FAR CPA Exam Review Course

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Hello, and welcome to the Bisk CPA review is coverage of the financial accounting and reporting section of the CPA exam. My name is Bob Monette, and I'll be your instructor for this FAR CPA Review course. and in this FAR CPA Exam course, we're going to be discussing a very important topic, a very heavily tested topic. And that is how a corporation accounts for income taxes.

Before we begin the class, I want to say just a couple of words on the way to get the most from this FAR CPA Exam course. The big thing to remember is that you have to avoid just sitting back passively and watching the video. The key to getting the most from this FAR CPA Review course is to treat this video like a normal class, be active.

Take good notes. When we get to problems, shut the video down, do the problem, get your answer before you come back and go through the problem with me. I think you'll find if you do those things, you'll get much more out of this CPA Review FAR course. And of course that's what we both want. So with that in mind, let's get into our topic, which again is how a corporation accounts for income taxes.

And the basic challenge is this. When a corporation gets to year end, And they go to put down their journal entry to record income taxes. The basic problem is that there are differences. There are differences between the income that the company has reported on their income statement and the income the company has reported on their tax return.

And as you probably know these differences between what the corporation reports on their income statement and what the corporation reports on their tax return. Falls into two categories. There are temporary differences and there are permanent differences. That's all there are. It's either going to be a temporary difference or it's going to be a permanent difference.

We're going to begin with temporary differences. And the first thing I want to establish is this what causes temporary differences? Let's be clear on this. Just remember what causes all temporary differences. All of them is this situation. The corporation is using one method of accounting on their books and another method of accounting on their tax return.

That's what causes all temporary differences. Anytime a corporation is using one method of accounting on their books and another method of accounting on their tax return. As I say, that's what causes all temporary differences. Now stay with me when a corporation 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. I want you to know there are only two types of temporary differences. Let's go over them type one, a type one, temporary difference would be this. There are revenue or expense items that belong on the income statement.

Now. GAAP says you must report these items now, but they won't be on your tax return until later that's type one revenue or expense items that belong on the income statement now, but won't be on the tax return until later type two, the second type of temporary difference. And I know you're ahead of me would be the exact opposite.

There are revenue and expense items that belong on the tax return. Now. But won't be on the income statement until later. And I want you to know that's all there is it's either revenue or expense items that belong on the income statement. Now won't be on the tax return until later, or the opposite type to revenue or expense items that belong on the tax return.

Now won't be on the income statement until later.

Now, what I want to do next is go through some examples of each type. And I'll tell you that the good thing about the CPA exam is that the same temporary differences are in the FAR CPA Exam again and again and again, there are some ones they really like. And one thing we want to accomplish in this CPA Review FAR course is make sure you're comfortable with the common temporary differences you see most often in the exam.

So let's go back to type one. I said that the first type of temporary difference would be revenue or expense items that belong on the income statement. Now GAAP says you must report these items now, but they won't be on your tax return until later. So let's start with, we'll put down a column for books now.

And I call them for tax later, let's start with revenue or profit. How is it possible to have revenue or profit on the income statement? Now, in other words, GAAP says you have to report this item now, but it's not going to be on your tax return until later. Well, a great example of that would be a company that's involved with installment sales.

Let's say we have a corporation that makes lots of installment sales on their books. They're just using normal accrual, accounting, nothing fancy. So notice on our books. Now we put a cruel just on their books. They are using normal, cruel accounting, but notice on their tax return, they're using the installment sales method of accounting.

Now just think what's going to happen to this company. This company goes out and makes a sale. When would all the profit from that sale? Beyond their income state right away. Remember they're not doing anything fancy on their income statement, just normal accrual accounting. So if they go out and they make a sale, all the profits from that sale will be on their income statement on their books right away.

But because on their tax return, they're using the installment sales method of accounting on their tax return. They're going to defer the recognition of profit until the installments come in until the payments are received. So I hope you see that the way I do. Isn't that an example of how a corporation could have profit on their income statement now, but it's not going to be on their tax return until later when the installments come in, when the payments are received.

Now, listen very carefully. the FAR CPA Exam would refer to this as an FTA. This is a future taxable amount. That's how the FAR CPA Exam would refer to this example. This is an FDA. This is a future taxable amount. Doesn't that phrase make sense because won't the corporation be taxed in the future. When the installments come in, that's a future taxable amount.

Let's stay on profit. What would be another way that a corporation could have revenue or profit on the income statement now, but it's not going to be on the tax return until later. Well, let's say a corporation is involved with long-term construction contracts on their books. They're using the percentage of completion method, but on their tax return, they're using the completed contract method that let's think what's going to happen here.

Let's say this corporation 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, they estimate the project is 18% complete. Won't they recognize 18% of the estimated profit from that project on their income statement at the end of year one.

But, you know, this they'd be no profit from this project on their tax return until year five when they complete the project, because that's how completed contract works in completed contract. We recognize no profit from a project until it's completed until it's finished. So you see the basic problem.

Don't I have income on my income statement now, but it's not going to be on my tax return until year five. When I finished the project. the FAR CPA Exam would call this an example of an FTA. This is a future taxable amount because won't the corporation be taxed out in year five when they complete the project.

It's definitely an FDA, definitely future taxable amount. How about an expense? Let's go to that. How about an expense? A deduction that's on the income statement now. But won't be on the tax return to later. Well, what you're looking for here is any sort of estimated expenses and the one, one of the ones the FAR CPA Exam really likes we'll put in, we'll put in our schedule and that is warranty expenses.

Let's say a company guarantees their products against defects. They have a warranty on, on books, on the books, on their income statement. They use normal accrual accounting. And remember under GAAP, you have to estimate your warranty expense. In other words, if based on past experience, you expect 1% of your customers are going to want to refund in GAAP.

You have to take 1% of your sales and set up an, a crude or an estimated warranty liability. You'll have to accrue. You have to estimate your warranty expense. If 1% of your customers tend to want to refund, then you take 1% of your sales and set up in a crude or an estimated warranty expense on a crude or an estimated warranty liability.

Well, the point is IRS would disallow that IRS would disallow accrued or estimated warranty expenses. IRS will not like the, let the corporation take that warranty expense as a deduction on their tax return until they actually pay out the claims. So you see our basic problem. We have an expense on our books.

Now GAAP makes us estimate it makes us accrue it, but it won't be on our tax return until later when we actually pay out the claims. Now be careful the FAR CPA Exam would refer to this as a future deductible amount. Isn't this a deduction the corporation can take on the tax return in the future. When they pay out the claims, this is not a future taxable amount.

This is a future deductible amount. I want to make a point and I'm sure you already have gathered that. I feel this way. When you go in the exam, if you know that you're dealing with either a future taxable amount or a future deductible amount, once you really get good at that, once you get good at knowing whether something is a future taxable amount or a future deductible amount, you're really going to be strong in this area.

The air is not bad at all. Once you get that down because the whole area of accounting for taxes really comes down to dealing with these areas. So as long as you know, whether you're dealing with a future taxable amount or a future deductible amount, you're going to be strong on this. Let's go to type two.

What's a type two. Temporary difference. Well, we said there are revenue and expense items that belong on the tax return now, but won't be on the income statement until later let's start with revenue or profit. How was it possible to have revenue or profit on the tax return now, but it's not going to be on the income statement until later.

Well, what you're looking for here is anything collected in advance and the one we'll put in our schedule. Is I think the one, the FAR CPA Exam likes the most and that's rental income. Let's say that I'm a landlord. You're my tenant. That's our relationship. You rent out my warehouse and let's say you give me, you know, a certified check that's meant to cover five year's rent in advance.

All right. So you give me a certified check and I appreciate it. You give me a certified check. That's meant to cover five year's rent in advance. Think what's going to happen. If I collect 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 why? Because all IRS cares about is I collected the money. IRS does not care about the matching concept. IRS does not care about a cruel accounting. All IRS cares about is I've collected the money. So when I do my tax return, all five years, rental income will be on my tax return because I collected in an advance.

I collected it in advance, but you know, this. That rental income wouldn't be on my income statement until later as I earn it evenly over the next five years. So you see my basic problem. We end up with income on the tax return now, but it won't be on my income statement until later until I earn it evenly over the next five years.

All right. It's time for a little pop quiz. You have to get involved here. What do you think that the FAR CPA Exam would call this item? How do you think the FAR CPA Exam would refer to this? Is this a future taxable amount or a future deductible amount? What is this? Is this a future taxable amount? Is this an FTA or a future deductible amount?

An FDA? What is it? Very good. It's a future deductible amount. Why? Because we already paid the tax. We're not paying the tax in the future. We paid the tax. Now we can deduct this from our taxable income later. It's definitely an FDA, definitely a future deductible amount. I hope you got that. All right. One more.

How is it possible to have an expense, a deduction on our tax return now, but it's not going to be on our income statement till later. Well, you knew we'd have to get into this one. Let's talk about depreciation. Let's say on the tax return, we're using makers. We using the modified, accelerated cost recovery system.

We use whatever accelerated depreciation method, Congress dreams up. So let's say on our tax return, we're using makers, whatever accelerated method Congress is allowing, but let's say on our books, we're using straight line. You see the effect that has don't. We take a big deduction on our tax return. Now that we won't take on our books until later more slowly.

Under straight line. It's time for pop quiz again. What do you think the FAR CPA Exam would call this item? How do you think the FAR CPA Exam would refer to this one? Is it a future taxable amount or a future deductible amount? How about this one? Think about it. What is it? Very good. It's a future taxable amount. I already took a big deduction.

This is not a big deduction I can take in the future. I already got a big deduction on my tax return. I got it. I have to pay the taxes later. I have to pay the Piper later. That's definitely a future taxable amount. Now there's something I want you to notice from all the examples that we just went through.

And it's critical that you notice this notice that what is unique about temporary differences? What is singular about temporary differences? Is that temporary differences reverse themselves. They turn around and you can see that in the items we just went through. In other words, the rental income that's on my tax return.

Now that I collected in advance, we'll eventually get on my income statement later as I earn it, the depreciation I took on my tax return now eventually gets on my income statement later as I take it more slowly under straight line. The nature of a temporary difference is that it reverses itself. It turns around, in other words, in my first examples, if I wait long enough, the tax returns eventually catch up to the income statements or in my second examples, the type two, if I wait long enough, the income statements eventually catch up to the tax returns.

These just represent temporary differences in reporting. So you have to remember that the temporary differences reverse themselves. They turn around now, before we get into how you account for temporary differences, let's talk about the permanent differences. Let's get into these.

There are differences. Between what a corporation reports on their income statement and what a corporation reports on their tax return. But these differences are permanent. What is permanent mean? What it always means forever. In other words, I know you with me, permanent differences do not reverse themselves.

They do not turn around. They're permanent. There forever. They never reverse themselves. Why don't we start this the same way we started temporary differences. What causes permanent differences. We already know what causes temporary differences, right? We know that what causes temporary differences is a corporation using one method of accounting on their books and another method of accounting on their tax return.

We know that's what causes temporary differences. Well, what causes. Permanent differences. Let's be clear on it. What causes all permanent differences is this situation. The corporation has some item on their income statement, either revenue or expense. There's some item on the company's income statement, either revenue or expense that will never be on the tax return.

It'll never be on the tax return. That's why it never reverses itself because it never gets on the tax return. Now let's go over some examples of permanent differences. And I will say that once again, the good thing about the FAR CPA Exam is that the same permanent differences are in the FAR CPA Exam time. And again, and there aren't that many they like, but you've got to know them when you see them.

So let's go over the ones they like, let's say, for example, that a corporation takes out a life insurance policy on the president of the corporation and. The corporation is the beneficiary of the policy. That's important. It's what they call a key person. Policy. A corporation takes out a life insurance policy on the president of the corporation.

And again, it's important to remember that the corporation is the beneficiary of the policy. It's what they call a key person policy. Now, you know, what's going to happen. The corporation is going to pay premiums on that policy. So let's go through it. We'll those premium expenses. Beyond the company's income statement.

Definitely. Why? Because the company incurred them. That's all GAAP cares about those premium expenses are expenses. The corporation incurred in the pursuit of profit. So they're definitely on the income statement. Will IRS allow those premium expenses as an allowable deduction on the corporate tax return on the 1120.

No IRS would disallow that because if the corporation is the beneficiary of the policy, IRS will disallow those premium expenses. They're not an allowable deduction on the corporate tax return. So you see our basic problem. Don't we have an expense on the income statement. We have to report it because we incurred it.

But it'll never be on the tax return. It's disallowed. That's never going to reverse itself. That's a permanent difference. You're just stuck with it. You know, really what causes permanent differences is that GAAP and tax law just don't agree. It's another way to look at it. That's why you have permanent differences because there are instances where GAAP and tax law just don't agree on something.

