

So again, now we're going to put down a small T account for every account. They give us in the balance sheet except for cash and put the net change in each one of those accounts. And before I start doing this, you see what really we're about to do. What we're about to do is explain the change in cash by looking at the net changes in all the other accounts except for cash.

That's where the answer must be. So let's go through the accounts first available for sale securities in the last year available for sale securities went from zero up to 300,000. So that means in the last year there's been a $300,000 net debit increase to that account. So what we would do is put a $300,000 debit change in that account and double underline it.

Now notice accounts receivable in the last year, the net change to accounts receivable has been zero. I'm not even going to set up a T account for it. There's been no net change to accounts receivable. I don't set up a T account for it. I'm not worried about it. Inventory went from 600,000 to six 80. That is a net debit increased to that account of 80,000.

She put that $80,000 debit change in that account. And double underline that held the maturity investments, held to maturity. Securities went from 300,000 down to 200,000. That's a net credit decrease to that account. Of a hundred thousand. So put that credit change in that account and double underline that plant assets went from a million to 1,000,007.

That's a net debit increase to that account 700,000. Now this next point is a little, a little tricky, but I don't think it's going to bother you notice. There was no net change to accumulate a depreciation. The net change to accumulated depreciation was zero, but even though the net change was zero.

We're going to set up a T account for it because you're going to see fairly quickly. There's a lot of activity in that account. I don't think that's giving too much away. They usually is. So we'll just set up a T account for accumulated depreciation, but there's no net change. We'll work with it. As we go on, Goodwill went from a hundred thousand down to 90.

That's a $10,000 credit change to that account. Now let's do the liabilities and stockholders' equity. You have to do all of them. Accounts payable went from seven 20 to eight 25. That's a net credit increase to that account of 105,000 short-term debt went from zero to 325,000. That's a net credit increase to that account of 325,000.

And then finally common stock increased by a hundred thousand API C increased by 120,000 and retained earnings increase. By 450,000. So let's review the steps so far. What's the first thing I did find the change in cash because I'm going to prove out to that. I know in the last year, cash increased by a net debit of 130,000.

That's what my statement has to prove out to what was the next step? Put down three big T accounts, one for operating one for investing, one for financing. And then you put down a small T account. For every account, they give you in the balance sheet except for cash and put the net change in each one of those accounts.

Now, what we've done is set up this problem for our analysis. We haven't begun our analysis yet. All we've done is set up this problem for our analysis. And now we're going to begin our analysis. And I want you to know that there is a way that I always begin the analysis. And let me emphasize, you don't have to do this, you know, no textbook is going to say you have to do this first, but I think it's the most logical place to start to me.

The most logical place to start is by proving out retained earnings. I think that's always the logical starting point. We know in the last year, look at your T account retained earnings increased by a credit of 450,000. Let's prove out why retained earnings increased by a net credit of 450,000. Go to the additional information.

The first bullet says that net income for year two was 690,000. Let's post that. We're going to go to our first big T account. Make sure you do this with me now. Step by step. We're going to go to our first big T account, which is operating activity. That's our income statement section, and we're going to put that 690,000 net income in as a debit.

Now, why is it a debit? Because what you're going to learn as we go through this. Is that your three big T accounts operating, investing, and financing. Think of the debit side as provided the credit side is used. Okay. Even label it for your, in your viewers guide, just to get to the, you get used to it. And your three big T accounts operating, investing, and financing.

Think of the debit side has provided the credit side is used. And the point is net income provides cash from operations. Doesn't use it. So we're gonna put the net income on the debit side. In operating and we post the credit to retain earnings. So presumably net income was posted as a credit to retain earnings 690,000.

Now the next bullet down cash dividends of 240,000 were declared and paid in year two. Now, remember I said that this technique really uses two things. T accounts, journal entries. Now we have all the T accounts and I want you to know that I'm in the habit. Where I always make the dividend, my first journal entry.

That's just the habit I'm in. So when I see that the cash dividend for year two was 240,000, I have to assume they would've made their normal entry. They would have debited retained earnings, 240,000. Remember dividends come directly out of retained earnings, then not on the income statement in any way they come directly out of retained earnings.

So I assume they would've made the normal entry. They would have debited retained earnings, 240,000 and credit cash. 240,000. That's the normal entry for dividend. Now what's the first thing you notice about that entry. That's right. This cash, the minute you see cash in any entry it's got, it's got to be classified.

What kind of cash is that? Is that operating? No. Is it happy? No. It's Prince divots. Remember the div and divots is paid dividends. So we're going to go to our third. Major T account, which is financing activity. And we're going to post that $240,000 credit right there. See, the fact is that's cash used in a financing activity.

Why? Cause I'm always financing for Prince divots. Prince is that principle div is pay dividends. I is issue stock Ts is treasury stock transactions. Now let's post the debit. We're going to post the debit of course, to retain earnings 240,000 now. And look at that retained earnings account. We have now proven why retained earnings increased by net credit afforded in 50,000.

So you just put an X through it, just exit out. You never want to look at it again. That's sort of the process. Once you prove out the change in an account, exit out, you don't want to look at it again. And as I say to me, that's the most logical place to start. You don't have to, but I would always start by proving out the retained earnings.

Now we have a lot more to do. In this set of questions and we'll continue this set in the next class. Don't miss it. I'll see you then.