All right, let's stay on this. Let's say the president of the corporation dies. And the corporation collects a million dollars in life insurance. Remember the corporation is the beneficiary of the policy. It's a key person policy. So now the corporation collects a million dollars of life insurance. You know what I'm going to ask you will the million dollars of life insurance proceeds beyond the company's income statement.

Yes. It's other income, no doubt about it. When a corporation collects a million dollars of life insurance, that million dollars is on the. Company's income statement. It's other income. Is it on the tax return? No life insurance proceeds are just not taxed. So you see our basic problem. We have income on the income statement.

We have to report it. We're required to under GAAP, but that's never going to be on the tax return. Life insurance proceeds are simply not taxed. That's never going to reverse itself. It's a permanent difference. We just stuck with it. It's never going to reverse itself. Never going to turn around. Let's talk about another one interest income from municipal bonds.

Let's say a corporation invests in municipal bonds. You know, what's going to happen. The corporation is going to earn interest income on those municipal bonds. You know what I'm going to ask you. If a corporation earns interest income on those municipal bonds, will that interest income beyond the corporate on the corporations income statement?

Of course it will because they earned it. That's all GAAP cares about that's income that was earned. Is that interest income on the corporate tax return? No, it's not. Interest income from municipal obligations is simply not taxed. So you see our basic problem. We have income that's on the income statement.

We have to report it because we earned it, but it's not on the tax return because it's not taxed. That's a permanent difference. That's never going to reverse itself. Now, one more, one more. And we're going to have to get into this because it's a permanent difference. You have to be aware of in some of the problems in the exam.

Don't forget this difference. When one domestic corporation pays another domestic corporation, the dividend 80% is non taxable. Don't forget there's an 80%. What they call DRD dividend received deduction. Again, it comes up when one domestic corporation pays another domestic corporation. A dividend 80% is non taxable.

There's an 80% DRD on 80%. Dividend received deduction. Now I'm well aware that there's a 70% DRD and there's also a hundred percent DRD, but for our purposes in this FAR CPA Review course, we'll stick to the 80% DRD. Now you may not see why I brought this up. Let's say that you're a domestic corporation. I'm a domestic corporation and you send me a thousand dollars dividend.

Think about how that's going to play out if you're a domestic corporation and I'm a domestic corporation and. Welcome to Bisk CPA review comprehensive review materials for the CPA exam. To let you customize your own review programs to meet your individual learning style and ensure your success

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Hello, and welcome to the Bisk CPA review course and our coverage of the financial accounting and reporting section of the CPA exam. My name is Bob Monette. I'll be your instructor for this FAR CPA Review course. and in this FAR CPA Exam course, we're going to be talking about bonds. And other liability issues as well. But let me say that in this CPA Exam FAR course, we're going to spend most of our time talking about bonds because bonds are one of the most heavily tested parts of liabilities.

And as you'll see, as we get into this topic, there are so many ways the FAR CPA Exam can approach bonds in a problem that bonds are a trouble spot for a lot of students. So we are going to spend a lot of time on bonds.

Now, as you know, a bond is a debt security. When a corporation issues, bonds, they are borrowing money from the investors and the bond is evidence of that debt. When. Investors invest in bonds. They're investing in a debt security. So it's always evidence of debt for the corporation, issuing the bond. And I asked my advice where you right off the bat, the secret to bonds, if there is one is to master all the basic entries that you make with bonds, because you'll find that once you master the basic entries that you make with bonds now, no matter what.

the FAR CPA Exam comes up with no matter what they ask in bonds, no matter how complicated the problem, one way or another all bond problems come back to these basic entries. So that's where we're going to begin. We're going to go over all the basic entries on bonds, and I want to go right to a problem.

And your viewers guide. I want you to go to problem number one, and let's take a look at it. It says on January 2nd of the current year West issued, notice that word issued notice in this problem, we are on the issue side. And you have to be careful because sometimes in the FAR CPA Exam with bonds, you're on the issue side, sometimes in the FAR CPA Exam with bonds you're on the investment side.

So you pay attention to that. West issued 9%. Let's stop there. That 9% that's called the stated rate of interest. That is a rate of interest that's printed right on the face of the bond certificate, it's called the stated rate of interest printed, right on the face of the bond certificate. They issued 9% bonds in the amount of 500,000.

Let's stop right there. If it's $500,000 worth of bonds, it must be 500 bonds because remember in the CPA exam, bonds are always in denominations of a thousand in the CPA exam. One bond equals one, $1,000 debt. So if it's $500,000 worth of bonds, That must be 500, $1,000 bonds. Notice they mature in 10 years.

Now they say the bonds were issued for less than 500,000. The bonds were issued for 469,500. Why? Because they want the bonds to yield more than the stated rate printed on the bonds. They want the bonds to yield 10% and we we've, we've hit a concept that you want to know cold. Always remember that when bonds sell at a discount, there's effectively more interest.

Anytime you see a discount in the exam, you know, there's more interest for both sides. Now you see why I say both sides, because if you're the issuing company, a discount means there's effectively more interest expense. If you're the investor company, a discount means there's effectively more interest income, but at discount always means more interest.

And it's the kind of thing. If you know that cold you'll work a lot. Faster than these problems, you start eliminating answers. A discount always means more interest for both sides. They go on to say interest is payable annually. On December 31 West uses the effective interest method to amortize the bond discount.

Then they say in the June 30th notice six months have gone by the bonds were issued on January 2nd. And now in the June 30th balance sheet, what amount would West report? As bonds payable. And I want you to focus on that word report. Let's say more about it later, but they want to know what West would report for bonds payable.

Now, as I said, the secret to bonds, if there is one is to master all the basic entries that you make with bonds. So let's go back to January 2nd. Let's go back in time. Let's go back to January 2nd in this problem. What entry would West have made when West issue the bonds will? I think, you know, When West goes out and issues $500,000 with the bonds for four 69, five West is going to debit cash for what they collect 469,500, but they're going to credit bonds payable for 500,000.

You always credit bonds payable for the face amount of the debt. There's an absolute, the account bonds payable will always be credited for the face amount of the debt. So they're going to credit bonds payable for the 500,000. Then of course, what they do is debit discount on bonds. 30,500. That's the entry that West would have made when West issued the bonds.

Now, while we're focusing on this entry, I want to talk about some terminology. You know, that the face amount of the bonds is 500,000, but the critical question in the FAR CPA Exam is this. As of January 2nd, what is the carrying value of the bonds? Let's talk about the definition of carrying value. Never forget the carrying value of bonds is defined as the face amount plus any unamortized premium or a minus any unamortized discount.

Let me say that again. The carrying value bonds is defined as the face amount plus any unamortized premium or minus any unamortized discount. So I think we can agree that as of January 2nd, the carrying value of these bonds would be the face amount, 500,000 minus. The unamortized discount, 30,500. Right now the bonds have a carrying value of 469,500.

And let me say that partly what caring value is all about is they want to be sure that you, as a student, understand how this debt is carried in the financial statements. That's really the point. This debt is not carried in the balance sheet as a $500,000 liability. No it's carried and the balance sheet as a liability, a 469,500.

Because remember discount or premium in terms of presentation is presented on the balance sheet as part of the debt. So right now this is on the balance sheet as a liability of 469,500. That's its carrying value. Now, when we go to the bottom of the question and it says in the June 30th balance sheet, what amount would West report for bonds payable?

I'll tell you a lot of students go for answer D. Because they think, well, we know the account bonds payable is always credited for the face amount of the debt. Wouldn't bonds payable be answer D 500,000. No. Now let me say this. It might make you feel better about it. If the examiner asked what's the balance in the account, bonds payable, the answer would be D that makes you feel a little better about that.

If the examiner asked what's the balance in the account, bonds payable. No question. It's answer D. That's not what they asked. They asked how we report the debt. That would report's important. They said, what about would West report for bonds payable? How was debt reported and a balance sheet at its face amount, plus any unamortized premium or minus any unamortized discount?

That is how debt is reported in the balance sheet. So we're back to caring value again. Now there's a, another mistake. A lot of students make notice these bonds pay interest annually on December 31. Annual interest. Now, the issue of the bonds on January 2nd, we're doing a balance sheet on June 30th, just after six months.

So some students sit in the FAR CPA Exam and say, well, since only six months have passed and the bonds pay interest annually, there wouldn't be any interest adjustments at this point, not by June 30th. So why wouldn't we still be at answer a why wouldn't we still report the debt at four 69 five? Well, I think, you know, Y a is wrong.

Because it doesn't matter how you pay the interest on June 30th, you'd make your accruals. So don't forget that. So let's think about the interest adjustment we would make on June 3rd.

I assume it's June 30th and let's start with straight line. Amortization of that discount. I know that West uses the effect of interest method, but let's say it's June 30th and West uses the straight line method to amortize the bond discount. Well, I have some more advice for you. Anytime you go to make an interest adjustment with a bond.

I think that you should always start with an absolute start with something. the FAR CPA Exam can't play around with it. You know what that is? The actual interest check they send out. Always remember that the actual interest check they send out is always based on the stated rate of interest times, space value.

Remember that formula stated rate of interest times face value will always get you the check they send out. That's never the FAR CPA Exam can't play around with that stated. Time-space stated time-space, that'll get you the interest check that goes out. So let's get the interest check. We know the stated rate printed on the bond is 9%, but for six months, remember it's June 30th would be four and a half percent times the face amount, 500,000.

We know the interest check is going to be 22,500. So in this entry, we're going to credit interest payable. 22 five notice we don't credit cash. It's not paid until December 31. We're at June 30th making our accruals. So they would credit interest payable. 22,500. Now follow me through this. If they're going to use straight line amortization of that discount while we know they are ten-year bonds.

If they're 10 year bonds, isn't that 26 month periods. So in straight line, you would take that $30,500 discount divided by 26 month periods. And you would credit discount 1005 25. You would take $1,525 of discount amortization, and you would debit interest expense. 24,825. That is the adjustment you would make in straight line.

Now we've hit another major point something you have to remember, and I'll really just memorize it because you'll work so much faster. If you know this cold, never forget that amortization of a discount always increases carrying value. On both sides. We'll get to the investor side later, but the fact is amortization of a discount always increases carrying value.

And as I say, if you know that you'd just work a lot faster, so what's just happened is carrying value has gone up 1005, 25 because of that discount amortization. So didn't the carrying value go from the old carrying value, four 69 five up 1005 25. To answer C you might just put your own notes. Right next to answer.

See straight line. If this had been straight line, the answer would be C another point. I want to make what you have to make. What you have to love about straight line is that you're going to make the same interest adjustment every six months for 10 years. Now, you know, we're not gonna do all those entries, but I want you to recognize that's what everybody loves about straight line.

We're gonna make the same interest adjustment like clockwork every six months. For the next 10 years. So what's going to happen. Carrying value is going to go up 1005, 25 up 1005, 25 up 1005, 25. So 10 years from now, when the bonds mature, what will be the carrying value of the bonds? 500,000. What's the last entry the issuing company makes they debit bonds payable, 500,000 credit cash, 500,000.

It's a debt at maturity. The company has to pay back the face amount of the debt. I don't care whether they sell bonds at a discount or a premium at maturity, you always have to pay back the face amount of the debt. So that's, what's going to happen here. We're going to take 1005 25 discount amortization every six months, 1005, 25, 1005, 25.

Carrying value keeps going up and up and up. So what maturity, the carrying value of the debt is 500,000. And as I say, the last entry the issuing company would make is debit bonds payable, 500,000 and credit cash. 500,000. At maturity, they have to pay back the face amount of the debt. And that's really the whole cycle.

Now we know in this problem, West does not use straight line West uses the effective interest method. Of amortization. So let's get into that. First of all, under the effect of interest method, would that change the initial entry that Westmaid back on January 2nd? No, the entry on January 2nd, when the issue of the bonds would be the same, all that's affected by the effect of interest method are the interest calculations.

So now let's assume it's June 30th, first year, June 30th, what would be the entry under the effective interest method now? Before we get into this entry. I want to make a point. I want you to be aware that the CPA exam asks more questions about the effective interest method of amortization than any other single thing about bonds.

Let me say that again. Never forget that the CPA exam asks more questions about the effective interest method of amortization than any other single thing about bonds. Not all they ask, but you've got to, you've got to really be comfortable with the effect of interest method. So we've hit another major point.

Here is a huge thing. You have to remember under the effective interest method, the way you calculate your interest is you will multiply the effect of the yield of the bond, not the stated rate. You're going to multiply the effect of yield of the bond times carrying value. And this is why carrying value is so critical because to get your interest in the effect of interest method, you have to multiply the effect of yield of the bond, not the stated rate, the effect of yield of the bond times, carrying value.

So let's work it out. In this problem, the effect of the yield is 10%, but for six months would be 5% times carrying value for 69 five. Aren't they going to debit interest expense 20 3004 75. How about the check that goes out? That's not going to be any different interest check is always stated time space.

We know to get the interest check. Take the stated rate printed on the bonds 9%, but for six months would be four and a half percent times face value, 500,000. They're still going to credit interest payable 20, 25. So let's just pause on the entry right there. You see why the FAR CPA Exam loves the effective interest method, because that's what you have to keep straight in your mind that the interest expense is the effect of yield of the bond.

Not the stated rate times, carrying value, not face value, but that has no effect on the check that goes out. The interest check is always stated. Time-space. That's what you have to sort out in your mind. Now, obviously the entry doesn't balance, we need a credit of $975 to balance the entry out. You know what that is?

That's the discount amortization for that six months. So credit discount nine 75 and that nine 75 is a plug. There's no other way to get it. It's the difference between the expense and the interest check. It's why entries help you a lot, if you have to, because a lot of times in the exam, they want the amortization for the year.

Well, the best thing to do is go to the scrap paper and put down an entry. Because the amortization is a plug. It's the difference between the expense and the interest check in the effective interest method. All right. So we know that amortization of a discount always increases carrying value. So it didn't carry value.

Just go up nine 75, it went from four 69, five up nine 75 to answer B 470,475. Let's go to December 31. At December 31 in the effective interest method, would you put down the same entry? No. Why? Well, because when you get to December 31, the effective yield is still 10%, but for six months it would still be 5%.

That's not going to change as you go from payment to payment to payment, the effective yield is not going to change. It's still 5% for six months, but of course, what has changed is carrying value. Because of the adjustment back on June 30th, caring value went up nine 75 to answer B 470,004 75. So on December 31, we'll take the effective yield of the bond.

5% times the new carrying value, 470,004 75. And we're going to debit interest expense 20 3005, 24. But as you know, that has no bearing on the check that goes out. We'll still going to credit interest payable. For the state rate of interest 9%, but for six months would be four and a half percent.

Time-space value. 500,000 was still going to credit interest payable, 22, five entry doesn't balance. We need a credit of 1,024 to balance the entry out. That's the amortization of the discount for the last six months. And it's a plug. It's the difference between the interest expense and the check. And there's really no other way to get that.

Another point. I know you with me. If the CPA exam had asked, what is the amortization for the year? You'd have no choice, but to add up nine 75 plus 1,024, and there's not another way in the universe to get that answer. I hope you with me, you've got to be comfortable with the effect of interest method.

What's the balance in interest payable now? Well, it was 22 five June 30th. We've added another 22 five is the balanced interest payable, 45,000. And now. Annually. They make the payment. They would debit interest payable, 45,000 credit cash. 45,000. They'd make the payment. Let's do a premium.

Let's go to problem. Number two. Improv number two, they say on may, first bolt issued notice we're on the issue side, not the investor side bolt issued 11% bonds. We note that 11% is that's the stated rate printed right on the bonds. 11% bonds in the face amount of a million dollars. Well, that means there must be a thousand bonds because bonds are always in denominations of a thousand.

So if it's a million dollars worth of debt, it must be 1000 thousand dollar bonds. They mature in 10 years. The bonds issued to yield notice a little less than the stated rate. The bonds are going to yield a little less than the stated rate. 10%. Why is that? Because they sold the bonds at a $62,000 premium.

All right. So we've hit another major point. What you want to absolutely know cold is that when bonds sell at a premium, there's effectively less interest for both sides. That's what a premium always means. Effectively less interest for both sides. And you know why I say both sides? Because if you're the issuing company, a premium means there's effectively less interest expense.

If you're the investor company, a premium means there's effectively less interest income, but a premium always means less interest for both sides. Effectively bolt uses the effective interest method to amortize that bond premium interest is paid semi-annually on November one and may want in the October 31 balance sheet.

So we're doing a balance sheet on October 31. What would bolt report as unamortized bond premium? Well, let's get a little practice on this. Let's go back to May 1st on may. First, what entry did bolt make when bolt issued the bonds? I know you get used to it. Wouldn't bolt have debited cash for what they collected 1,000,060 2000.

They credit bonds payable, always for the face amount of the debt, a million, and they would credit premium on bonds. 62,000. That's the initial entry bolt would've made. As the issuing company now, as of May 1st, what's the face amount of the debt, a million what's the carrying value of the debt? Well, that would be the face amount, a million plus any unamortized premium 62,000 carrying value of the debt initially is 1,000,060 2000.

And as I said, partly what caring value all about is to be sure that a student understands how debt is carried in the financial statements. And this debt would be carried in the balance sheet. Not, not as a liability of a million, it would be carried on the balance sheet as a liability of 1,000,060 2000, because remember discount or premium is always presented in the balance sheet.

As part of the debt. Let's do some interest adjustments. Let's say six months go by. We're doing a balance sheet here on October 31. So let's say it's October 31, six months. Go by and let's start with straight line amortization of the premium. Let's get some practice on straight line.

Well, let's start with the interest check. We know that they, they can't play games with that. The actual check that goes out is always based. On the stated rate of interest printed on the bonds 11%, but for six months would be five and a half percent times face a million. We know they're going to credit interest payable, 55,000.

And you know, why credit interest payable, not cash because it's not paid till tomorrow morning, November one, we're an October 31 making our rules. So we're going to credit interest payable, 55,000. Now, if it's straight line, how do we look at this? If it straight line average amortization of the premium, we're going to say, well, these are 10 year bonds.

That means it's 26 month periods. So in straight line, we'll take that $62,000 premium divided by 26 month periods. And we will debit premium $3,100. We'll take 3,100, a premium amortization and debit interest expense just 51 nine. So when they ask at the bottom of the question in the October 31 balance sheet, what would bolt report as unamortized bond premium?

Well, we know. The unamortized bond premium started out at 62,000. We just amortized 3,100 of it. So it's down to answer C 58, nine. So you're getting, you might want to just right next to answer C straight line. If this had been straight line, the answer would be C and we also know what we love about straight line.

What we love about straight line is we're going to make the same interest adjustment every six months for the next 10 years. And Karen value is going to keep going down 3,100. We've hit another major point. Remember amortization of a premium, always decreases carrying value on both sides. Again, it's the kind of thing.

If you know that cold you'll work a lot faster, you know, amortization of a premium always decreases carrying value on both sides. So carrying value has gone down 3,100 and every six months we'll make the same entry like clockwork and straight line. So it's so carrying that is going to go down 3,100 down 3,100 down 3,120 times.

So 10 years from now, When the bonds mature, what will be the carrying value of the bonds? A million what's the last entry bolt makes debit bonds payable, a million credit cash, a million. They have, it's a debt at maturity. They have to pay back the face amount of the debt. Whether they sell bonds at a discount or a premium at maturity, they've got to pay back the face amount of the debt.

As, you know, bolt does not use the straight line method bolt amortizes the premium using the effective interest method. So let's get some practice on the effective interest method. We know that when we do a balance sheet on October 31, and we have to accrue our interest. It's not going to be paid until November one.

The way bolt is going to work out their interest expense for the six months, they're going to take the effect of yield of the bond, not the stated rate, the effect of yield, which is 10%, but for six months would be 5% times carrying value 1,000,060 2000. We know bolt is going to debit interest expense 53,100.

But as you know, that has no bearing on the check that goes out. The interest check is always. Stated time-space so pick up the stated rate printed on the bonds 11%, but for six months will be five and a half percent. Time-space a million. We know they're going to credit interest payable, 55,000 entry doesn't balance.

We need a debit of 1900 to balance the entry out. That's the amortization of the premium for that six month period. And it's a plug there's no other way to get it. So when they asked at the bottom of the question in the October 31 balance sheet, what amount would bolt report as unamortized bond premium?

Didn't the bond premium. Just go from 62,000 down 1900. We amortized 1900 of it down to answer bait. Now the unamortized premium is 60,100.

Let's look at a problem from the investment side, because as I've been saying in this CPA Exam FAR course, in the FAR CPA Exam with bonds, sometimes you're on the issue side. Sometimes you're on the investor side.

Let's go to problem. Number three, probably number three says on July 1st, 2009 Fox company purchased knows that word purchased run the investment side here. Fox purchased 400 of the $1,000 face amount of 8% bonds. Of day corporation. All right. So Fox is purchasing $400,000 worth of bonds. The stated rate on the bonds printed on the bonds is 8%, but notice Fox purchased the bonds for three 69 to a little less than face amount.

Fox bought the bonds at a discount. Why? Because they want the effect of yield to be 10%. You know, a discount always means it's effectively more interest than the stated rate. And that's the case here. They say the bonds mature July 1st, 2014. So notice the a five-year bonds. They go from July 1st, 2009 till July 1st, 2014.

And they say that

Fox uses the effective interest method to amortize the discount. The bonds are appropriately recorded. As a held to maturity investment, they wanna know the bonds. How with bonds be reported in foxes, December 31, 2009 balance sheet. All right, so let's do a couple of entries from the investment side. Let's go back to July 1st, 2009 back on July 1st, 2009, when Fox purchases $400,000 worth of day corporation bonds for three 69.

To what Fox will do is just simply debit. Investment in bonds for what it costs them 369,200 and credit cash, three 69. To notice that the investor normally would not set up a separate discount account, you can do it that way, but I think it's simpler just to treat it as if the investor would record all their investments at cost.

They would just simply debit investment in bonds for what it cost them 369,200 and credit cash. 369,200, or now that was on July one. We're doing a balance sheet six months later. So let's say now it's December 31, 2009. And what if Fox used the straight line method of amortization? Let's look at straight line from the investor side.

Well, first of all, we know the interest check that Fox is gonna collect, right? The interest check that Fox is going to collect would be based on. The state of rate of vendors printed on the bonds times face them out. So let's pick up the stated rate printed on the bonds 8%, but for six months would be 4% times the face amount of the bonds.

400,000. We know the Fox is going to debit interest receivable, 16,000 notice not cash. It's not paid, not collected until tomorrow morning, January one. Bonds pay interest. Semi-annually July one, January one. So if you're a Fox, you're not going to collect the money until tomorrow morning, January one, again, we're at December 31 making new cruel.

So Fox is going to debit interest receivable for 16,000. Now, as I said, a moment ago, the investor does not usually set up a separate discount account, but the discount is there. There's a. $30,800 discount here and in straight line, how are we going to look at it? Well, these a five-year bonds, they go from July 1st, 2009 until July 1st, 2014, that's ten six month periods.

So in straight line, Fox would take that $30,800 discount divided by 10, six month periods. And take 3,380 of discount amortization. Now they don't have a separate discount account. So they would just debit investment in bonds, 3000 Oh 80 and credit interest income, 19,000 Oh 80. And once again, straight line, the beautiful thing about it.

We make the same adjustment like clockwork every six months for the next five years. And we know that amortization of a discount always increases carrying value on both sides. So notice carrying value investment bonds is going to go up three thousand eight hundred eighty three thousand eight hundred eighty.

You're going to make that entry 10 times. So five years from now, when the bonds mature, what's the carrying value of the investment 400,000. What's the last entry Fox mix. They debit cash 400,000. They get the money back. Remember they invested in a debt security and at maturity, they get paid back the face amount of the debt.

So maturity Fox would debit investment in Vaughn's 400,000, excuse me, they would debit cash 400,000. They get their money back. They would debit cash, 400,000 and credit investment bonds, 400,000. And that's the whole cycle. But of course we know that Fox does not use straight line.

Uses the effective interest method of amortization. So let's apply the effect of interest method of amortization to the investor. Well, again, we know that. The effect of interest method. When you see it has no bearing on the first entry, the entry that was made back on J J July one, when Fox purchased the bonds, wouldn't be any different, all this affected ever by the effect of interest method, our interest calculations.

So let's do it. If it's December 31 and Fox uses the effect of Indra's method. Well, here again, we know that the interest check Fox is going to collect, right? The interest check, the Fox is going to collect will be based on state of time-space. So we pick up the state of rate of interest printed on the bonds 8%, but for six months would be 4% times the face amount of the bonds, 400,000 Fox is still going to debit interest receivable, 16,000 interest check is not going to change, but here's what is going to change to work out the interest income that Fox earned for that six months, you would take the effective yield of the bond, which is 10%, but for six months would be 5% times the carrying value of the investment three 69 too.

And credit interest income, 18,004 60. That's the income they earned for that six month period and the entry doesn't balance. This next number is a plug as it always is. We simply need a debit of 2004 60 to balance the entry out. That's the amortization of the discount for that six month period. That's always true in the effective interest method that the amortization for the period is a plug.

It's the difference in this case between the cash and the income. And there's no other way to get that. You plug it in. So we're going to debit what, for 2004 60, they don't have a discount account. So debit investment in bonds, 2004 60 carrying value goes up 2004 60. So when they ask at the bottom, how would the bonds be reported in the December 31, 2009 balance sheet?

Well, they were at three 69 too, but amortization of a discount always increases carrying value. So carrying value has gone up 2004 60 up to answer C. Three 71, six 60. I think, you know what I'm saying? When you win that exam, make sure you're comfortable with the effective interest method on both sides, whether you're on the issue side or the investor side.

Now you also may remember this, that in in in another class, if you had this with us, when we talked about investments, we said, There are trading securities trading securities are accounted for at fair market value. There are available for sale securities available for sale. Securities are accounted for at fair market value.

Lemme, this is the third category. The third category of investments is held to maturity investments. And what we said in that glass was that held to maturity investments are accounted for under amortized costs. Not fair value held to maturity investments are not accounted for at fair value. Held to maturity investments are accounted for.

Under amortized costs. So just so that this is in your mind, and you're thinking this way, what we just went over is amortized cost for the investor. What we just applied to this hell to maturity security is amortized costs. Notice there's the straight line approach to amortize costs. There's the effect of interest approach to amortize cost, but held to maturity investments.

Must be accounted for under amortized costs. So just be aware, there's the straight, if you're the investor, there's the straight line approach to amortize costs. There's the effective interest approach to amortize cost. Another point I want to make, and I'm sure you probably know this, but it has to be said that if interest is a material item on the income statement for the issue or the investor, alright.

For the issue or the investor, if interest is a material item on the income statement, The effect of interest method is required. The effect of interest method of amortization is theoretically preferred companies can use straight line, but only if interest is immaterial. If interest is a material item on the income statement for the issue or the investor, the effective interest method is required.

It is theoretically preferred. As I say, companies can still use straight line if interest is immaterial, but. You have to be aware that sometimes in the exam, maybe for simplicity in some problems, they'll have you use straight line. Now what I'd like you to do next is try something, try some problems and get some practice on this.

And I think that it's so critical when we get to an area where I'd like, I want you to do problems that, you know, you shut the class down. Do you know, do the problems, get your answers first. Before you come back to the class and we go through them together. You'll find you get much more out of the class if you do that.

So what I'd like you to do is shut the class down, do questions four through eight, four through eight, and then come back and we'll talk about them together.

Welcome back. Let's look at these questions together in number four, we're talking about web company. I'm sure you notice that web company is the issuing company. We're on the issue side. Now, as you started the question, I hope you noticed that as we start the face value of the bonds is a hundred thousand carrying value is 105,000.

The stated rate of interest printed on the bonds is 7%, but the effective yield is six. What I'm saying is that partly what they're testing in a bond question is whether or not a student has all these concepts sorted out and you may not be there yet, but once you get comfortable with bonds, that's how you look at a question like this.

You take one, look at it and you say, Oh, I see the face amount of the bonds is a hundred thousand. Carrying value is one on five stated rate of interest is 7%, but the effective yield is six. And of course the effective yield is below the stated rate because they sold the bonds at a premium. And as of June 30th, year two, the premium, the unamortized premium must have been 5,000.

If the face value that on June 30th year two is a hundred thousand carrying value is 105,000. That would mean that the unamortized premium on June 30th year two was 5,000. Well, they want to know what would be unamortized premium a year later. June 30th year three to solve this. You had to think about the adjusting entry that would be made for interest on June 30th, year three.

So let's just put it down. We know when web does their entry or record interest on June 30th, year three, they use the effective interest method of amortization. That's what the problem says. So we know under the effect of interest method, the way Webb would get their interest expense for that year. Would be by taking the effective yield of the bonds, which is 6% times carrying value, 105,000.

We know web is going to debit interest expense 6,300. But as you know, that has no bearing on the check that actually goes out. The check that goes out is always based on the state rate of interest printed on the bonds. 7% times the face amount, a hundred thousand. We know they're going to credit cash 7,000 and here you could credit cash.

Because it's paid on December 31. So credit cash, 7,000. Well, you notice the entry doesn't balance. I simply need a debit of 700 to balance the entry out debit premium 700. That's the amortization of that premium for that yearly period. So when they ask us at the bottom of the question, what would be on amortized premium on June 30th, year three?

Well, we know a year ago on amortized bond premium was 5,000. Now they've amortized 700 of it. So on June 30th, year three on amortized premium would be answered C 4,300. Now another thing I want to mention, notice that every problem we've done so far has been what is called term bonds, meaning they mature after term of time.

It's want you to notice that that these are 10 year bonds. They mature after 10 years after term of time, these are called term bonds. And that these are the most common type of bonds you see in the exam. In number five, Foley company is preparing the electronic spreadsheet below to amortize the discount on its 10 year, 6%, hundred thousand dollar bonds payable.

Now the bonds were issued on December 31. So they yield a little bit more. They wanted them to yield 8%. Well, they want them to yield more than the stated rate. Of course, they sold the bond at a discount and they say that Foley uses the effective interest method to amortize the discount. Now they give us this little table and if you look at the table, we know the carrying value of the bonds at the end of the first year is 86,580.

That's in box E too. They say what formula would fully use in cell  to calculate the carrying amount, the carrying value of the bonds at the end of year two? Well, we know it's a discount and we know amortization of a discount always increases carrying value. So the answer is a, if I take what is in . The carrying value at the end of year one, add the discount amortization for the year.

What would be in box D three, that would give me the new carrying value in box.  just, it's a matter of knowing that amortization of a discount always increases carrying value. So if I know the carrying value at the end of year two, and I want to know the character at the end of year three it's it's what's in that box, easy to add.

The discount amortization for year three, which is box D three, answer a

in number six, they say on July 1st Cody paid 1 million, 198,000 for 10% 20 year bonds. With a face amount of a million. So I'm sure you noticed in this problem, we're on the investor side, sometimes in the FAR CPA Exam with bonds, you're on the issue side. Sometimes the FAR CPA Exam with bonds you're on the investor side.

You want to be sensitive to that. Now in this case, Cody paid a premium, Cody bought a million dollars worth of 10% bonds and paid a premium I'm 198,000. Why? Because they want the bonds to yield a little less than the state of rape. 8% Cody, the investor uses the effective interest method and they want to know what would be reported as the carrying value of the investment in Cody's December 31 balance sheet.

In other words, six months later, the investment was purchased on July one. We've got to work out the carrying value of the investment six months later, December 31. So think about the adjusting entry that Cody would make the interest on December 31. Well, we know. Under the effective interest method, the way the interest adjustment is going to look, first of all, the interest check that code is going to collect, right?

The interest check, the code is going to collect will always be based on the state of rate of interest printed on the bonds time-space amount. So if you take the stated rate, which is printed on the bonds 10%, but for six months would be 5% times the face amount of the bonds, a million we know Cody's going to debit cash.

50,000 and it is paid on December 31. So Cody would debit cash, 50,000, the state of rate of interest printed on the bonds 10%. But for six months would be 5% times the face amount of the debt, a million. We know Cody's going to debit cash 50,000, but we also know under the effect of interest meant the weighty, the way Cody calculates the income they've earned for that six months is by taking the effective yield of the bond, which is 8%, but for six, but for six months would be 4%.

Times carrying value 1 million, 198,000. Cody's going to credit interest income, 47,009 20. That's the income that Cody earned for that six months entry doesn't balance. Cody simply needs a credit of 2000 Oh 82,000 hundred 80 to balance the entry out. Cody would credit investment in bonds. That's the amortization of the premium for that six month period.

And it's a plug. It's the difference between the cash and the income. That's why entries helped you a lot. And remember Cody wouldn't have a separate prima counsel. Cody would just credit investment bonds 2000 Oh 80. So when they ask what would be reported as the carrying amount of the investment. And Cody's the seven 31 balance sheet.

Well, we know amortization of a premium always decreases carrying value. So the investment in bonds went from 1 million, one 98, down 2,880 to answer C that's the carrying value of investment in bonds. And notice again, we're dealing with the most common type of bonds you see in the FAR CPA Exam term bonds, these bonds mature after term of time.

In 20 years now in number seven, there's no numbers. It's a theoretical type of question. They say,

how would the amortization of a discount on bonds affect two things? How would the amortization of a discount affect the carrying value of the bonds and also net income? And I want you to think about something before we actually put an answer down. I want to think about this first. In that question. Are you on the issue side, the investor side, or you can't tell what we thought about that because it matters in number seven.

Are we on the issue side, the investor side? No way to know, definitely the issue side, because it's amortization of a discount on bonds payable, the liability. If it's the liability bonds payable, we're on the issue side. Now this question. Refers to a couple of concepts we've gone over in this FAR CPA Exam course. And I hope you thought about them.

First of all, what does amortization of a discount always do? The carrying value always increase. So if you just knew that that narrows it down to a or B, because we know amortization of a discount always increases carrying value. Here's another concept. When a bond sells at a discount, is there effectively more interest or less?

What's a discount always mean there's effectively more interest for both sides. And if I'm the issuing side, And I know I am because it's bonds payable, there's effectively more interest expense. And if the expenses are more, the income is decreased and the answer is a, got to think it through. Remember when a bond sells at a discount, there's effectively more interest for both sides.

And if I'm the issuing company, I know I am because bonds payable that a discount would mean there's effectively more interest expense. If the expenses are more. The income has decreased. So you ended up with answer a, let me ask you this. What if it was the investor side in number seven? Is it the same answer?

Let's think it through, if you're the investor, what does amortization of a discount to the carrying value still increase? But if I'm the investor, a discount means there's effectively more interest income, and the answer would be B you might want to just be your own study right next to answer B investor.

So that's what it comes down to. It's a, if it's the issuer B, if it's the investor, notice it can matter in the exam. What side you're on. It can determine your answer. The most important thing to notice in that question. You know, if you had this question in the exam, the most important thing to notice is what side you were on.

Oh, bonds payable. It's the liability. I'm on the issue side, because if you don't stop and think about that, you could get that question wrong. Same thing with number eight. They say, how would amortization of a premium on bonds payable? It's the liability run, the issue side effect, the carrying value of the bonds and also net income.

Well, we know amortization of a premium always decreases carrying value on both sides. So if you just knew that, you know, it's C or D what else do we know? We know that when a bond sells at a premium, there's effectively less interest for both sides. And if I'm the issuing company, I know I am cause it's bonds payable.

A premium means there's effectively less interest expense. And if the expenses are less, the income has increased. And the answer is D I hope you got that. And of course, if you were the investor at sea, right, if you're the investor, what does amortization, but premium due to carrying value decrease. But if I'm the investor a premium means it's effectively less interest income in GOM and the answer would be, see it.

See if it's the investor. D, if it's the issuer, just be careful to always know what side you're on in a question.

Now, I would say to, to this point in this FAR CPA Exam course, all we've talked about are what I would call. The basics on bonds. We've really talked about now, the basics, which you have to master, and I don't want to show you next is the kind of problems they have in the exam, where they just assume, you know, all the facts, they assume, you know those, and then they put a few little wrinkles into the problem as well.

And the first wrinkle we're going to look at is serial bonds. Let me just give you a quick definition, a cereal bond. Is a bond where the principal gets paid back in a series. That's really all it means the principal will get paid back in a series. So for example, you could have $10 million of serial bonds, outstanding and pay back the principal, a million dollars every year for 10 consecutive years, that's a cereal bond.

You pay back the principal, a million dollars every single year for 10 consecutive years. In other words, the way they structure it, they have a million dollars worth of the bonds. Mature in one year, another million dollars worth of, of the bonds mature in two years now, the million dollars worth of bonds mature in three years.

That's how they do it. They have the bonds mature in a series, and that way the principal gets paid back in a series. That's what they mean by a serial bond, as opposed to the kind of bonds we've looked at so far in this glass term bonds, right term bonds mature after term of time, you know, 10 years now we're into serial bonds with a bonds mature in a series.

Now. What I want you to be confident on is this, if you get a cereal bond question in the exam, just remember none of your basic principles change. All the basic principles are the same. All that's different is you're paying back the principle in a series. And I want you to be confident that you can break down a problem like this.

If you just apply the basics that, that you do know.

Let's go to a problem. Okay. Number nine, if you go to number nine, it says on December 31, 2012, Arnold issue $200,000 of 8% serial bonds. And you know what that 8% is. None of your basic principles, change that 8%. That's the stated rate printed on the bonds to be repaid in the amount of 40,000 each year.

Stop right there. See that's what makes it a serial bond. That's really all that's different. They're going to pay back the principal $40,000 every year for five consecutive years, interest is paid annually annually on December 31. Then it says the bonds were issued to yield 10%. So they want the bonds to actually yield more than the stated rate.

10%. And therefore they sold men a discount. Of course it says the bond proceeds were one 90, two 80. They sold the bonds. So they sold $200,000 worth of bonds for one 90, two 80. So the bonds would yield a little bit more than the stated rate, which is 8%. They want the yield 10%. Based on the present values at December 31, 2012 of the five annual payments as follows.

And they give us this table and let's be honest. The most intimidating thing about this question is the table. You know, a lot of people just don't like bonds anyway, as an area. And then they get in the exam, they see a problem like this, they see that table and they just get, Oh, they get discouraged. No need to get discouraged here.

If you know your basics, you can break the problem down. Now, first of all, if you look at the table, weren't we already told that the bond proceeds were one 90, two 80. We know they sold the bonds for one 90, two 80. And if you look at the table, the table just shows you all the calculations. They went through to arrive at that number one 92 80.

We don't have to have that. We don't need that table for anything. Again, it just shows you all the calculations. They went through to come up with what the bond should sell for. One 92 80, and we already knew that. So we don't really need that table. It's really just a big bluff and it's very effective.

It's going to get to people, get discouraged. What did was that table don't even need it. Then it says, Arnold, amortizes the discount by the effective interest method. We know that we know the effect of interest method. No reason to back down from this question in the December 31, 2013 balance sheet. So here has gone by.

In the December 31, 2013 balance sheet. And what I'm out with Arnold report as the carrying value of the bonds? Well, let me just show you a couple of entries here because when you see entries, I think you'll see my point that it just comes back to your basic principles. Let's go back a year. Let's go back in time to December 31st, 2012.

If I'm Arnold, what entry would I have made back on December 31, 2012. When I issued the bonds? Well, when Arnold issued the bonds. Arnold would have debit and cash for one 92 80, we told, we were told the bond proceeds were 190,000, two 80. So we know that Arnold would have debit and cash for the proceeds 190,000 to 80 Arnold would credit bonds payable, always for the face amount of the debt, 200,000.

You know that now at this point, the entry doesn't balance, we need a debit of 9,007 20. The balance, the entry out, you know what that is? Debit discount, 9,007 20. Now, if you look at that entry, what does that entry look like? The entry you make for any bond? It's the same entry you'd make for a term bond.

The fact that it's a serial bond, doesn't change that initial entry. Now let's go ahead. A year. A year goes by it's now December 31st, 2013. Let's apply the effective interest method because we know the effect of interest method. Don't we know. Under the effective interest method, the way Arnold would calculate their interest expense for the year, they would take the effective yield of the bonds, not the stated rate, the effective yield, which is 10% times carrying value.

What's carrying value of the bonds. Would it be the face amount of 200,000 minus the discount, 9,007, 20 carrying value of the bonds 190,002 80. So if you take effective yield of the bond, 10% times the carrying value, one 90, two 80. He wouldn't Arnold have debit interest expense 19,000 Oh 28. But as you know, that has no bearing on the interest check that goes out.

Interest check that goes out is always stated time-space. So to work out the interest check, take the state of rate printed on the bonds. 8% times the face amount, 200,000, Arnold's going to credit cash. 16,000 entry doesn't balance. Does it. We simply need a credit of 3000 Oh 28 to balance the entry out.

We're going to credit discount 3000 Oh 28, because you know what that is. That's the amortization for the year. Look at that entry. What does that entry look like? Isn't that the entry you make for any bond is that the entry you make for a term bond, you see what a bluff this question is because people would be very intimidated by this question.

But if you know that the basics on bonds, you can break it down. Now, there is finally something different and you know what it is. What makes this a serial bond? What makes this a serial bond is we're going to pay back the principal in a series. We're going to pay off $40,000 a principal every year for five consecutive years.

So I'll grant you. This is different with a serial bond. You've got to remember to make one more entry where you debit bonds payable, 40,000 credit cash, 40,000, because you are going to pay off 40,000 a principal every year for five consecutive years, paying back the principal in a series. So I'll grant you.

That's different. With this, with the Syria bond, you have to remember to make one more entry. Will you debit bonds payable for the 40,000 and credit cash? 40,000. Those are the entries that would have been made. All right. So now what they want, they said, what would Arnold report as the carrying value of the bonds?

December 31st, 2013? Well, let's work it out. What was carrying value? When we started, when we carry, when we started carrying value was the face amount, 200,000 minus the discount, 9,007, 20 carrying value. When we started. 190,000, 280. All right. Now what's going on. What's going to affect carrying value.

Didn't we take 3000 hundred 28 of discount amortization for the year, and don't, we know amortization of a discount always increases carrying value on both sides. So you're going to add three Oh two eight as you know that, you know, that I hope not at this point, without even thinking amortization of a discount always increases carrying value on both sides.

So carrying value would go up 3000 Oh 28. Anything else? Sure. We paid off 40,000 in principle. So Karen value will go down 40,000 to answer D one 53, three Oh eight. If you know your basics, you can break that problem down. Now, w w we want to have to do the entry per se, but let's just talk it through. How would you interest for the next year if you want to do the following year?

Well to work out the interest expense, it would be the effect of yield 10% times the new carrying value, one 53, three Oh eight, right? The new carrying value answer. D what would be the credit to cash? 8% of 68% of 160,000 man. We paid off 40,000 of principle. So to work out the interest check, it would be state of time-space.

So the state of rate, 8% times the face amount. Of the bonds remaining would be 160,000. And the difference would be your amortization. You're still applying your basic principles.

What I'm going to mention next is. Really just definitional, but I want to make sure that you're aware of it. I want to make sure, you know, the difference between a debenture bond and a collateral bond just very quickly. A debenture bond is a bond that is not secured with any collateral. It's not secured with any assets.

Just remember debentures represent unsecured debt. That's what it is. No, we know them better as junk bonds. That's what they're referred to as junk bonds. All right. That's what it, the venture is a bond that is not secured with any collateral, not secured with any assets, unsecured debt. Now a collateral bond of course, is not junk at all.

It's the opposite. A collateral bond is a bond that is secured with specific collateral collateral bonds always represent secure debt. Now show you one way they could hit this. Let's go to problem. Number 10. Hancock company. And we're given the December 31 year one balance sheet and they have four bond issue, bond issues here.

They have some that are secured, some that are unsecure and they say, what are the total amounts of cereal bonds and debenture bonds? So we gotta work out two things. What's the total amount of cereal bonds. What's the total amount of dementia bonds. Well, Let's look at each bond issue here. In fact, why don't we, why don't we put next to each bond issue next to each number here?

The two 75, the one 25, the two 50, the 200 next, each one next, each one of those numbers let's put S for cereal T for term let's just label each one. Is that 275,000. Is that a cereal bond or a term bond? Well, you put an S there because notice it matures annually. You might want to underline it. Matures annually.

Some of the principles going to mature every year. So that's a serial bond. Now the 125,000 put a T there that's a term bond because it matures after, after a term of time in 2021, next to the two 50, that's a term bond because notice it matures after term of time out in 2020. And then the last one, that 200,000 put an essay.

That's a serial bond because notice it matures annually, 50,000 matures every year. Some of the principal matures every single year in a series. That's a serial bond. So if you did that, you know, your serial bonds are the 275,000 plus the 200,475,000. So that right away, narrows it down to a or B. If you just know what a cereal bond is, you see real bonds are the two 75 plus the 200, 475,000.

So if you just knew the definition of cereal bonds, it narrowed it down to a or B. How about debentures. What's the bench mean on secured. So just add up the unsecured portion, add up to 75 plus one 25. And the answer is a debenture just means unsecured and notice you can have unsecured term bonds. You can have unsecured serial bonds.

The venture means unsecured, and you can have unsecured serial bonds. You can have unsecured term bonds, either one. Now what we're going to get into next. It's something that the FAR CPA Exam loves as a little wrinkle in a bond question. And that is what do we do when bonds are sold between interest rates?

Well, here's the bottom line. Anytime bonds are sold between interstate. You always assume in that exam, that the seller of the bonds will charge the buyers for accrued interest up to the date of sale. That's always the assumption in the FAR CPA Exam when bonds are sold between interstates, you have to assume that the seller of the bonds will charge the buyers for accrued interest up to the date of sale.

Let me show you a problem. If you look in your viewers guide, you'll see a little problem. Let's say that a company issues. $10,000 of 6% bonds on September one. All right. So we know that a company has issued $10,000 of 6% bonds on September one, but notice the bonds pay interest semi-annually on June 30th and December 31.

So obviously if the bonds pay interest, semi-annually June 30th and December 31, and they sold the bonds on September one. They did sell the bonds between interstates. All right. Now my first point is don't mess up the months. Here's what automatically happens because the bonds were sold between interest rates.

You, the buyers will be charged accrued interest from when to when just remember the way this calculation always goes for interest for crude interest, it always goes from the last time interest was paid. In this case, June 30th, up to the date of sale, September one, you, the buyers will be charged, accrued interest.

For July and August. Let me just do that again because a lot of students mess up the months. The way the calculation for accrued interest goes always is from the last time interest was paid. In this case, June 30th, up to the date of sale, September one, you, the buyers would be charged accrued interest for July, August.

So hope you see it's those two months. All right, now the math is very easy here. If you take 6% of 10,000, that's $600 of interest for the year divide by 12 months, it's $50 a month. Again, I took 6% of 10,000 that's $600 of interest for full year divided by 12 months, the interest is $50 a month. Let's do a couple of entries.

If you're the issuing company on September one, you're going to debit cash 10,100. Notice the issuing company is collecting an extra, a hundred dollars cash. Why? Because they charged for crude interest for July and August. $50 a month. So if he, the issuing company, you're going to debit cash, 10,100, you're going to credit bonds payable, always for the face amount of the debt 10,000.

And what they do is credit interest payable, a hundred. That's how they handle it. Interest pay why interest payable, because they owe it back to the investors. That's how the system works. Yes. When bonds are sold between interstates, the investors have to pay interest up to the date of sale, but to get it right back.

The company owns it back to you. How are they going to give it back to you? Because they're going to send you a six-month interest check. Like everybody else, just how the system works. All right. Now let's say you're the investor on September one. What are you going to do? If you're the investor, you're going to debit investment in bonds, 10,000 credit cash, 10,100.

Notice you, if you're the investor, you're charged an extra, a hundred dollars cash because you bought the bonds between interstates that's for the accrued interest for July and August. So credit cash, 10,100. And what the investor will do is debit interest receivable a hundred, because they're going to get it back.

They're going to get a six month interest check like everybody else. So I just want to show you that the way this is handled, it's all handled through interest payable, interest receivable. Let's go to December 31 on December 31. If you're the issuing company, just think about this now on December 31. If you're the issuing company you've actually incurred in interest expense.

For how many months for September, October, November, December, remember, remember they borrowed your money on September one. So if the, if you're the issuing company, you've actually incurred an interest expense for four months, September, October, November, and December times $50 issuing company is going to debit interest expense $200.

But of course, they're going to credit cash 300. They send everybody a six month interest check and now they debit that interest payable for a hundred. They set up back on September one. So hope you see how that works because they've actually incurred an interest expense before months. They borrowed your money on September one.

So they've incurred an interest expense for September, October, November, December four months, times $50, debit interest expense, 200, but credit cash, 300. They send everybody a six month interest Jack, and then they debit the interest payable for a hundred. They set it back on September one. If you're the investor on December 31, You're going to debit cash 300.

You get a six month interest check like everybody else. So you'll debit cash 300, but you'll credit interest income for just 200. You've only earned income for four months. Right? You made the investment on September one. So you've only earned income for September, October, November, December four months, times $50.

So you'll create an interest income for 200 and credit interest receivable. The interest receivable you set up back on September one. Now you credit that interest receivable a hundred. That's how the system works. It's all it all. It's all handled through interest payable, interest receivable. And of course, one of my messages to you is it's obvious, but when you get bond questions in that exam, be very careful of dates.

Now, you know, that's true all over the financial exam, but always watch out for dates because they love bonds between different States. I'd like you to try a couple of weeks. Try problems, 11 and 12, 11, and 12.

Welcome back in number 11, they're asking at the bottom. What amounted, how received from bond issuance? Well, let's start with basics. We know if you're how. You literally went out and sold $300,000 worth of bonds at 99%. So if you multiply 300,000 times 99%, if you're how you literally collected 297,000 cash, just for the bonds, 297,000 and notice that the answer C, but you can't stop there.

And you know why, I'm sure you notice the bonds pay interest. Semi-annually on April 1st and October for us, but they sold the bonds July 1st. So what automatically happens is how would have charged the investors for accrued interest from the last time interest was paid. Don't mess up the months. Now it always goes from the last time interest was paid April 1st up to the date of sale.

July 1st, the buyers would have been charged accrued interest for April, may, June. From the last time interest was paid April one, up to the date of sale, July one, the buyers would have been charged accrued interest for April, may, June. So let's work it out. I'm going to take the face amount of the bonds.

300,000 times the stated rate 10%. That's 30,000 of interest for a full year, but we don't want a full year. We just want April, may, June three, twelves, one quarter of 30,000. So to summarize if you're how. You're collecting 297,000 cash for the bonds. 7,500 recruit interest. The total amount you collected was 304,500, which is answer a, but let's put the entry down.

What's what's the entry, how it would make, how would debit cash for 304,500? That's why to answer a, because they say, what amount did Howe receive from bond issuance three Oh four, five. We know how it would credit bonds payable, always for the face amount of the debt, 300,000. Now what. Wouldn't how credit interest payable?

7,500, because they owe the interest back just how the system works. Yes. They charged recruit interest up to the date of sale, but they owe it back. So how would credit interest payable? 7,500, the entry doesn't balance. We need a $3,000 debit the balance, the entry out, you know what that is? Debit discount on bonds 3000, by the way, can I prove out that discount?

Do I know it's right? I do. Don't I. Don't I know that how so the sold the bonds for 99. So isn't there a 1% discount times 300,000. Makes sense. Doesn't it. And I kind of do that myself. Does my entry makes sense. It does, because I know, I know the bonds were sold for 99, so it has to be a 1% discount times 300,000 discount should be 3000 and it does come out.

Now, number 12, they ask Cain would realize net cash receipts from bond issuance of how much well get, let's start with basis. We know that if your cane, you are selling $200,000 worth of bonds at 103%, if you multiply 200,000 times 103% Kane literally got 200 and 206,000 just for the bonds. And I'm sure you notice that answer C, but you can't stop there.

Because once again, the bonds pay interest. Semi-annually January 1st and July one, but they sold the bonds March one, between interstates. So what automatically happens is the buyers would be charged, accrued interest from the last time interest was paid January one, up to the date of sale, March one, you, the buyers would be charged accrued interest for January, February.

So hope you work that out. Take the $200,000 with the bonds. Times the stated rate, which is 9%. That's 18,000 of interest per four year. We don't want a full year now multiply by two 12, January, February over 12 to 12, one sixth of 18,000. So to summarize, if your cane you're getting 206,000 cash for the bonds, 3000 for crude interest.

Wouldn't cane debit cash 209,000. Now that's answer B. That's not the answer either, but let's just finish the entry. We know Kane is going to debit cash 209,000. We know Cain is going to credit bonds payable, always for the face amount of the debt, 200,000. Now what credit interest payable 3000, because that's how the system works.

They charged recruit interest up to date of sale, but they have to pay it back. So credit interest payable, 3000, the entry doesn't balance. We need a $6,000 credit to bounce the entry out. You know what that is credit premium on bonds 6,000. Can I prove that premium out? Sure. We can. We know the bond. We know the bonds sold for one Oh three.

So there should be a 3% premium times, 200,000 just tells you that your entries right on the right track premium should be 6,000. Now, the reason why it's not answer B is because they threw in some bond issue costs. And I just want to mention that this is, this is something that Sam does a lot. the FAR CPA Exam loves bond issue costs.

Let's talk about these for second. There it's expensive to issue bonds. There are costs involved called bond issue costs. What a bond issue costs cost for printing the bonds in graving, the bonds legal fees related to the bond issue, accounting fees related to the bond issue and underwriters fee. That's pretty much it.

Those are your bond issue costs, but it's expensive. It's printing and graving the bonds, legal fees related to the bond issue, accounting fees related to the bond issue and underwriters fees. Now I want to make a point in the CPA exam. Always assume that bond issue costs will be paid in cash upfront.

That's always the assumption in the FAR CPA Exam that bond issue costs will be paid in cash upfront. So. Now let's make the entry of the bond issue costs. Now that we've made the entry for the bonds, we're gonna make another entry where we debit bond issue costs 10,000 credit cash, 10,000, because in the exam, you always assume the bond issue costs will be paid in cash upfront.

So now that we have the entry for the bonds, issuing the bonds, a separate entity for the bond issue costs, we would debit bond issue costs 10,000 credit cash, 10,000. So when they ask at the bottom Cain would realize net the word net kind of tips it off. Doesn't it. What would be the net cash receipts from bond issuance?

Well, what Kane netted out of that bond issuance is the 209,000 from the bonds minus the 10,000. A bond issue costs that have to be paid in cash upfront. What Kane netted out of that bond issuance is 199,002 Oh nine minus 10. Answer D 199,000. Now one of the points. Noticing my entries I've actually set up an account called bond issue costs.

What happens to that? Well, quick point, that account bond issue costs that is a balance sheet account. It belongs on the balance sheet under other assets and know, and don't forget the bond issue costs will be deferred and amortized to expense over the life of the bonds. So that's what happens to that account?

That account bond issue costs. It's a balance sheet account goes on the balance sheet under other assets it's deferred charge. And just remember that the bond issue costs will be deferred and amortized to expense over the term of the bonds.

Now here's what I want to get into next. Let's say that I go through the printing, the engraving, the legal fees, the accounting fees, the underwriter's fees. And I finally have some Monette company, 10% bonds. They just delivered from the printer. Oh, I've gone through the printing and the engraving and the legal fees and the accounting fees and the underwriters fees expensive.

And I finally have some, a net company, 10% bonds. That's the stated rate printed on the bonds. But when I get out in the marketplace, I find the companies just like mine are paying 5% interest on their debt. Well, think about it. If. My S my stated rate of interest printed on the bonds. Remember, I'm stuck with that, but the prevailing rate of interest is five.

What am I going to do? Am I going to rip the bonds up? And now get some print up some 5% bonds. I mean, you'd go broke. You know, you've just gone through all these costs. So if the prevailing market rate of interest is 5%, my state rate is 10%. Of course, everybody wants my, everybody wants my bonds. There's a lot of demand.

So the price rises, why the bonds sell at a premium because the price starts to rise. And the price of my bonds will rise exactly to the point, not a fraction, more, not a fraction, less where the effective yield of my bonds will be 5%. The prevailing market rate of interest. What if I had some in that company, 10% bonds, you know, hot off the PR hot off the printer, that company 10% bonds.

But what I get out in the marketplace, I find the companies just like mine. Are paying 15% interest for their debt. Well, nobody wants my bond. The price starts to drop and the price of my bond would drop exactly to the point, not a penny, more, not a penny, less with the effective yield of my bond would be 15%.

See, this is how discounts and premiums are used. Discounts or premiums are used to adjust the state rate of interest printed on the bonds. You're stuck with that to the prevailing market rate of interest. People will not buy your bonds if they don't yield the prevailing market rate of interest. All right.

So here's my point. How would, you know what the premium should be on 10% bonds? So they yield exactly 5%, no more, no less. How would you know what the discount would be on 10% bonds? So the yield exactly 15%, not a fraction, more, not a fraction, less, you know, how is the market price of bonds determined?

Well, the answer is that it's done with present value tables. That's how it's done. And. This is the rule we work with. You gotta know this rule. If the FAR CPA Exam wants you to work out the market price of bonds, remember the rule, the rule is use present value of a dollar table for the principle present value of an annuity table for the interest at whatever you want the bonds to yield.

Let me say that again. That's the rule you work with. the FAR CPA Exam wants you to work out the market price of a bond. Just remember the rule. You was present value of a dollar table on the principle, present value of an annuity table on the interest at whatever you want the bonds to yield. Let's go to a problem.

Let's go to probably number 13. It says on January 1st, 2007, Dean company issued 10 year bonds with a face amount of a million and a stated interest rate of 8%. So that's what that, you're stuck with. That that's the state of regular print it's printed on the bond. Notice interest is payable.

Semi-annually you might want to circle that word. That's a key word here. Interest is paid semi-annually on July one and January one, but then it says the bonds were sold. So they yield 10%. They want the bonds to yield more than the state of rate. They want the bonds to yield 10%. They give us present value factors and the bottom it says, what is the total issue price for these bonds while you're in the exam, you got this problem, you think, all right, here's the rule I'm working with.

I use present value of a dollar table on the principal at whatever I want the bonds to yield, right? It's present value of a dollar table on the principal. Now we know the principal down here is a million, but you see how they tried to mess you up. They tried to mess you up because they gave you two present value of dollar tables.

They gave you present value of a dollar at 10 periods of 10%. They also gave you a present value of a dollar 20 periods at 5%. Am I going to use 0.38, six or 0.37, seven. Point three, seven, seven. Hope you got that. Why, why? Point three, seven, seven, because they said they want to send me an annual yield.

That's important. In other words, w when I see that word semi-annual, that tells me that whatever, I charge my investors for these bonds, they have to yield. They have to yield 5% every six months for 20 periods of six months. Each not yield 10% for 10 annual periods. Let me say that again. I see that word semi-annual it tells me, Hey, whatever, I charge my investors with these bonds, they have to yield 5% every six months for 20 periods of six months.

Each not yield 10% per 10 annual periods. So we are going to use 0.3, eight, six. If they'd said the word annual, I would have used three, eight, six, if that makes sense to you. They said it was annual interest. I would have used three 86, but because they want to send me annual yield, I'll use 0.37, seven. So let's work it out.

I'm going to take the million dollars of principal. Times 0.37, seven, that discounts to $377,000, 377,000. All right, that's the first part. Now the next part is the part that bothersome students. The next, the next part of the rule says what use present value of an annuity table for the interest at whatever you want the bonds to yield.

I want present value of an annuity table on the interest. What you've got to get used to is that the actual interest checks that are sent out. Do represent an annuity cause aren't they a series of equal periodic payments over a specified number of periods. Let me say that again, the interest checks that are actually going to be sent out, they do represent an annuity because after all they do represent a series, a series of equal periodic payments over specified number of periods.

So let's work out the interest check. How do I work out the interest check every time it's the stated rate printed on the bonds time-space value. So to get these interest check, that's going to be sent out. Take the state of rate printed on the bonds 8%, but for six months would be 4% times the face amount of million.

I think we can. A great, if all goes, according to plan, they're going to send out 40,000 of interest every six months for the next 10 years. Isn't that a series of equal periodic payments over a specified number of periods, interest checks are an annuity. What factor would I use here? 6.14, five or 12.4, six to 12.462.

Cause I want to send me annual yield. Hey, whatever. I charge my investors for these bonds. I want them to yield 5% every six months for 20 periods of six months. Each not yield 10% for 10 annual periods. Not what I want. If they'd said the word annual, I would've used 6.1, four or five, they want to send me annual yield.

So let's do a second calculation. I'm going to take that $40,000 annuity. The interest checks are an annuity times 12.462, that discounts to four 98, four 80. If you add up the discounted present value, the principle 377,000 plus the discounted present value of the annuity interest checks four 98, four 80.

These bonds would sell for answer a eight 75, four 80. That's how that's, how it's done. It's present value of a dollar table and the principle plus present value of an annuity table on the interest at whatever you want the bonds to yield. Try number 14, see how you do, and then come back.

Welcome back. Let's look at number 14 together. I'm sure you noticed that number 14 is a little different in the sense that what they want you to work out is the market price of each individual bond. But I think we can agree. It doesn't matter whether they want the market price of a whole bond issue or the market price of one single bond.

It comes back to the same thing. It's present value of a dollar table on the principle, present value of an annuity table on the interest at whatever you want the bonds to yield. Now, these bonds have a stated rate printed on the bonds. You stuck with that 6%. They want them to yield 8%. So let's apply our rule.

I want present value of a dollar table on the principal. The principal amount is 800,000 at whatever I want the bonds to yield. I want them to yield. 9% annually is annual interest here. So let's get our first factor present value of a dollar 10 periods at a 9% yield. The factor was 0.4, two two. If you take that factor 0.4 to two times the principal 800,000, that discounts to 337,600, three 37 six.

Now the next part does bother some people. We have to use present value of an annuity table on the interest because the interest checks really are an annuity. They represent a series of equal periodic payments over a specified number of periods. So let's get the interest check. Interest check is always the stated rate of interest printed on the bond.

6% times face 800,000. I think we can agree. The annual interest check is $48,000. If all goes according to plan. They're going to send out $48,000 of interest every year. For the next 10 years. It's not a series of equal periodic payments over a specified number of periods. It's an annuity, but I want it to yield 9%.

Let's get our second factor. Present value of an ordinary annuity, 10 periods at 9%. The factor is 6.418. You take that factor 6.418 times the annuity, which is 48,000. That discounts to 308,000 Oh 64, three Oh eight. Oh, 64 added up this kind of present value. The principle three 37, six plus discounted present value the interest three Oh eight Oh 64.

These bonds should sell the added up. These bonds should sell for 645,006 64, six 45, six 64, but they want the market price. Each individual bond. All I'll have to do is take what the bond issue should sell for. 645,006 64 and divide by how many bonds. They must be 800 bonds. Bonds were in denominations of a thousand it's $800,000 worth of bonds.

It must be 800 bonds. If I divide by 800 bonds, each bond would sell for $807 and 8 cents. The answer is C it's. Present value of a dollar table on the principle, present value of an annuity table on the interest, whatever you want the bonds to yield.

Now, what I want to get into next is something the FAR CPA Exam loves. And that is how would you determine a gain or loss, a gain or loss on early retirement of bonds? Let's. Go to a problem.

Let's go to the next problem, which is number 15, 15 says on January 1st year one Fox issued a thousand of its 10% thousand dollar bonds for 1,000,040 thousand stopped right there right away. You notice that originally there was a $40,000 premium might want to write that, just jot that down. Because originally they sold a million dollars worth of bonds for 1,000,040 thousand.

So originally there was a $40,000 premium. The bonds were to mature on January 1st of year 11. So they 10 year bonds, but were called at one Oh one. Anytime after December 31 year four, you might want to underline call bullet one-on-one. We'll talk about that in a minute. Interest was paid semi-annually.

On July one and January one, then they say on July one year six, that's the key date? July one year six Fox called all North. They called in all the bonds. You gotta be careful. They could call in half the bonds. They could call in a quarter of the month, but they called in all the bonds and retired them.

The premium was amortized on a straight line basis bef before taxes. What was Fox's gain or loss in year six. From this early extinguishment of debt. Now I'll tell you what I like to do with, it's not going to surprise you, but I there's a couple of ways you can do a problem like this. But what I really like is a journal entry.

You get a problem like this in the exam. They're very common. I would go right to my scrap paper and just think if I'm Fox and I retire these bonds, what entry am I forced to make? My point is you can almost force it. If you just think if I'm Fox, I'm the retirement company. One entry, my forced to make well let's let's work it out.

Fox is retiring a million dollars worth of debt. So wouldn't Fox have to debit bonds, payable, a million, got to get the debt off your balance sheet. All right. Now what was the cash that Fox paid out to get the bonds back? Well, they said bonds are called blood one-on-one you know what that means when you see bonds are called, but one-on-one, that means anytime the company wants the company can call the bonds back in and retire them.

At 101% of face value. We say that again, when you see bonds are callable at one-on-one, that means anytime the company wants, they can call the bonds back in and retire them at 101% of face value. So I'm going to take 101% of a million. We know that Fox would have credited cash, 1,000,010 thousand. That's the cash that went out to retire the bonds, 1,000,010 thousand.

Now I don't want to dwell on this, but why do you think this is happening? Why is Fox doing this? What has probably happened? Interest rates have come down. Interest rates have come way down. So what Fox is going to do is issue some new bonds at a much lower interest rate. Get that cash and retire the old bonds.

So that's, what's going on. It's refinancing. That's probably what's going on here. Fox is going to issue some new bonds at a much lower interest rate. Get that cash and use that cash to retire the old bonds with a higher interest rate. It's our, it's a refinance. All right now, if you're with me on the entry to this point, now we want to pause here.

The next part of the problem is the hardest part. So listen carefully. Don't we know that Fox originally sold the bonds at a $40,000 premium don't. We also know that the premium is advertised on the straight line basis. Don't we know also that these a 10 year bond, they go from January 1st year one to January 1st, year 11.

The ten-year bonds. So what they do in straight line wouldn't in straight line Fox have taken, has wouldn't Fox them taking that $40,000 premium divided by 10 straight line years. The term of the bonds in straight line wouldn't Fox have amortized 4,000 of that premium every year. Now, how much time has gone by if Fox is amortizing 4,000 of that premium every year.

Well, all of your one has gone by all of your two, all of your three, all of you for all of your five and half of your six. I hope you see that five and a half years have gone by, right? Because they retired the bonds of July 1st year six, five and a half years have passed. So here's what you do. Take five and a half times, 4,000 in straight line, they would have amortized 22,000 of that $40,000 premium will be, see that.

If I take five and a half years, times, 4,000 of amortization every year in straight line, they would have amortized 22,000 of that on advertised premium. So what's the balance in unamortized premium? Well, it was 40,000. They've amortized 22,000. The balance and unamortized premium is 18,000. Now in the century, we're going to debit on amortized premium 18,000.

Hope you see where I got that? The original premium was 40,000 they've amortized, 22,000 of it. So the balancing unamortized premium that's on the balance sheet is 18,000. So we're going to debit on amortized premium 18,000. Why? Because we retired that also, this is really what they're getting at. They want to make sure the student understands that if you retire debt from your balance sheet, you must also retire any unamortized discount premium or issue costs related to that debt.

Is that again? When you retire debt from your balance sheet, you must also retire and the unamortized discount premium or issue costs related to that debt. There are no issue costs in this problem, but if there are any unamortized issue costs, you'd retire those as well. But all of these items get taken off your balance sheet when you retire debt.

All right. Now, if you, with me, to this point, the entry doesn't balance, we simply need an $8,000 credit to balance the entry out that's gain on retirement bonds. And the answer is D. And just to emphasize that is an ordinary game up and continuing operations, just an ordinary game up and continuing operations that would be gained on retirement.

A debt of 8,000. Now you can see one of the reasons I like entries. I like an entry because the entry kind of salt kind of settles. Whether it's a gain a loss. If you need a debit to balance the entry out, it's a loss in retirement. If you need a credit, it's a gain in retirement. And I point that out because a lot, some students that can quickly get the number, but they aren't sure whether it's a gain or loss.

That's very common. You know, students get the number very quickly. They just aren't sure where there's a gain or loss. We put an entry down. It's clear if you need a debit to balance the entry out, it's a loss in retirement. If you need a credit, it's a game. All right. Like you try one, try number 16 and try the entry.

Try number 16 and put the entry down that heart would make when heart retires, those bonds.

Welcome back. Let's look at number 16 together. I'm sure you noticed that Hart is retiring $500,000 worth of bonds. So if you think about the entry hard hats to make hard hats is going to have to debit bonds payable. 500,000. You've got to get the debt off your balance sheet. Now, what was the cash that Hart paid out to get the bonds back?

Well, notice as hard had to pay one Oh two, so you take 102% of 500,000 heart must have credited cash, 510,000. That's the cash that hard paid out to get the bonds back. Now, the next part is the hardest part. I'm sure you noticed that originally the bonds sold for 98. So originally there was a 2% discount.

Yeah. Originally the bond sold for 98. Originally there was a 2% discount times, 500,000. Originally there was a $10,000 discount originally that was 20,000 of bond issue costs. They amortize the discount and the bond issue costs by the straight line approach. Now, how many years have gone by how much has been advertised?

Well, these are 15 year bonds and they were issued on January 1st, 2008. They're retiring them on January 1st, 2020, having 12 years gone by. So here's what, here's the best way to do it. Since 12 of the 15 years have passed the 15 year bonds, 12 years have passed take 12 or 15. That's 80% since 80% of the 80% of the time has passed.

In straight line, they would have amortized 80% of that $10,000 discount. So the balance in unamortized discount is 20% or 2000. We're going to have to retire that. So credit on amortized discount, 2000. Let me just do that again. 12 years of passed from January 1st, 2008 to January 1st, 2020, since 12 of the 15 year term is past 12 or 15 is 80%.

Since 80% of the time has passed. In straight line, you would have amortized 80% of that, that discount, that original discount of 10,000. So the balance in unamortized discount, that's still on the balance sheet is 20% or 2000. We have to retire that also. So credit unamortized discount, 2000 same thing with the issue costs since 12 of the 15 years have passed since 80% of the time has passed in straight line, you would have amortized 80% of the bond issue costs.

So the balance in unamortized issue costs is 20% or 4,000. So we're going to credit on amortized issue costs 4,000, 20% of 20,000 or 4,000. Remember, that's an asset that's in other assets on the balance sheet, but that gets retired. That makes the point. Anytime you retire debt from your balance sheet, you must also retire any unamortized discount premium or issue costs related to that debt.

Now, if you've got the entry down to this point, It doesn't balance. We need a $16,000 debit to balance the entry out. That's a loss and retirement of bonds. And the answer is a and again, I want to point out just an ordinary loss up in continuing operations, a loss on retirement, you know, try an entry with problems like that.

It really works well.

Now, what I want to get into next is bonds that are issued with stock purchase warrants. Now we're going to talk about bonds that are issued with stock purchase ones. First of all, what is a stock purchase warrant? A stock purchase warrant. It's just like a stock option. Just think of it as a stock option, think of it as a stock option.

It allows the holder to purchase so many shares of stock within a certain period of time at a certain fixed price called the option price or the exercise price. Again, this stock options, but that's what a stock warrant is. It allows the holder to purchase so many shares of stock within a certain period of time at a certain fixed price called the option price or the exercise price.

So when people are holding warrants, they can buy shares of your stock at that fixed price. Called the option price or the exercise price. Now here's the point. Sometimes companies will issue bonds and they'll have warrants attached to the bonds. Now, why did they do this? The reason why a company would attach warrants to the bonds is to make the bonds more attractive, more marketable.

And it also holds down interest rates. Now, right now, interest rates are very low. So you don't see it as often. You know, when interest rates are high stock warrants will keep interest rates a lot lower and you see why. You know, rather than in other words, a company issues, bonds, but rather than give you the market rate of interest, they give you a pitiful rate of interest, but to get you to buy the bonds, they throw in some stock warrants, they throw in some stock options.

So that's how these are used. They make the bonds more marketable.

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hello,  welcome to the Bisk CPA reviews, coverage of the financial accounting and reporting section of the CPA exam. My name is Bob Monette, and I'll be your instructor for this FAR CPA Review course. and in this FAR CPA Exam course, we're going to be discussing a very important topic, a very heavily tested topic, and that is.

Consolidated financial statements before we dive into the material, though, let me just take a moment to give you some advice about the best way to use this FAR CPA Review course. The important thing to remember about a class like this is to avoid just sitting back passively and watching the class. You want to treat this like any other class take good notes later in the class.

When we go to do problems, shut the class down, get your answers to the problems before you come back and discuss the problems with me. I think you'll find if you do those simple things, you get much more out of this CPA Exam FAR course and that's what we both want. So with that said, let's get right into this topic.

As I mentioned in this FAR CPA Review course, we're going to be discussing the accounting issues that are raised when one company called the parent company acquires the outstanding voting common stock of another company called the subsidiary company. And. If a parent company acquires more than 50% now that's key criteria.

If a parent company acquires more than 50% of a subs voting shares that represents control. Now, the parent company has control over the subsidiary company and when a parent company has control over subsidiary company, that parent and that subsidiary are required, they are required. To prepare, consolidated financial statements.

Now, as I say, that's key criteria, let's just go over that one more time. If a parent company acquires more than 50% of a subs voting shares, and I have to warn you, I always have some students that talk as if it's 50% or more. It's not 50% or more. If my parent company acquires more than 50% of a sub's voting shares that represents a controlling interest.

And when a parent company has a controlling interest in a subsidiary company, consolidated statements are required. Now why are consolidated statements required? Very simply consolidated statements are required because we always work under a presumption that consolidated financial statements are more meaningful, more meaningful to shareholders.

Creditors are the interested parties. Consolidated statements. The argument would be, are more meaningful than if the parent and sub would have continued to issue separate statements. So that's the bottom line. That's the basic premise of this FAR CPA Exam course that consolidated statements are more meaningful than separate statements.

Now, in this CPA Review FAR course, we are going to get into how you actually prepare consolidated financial statements, but I don't want to get into that quite yet. I want to start with something else. First, we're going to start off this FAR CPA Exam course by looking at the types of problems that come up in the exam, where the parent company owns 50% or less of a subs voting shares.

And let me have you think about something right away. If a parent company owns 50% or less of a subs voting shares, is there any way that parent and sub can prepare consolidated financial statement? No, because what's missing is control. Remember we can only justify a parent and subsidiary combining their statements, consolidating their statements.

When a parent company has control over the subsidiary company, and we know how control is defined. It's a parent owning more than 50% of subs voting shares. So let me get to my point. If a parent company owns 50% or less of a subs voting shares. And we agree there's no consolidation because there's no control.

Well, now the sob is just another investment on the parent's balance sheet. I hope you see that connection if there's no consolidation because there's no control. Well, then the subsidiary would just be another investment on the parent's balance sheet. So that's now going to be our focus. If the sub is just another investment on the parent's balance sheet, what is the proper way for the parent to account for the investment in the subsidiary?

And as you probably know, there are two acceptable methods of accounting for investments in common stock. There is the cost method and there is the equity method. So I want to really begin this FAR CPA Review course by going over these methods because you have to be comfortable with these methods. We're going to begin with the cost method.

And I really think the best way to study both of these methods is to know the journal entries for each method. If you know the journal entries for each method, you really can break down any problem. That's in the FAR CPA Exam on this.

So let's start with the cost method. If you look at your viewers guide, you'll see a problem. Let's say on January one, a parent company purchased a thousand shares of a subs, voting common stock and paid $10 a share and notice the parent has decided to account for that investment under the cost method.

What are the entries we make on the cost method? Well, first of all, on January one on the day of acquisition, the parent is going to debit investment in sub for the cost of the shares. That's a thousand shares at $10 a share. So they're going to debit investment in sub for $10,000 and credit cash, $10,000.

So notice under the cost method, we establish the carrying value of the investment at the cost of the shares. All right. Now let's say a year goes by, let's say it's December 31 year one, and the sub has reported 10,000 of income. The question is what entry would the parent make on its books? Under the cost method to reflect the fact that the sub is reported income.

Remember, we're looking at this from the parent's standpoint. So that is the question. What entry would the parent make on its books onto the cost method to reflect the fact that the sub is reported income. And I think, you know, this no entry, the parent makes no entry on its books under the cost method to reflect the fact the salvage reported income.

Let's go ahead another year. Now let's say it's December 31, year two, and now the sub. Has reported a $20,000 loss, same question. What entry would the parent make on its books? Under the cost method to reflect the fact that the sub has reported a loss. And again, there's no entry. So notice this under the cost method, we establish the carrying value of the investment at the cost of the shares.

If the sub reports income, no entry on the parent's books, if the sub reports a loss, no entry on the parent's books. One more thing. What if the sub. Sends the parent a dividend, let's say the sub sends the parent a $500 dividend. What's the parent going to do? Well, you know, the parents going to debit cash for what they collect 500, and this is very important.

The parent's going to credit dividend income, 500 notice under the cost method. Parent treats dividends from the sub as dividend income. Now, one other point when a parent. Has an investment in sob being accounted for under the cost method, that investment will be carried on the parents balance sheet as one of the parents available for sale securities.

That's what this is. When a parent company has an investment in a subsidiary being accounted for under the cost method. Then that investment is just carried on the parent's balance sheet as one of their available for sale securities. That's what this is now. I'm sure you see already. The cost method is a very simple method.

We established the carrying value of the investment at the cost of the shares. If the sub reports income, no one, no entering in the parent's books. If the sub reports a loss, no entry in the parent's books and at the sub pays the parent, a dividend parent treats that dividend as dividend income. It's a very simple method, but I want to make a point if you're in the FAR CPA Exam and you get a problem on the cost method, I'd be suspicious because it's a very simple method.

So if I were you. And I'm in the FAR CPA Exam and I get a problem on the cost method. I would always check to see if there's a liquidating dividend, always check to see if there is a liquidating dividend. I mentioned this because a liquidating dividend is the one way to try to complicate the cost method. Just a little bit.

Let me show you what I mean. Let's do another problem. Let's say on January one, a parent company purchased 5%. I have a subs voting shares. And again, we're assuming the parent does account for the investment under the cost method. We're going to assume a year goes by and on December 31, the sub reports, a hundred thousand of income.

And one more point now let's assume that the sob sends the parent a $7,000 dividend. Let's think about it. If the sub sends the parent a $7,000 dividend. We know the parent is going to debit cash for what they collect 7,000. And you see what they're hoping you do. They're hoping you sit in the FAR CPA Exam and go, Oh, it's the cost method.

So the parent would just credit dividend income, 7,000. And you can't, you see why in this problem? The parent owns 5% of the subs voting shares. If the parent owns 5% of the subs voting shares, what is the most. That the parent could possibly participate in the current income of the sub up to 5% up to 5,000.

That's the dividend income. I'll say it again because the parent owns 5% of the sub shares. The most, the parent could possibly participate in the current income of the sub is up to 5% up to 5,000. That's the credit of dividend income, 5,000. Now, if the parent is sent a check for 7,000, what is the other 2000?

Well, the argument would be. The other 2000 is a return of capital. So the other 2000 would be a credit to investment in sub our return on capital. And I want you to know that that 2000 that we credit to investment in sub that's, what the FAR CPA Exam would mean by a liquidating dividend. You have to have the FAR CPA Exam talk.

That is a liquidating dividend. And I think you see why I showed you that it's really the one way the FAR CPA Exam could complicate a problem that on the surface, it looks like a simple little cost problem.

Please go on your viewers guide to multiple choice question number one, it says an investor. In other words, a parent uses the cost method to account for an investment in common stock classified as an available for sale security. That makes perfect sense. Notice the wording, then, then they say dividends received this year, exceeded the investor, share dividends received this year, exceeded the parent's share of investees undistributed earnings since the date of the investment.

Didn't they just describe in words, the problem that we just did, where the parent got a dividend greater than their 5% share the amount of dividend revenue. Notice the very precise here. The amount of dividend revenue that would be reported in the investors, the parents' income statement for the year would be what, how about ag is dividend income?

The portion of the dividends received this year that were in excess of the investor share no anything you received this year, that's in excess of your 5% share is return of capital. That's not dividend revenue, that's a liquidating dividend. How about B. Would dividend revenue be the portion of dividends received this year, that we're not an excess of the investor's share that's right.

The answer is B anything you received this year that is not an excess of your 5%, your 5% share. That would be dividend revenue. I hope you're with me on the cost method, because now we're going to move on to something that's a little bit more challenging.

Now we're going to get into the equity method and here's the bottom line. If a parent company has significant influence, notice that phrase, it's a key phrase. If a parent company has significant influence. Over subsidiary company, then the equity method is required. If our parent company has significant influence notice, not just any influence, it has to be a significant amount of influence.

Over subsidiary company equity method is required. Let's cover all possibilities. If a parent company does not have significant influence over the subsidiary company, well, then the cost method is required. That is the bottom line. If a parent company has significant influence over the subsidiary company, equity method is required.

If a parent company does not have significant influence over subsidiary company cost method is required. That is the bottom line. So, you know what we're leading to. How do you determine significant influence? How do we know in practice? How much influence is a lot of influence? How do we know how much influence.

Is a significant amount of influence. Well, here's what you have to do. First. We have to look for evidence. Is there any clear evidence that the parent has a lot of influence over the subsidiary? I'll give you some examples. For example, if the parent is on the sub's board of directors, if the parent is on the sub's board of directors, that's evidence of significant influence.

Another one, if a parent. Makes policymaking decisions for the subsidiary company? Well, that would be evidence of significant influence could be another one. If the parent is the largest single shareholder in the subsidiary company, that would be evidence of significant influence. So you see how we're supposed to evaluate evidence.

If a parent company is on the subs board of directors, well, that's evidence of significant influence. If the parent makes policy for the subsidiary company, that's evidence. Have significant influence. If the parent is the largest single shareholder in the subsidiary company, that's evidence of significant influence in practice.

We're supposed to see if there's any clear evidence that the parent has a lot of influence over the sub, but then there's something else you have to factor into this. What if there is no evidence? What if there's no clear evidence to go by? Well, if there's no clear evidence to go by, we have a guideline.

If a parent company owns 20% or more notice, I didn't say more than 20%, I said 20% or more of the subs voting shares. Well, then you just assume significant influence equity has to be used. So don't forget you have that guideline first, you look for evidence, but if there's no clear evidence, we've got that guideline.

If a parent company owns 20% or more of the subs voting shares will, then we just assume significant influence equity would have to be used. Let me have you think about something, would it be possible for a parent to own 2% of the subsidiaries voting shares and have significant influence? Is that possible?

Sure. Because the parent could be on the subs board of directors. The parent could make all the policy for the sub. Remember if there's evidence of significant influence equity is required, it doesn't matter what percent of the stock you own. You only use the guideline. If there is no evidence. Let me ask you this quote, a parent owned 42% of a subs voting shares and not have significant influence.

Yes, it's possible. Cause another company. Could own the 58% and control everything. You don't really have a say in anything it's possible. And I'm not just trying to drive you crazy here. the FAR CPA Exam plays games with this. The, the people that write this exam know that a lot of people take the exam. Hopefully not my students, but a lot of people take the FAR CPA Exam and all they know about equity is 20% or more equity under 20% costs.

That's what a lot of people, that's, that's really the extent of what they know, but it's more complicated than that. First you look for evidence. Evidence comes first and then if there is no evidence, then you have you guideline. So the FAR CPA Exam can play around with that. In other words, you can be in the exam.

They could say Jones owns, you know, 3% of Smith's stock, but Jones is on Smith. Sported directors. Jones makes all the policy for Smith. That's an equity question because if there's evidence of significant influence, it doesn't matter what percent of the stock you own. Equity is required or they could go the other way.

the FAR CPA Exam could say Jones owns 41% of Smith's stock and does not have significant influence. That's a cost question. So I hope clear on how we're going to know in the exam. We have an equity question.

Why don't we do an equity problem. And here, once again, the best way to study this, I believe is to know the journal entries for the equity method. If you know the journal entries for the equity method, you're going to be strong. So if you look in your viewers guide, you'll see an equity problem. On January one, parent purchased 20% of the subs voting shares and paid 280,000 stop right there.

You see, I take the exam. You're in the exam. When you read that sentence, the parent purchase 20% of the subs voting shares for 280,000, you sit in the FAR CPA Exam and say, I have no evidence to go by. So I I've got no choice, but to use my guideline 20% or more, I assume that they do have significant influence.

Equity is required. I'm not minimizing how important that guideline is. It's extremely important. You use it a lot in the exam. All I'm saying is the guideline all by itself is not determinative. First. You look for evidence and if there is no evidence, then you have your guideline, but very often in the FAR CPA Exam you use the guideline.

So we're assuming this is an equity question. We're assuming the parent does have significant influence. So it is an equity question. Notice the next line. The fair value of the subs net assets on that day, total a million a year later, December 31, the sub reports, 60,000 of that income. And during the year, the sub paid 12,000 in dividends.

Let's go through the entries under the equity method. First of all, on January one on the day of acquisition, the parent is going to debit investment in sub for 280,000. Credit cash 280,000. So notice on the day of acquisition, we still establish the initial carrying value of the investment at the cost of the shares.

So January one, the parent on their books is going to debit investment in sub for the cost of the shares 280,000 credit cash to what an 80,000. So what you're noticing is on the day of acquisition, the cost and equity method are identical on that day. Now a year goes by it's December 31 and the sub.

Reports 60,000 of that income. I know, you know, this, when the sub reports income like this, this is the first place where the equity method will be dramatically different from the cost method. Why? Because under the equity method, the parent automatically automatically picks up their share of that income.

And I know you've seen this before. The basic thinking is because the parent owns 20% of the subs voting shares. The parent will automatically pick up 20% of that income or $12,000. Now what's the entry. The parent's going to debit investment in sub for 12020% of the subs income notice the carrying value of the investment rises by 12,000.

What does the parent credit? It's an account name. You have to get used to equity in the earnings of a subsidiary. That's the credit equity in the earnings of a subsidiary. You know what that represents that's investment income for the parent. That's investment income for the parent. That's going to end up on the parent's income statement for year one, but don't call it investment income.

The account name, the FAR CPA Exam likes would be equity in the earnings of a subsidiary or equity in the losses of a subsidiary because that's the bottom line with the equity method. Under the equity method, the parent automatically automatically picks up their share of the reported net income or loss or loss of a subsidiary.

How about the dividend during the year, the sub pay 12,000 in dividends? Well, you've got to assume if the parent owns 20% of the subs voting shares, the parent would have gotten 20% of that dividend or $2,400. What's the entry for the parent? Well, you know, the parents going to debit cash for what they collect 2,400, and this is very important.

What is the parent credit investment in sub. Notice the credit is to the investment account. Why? Because under the equity method, penetrates dividends from the sub as a return of capital, that's one of the major differences in the methods under the cost method, pantries dividends from the sob as dividend income, but under the equity method, parent treats dividends from the sob as a return of capital.

One other point when a parent has investment under the equity method. How will it be carried in the balance sheet? If a parent has an investment being accounted for under the equity method, how has it carried on the parents' balance sheet? Here's what I'd like. I'd like you to do whatever you have these entries.

We're going to set up a T account for investment in sub and let's post these entries to that T account. We know on January one. When the parent purchased 20% of the sub shares, the 280,000, we know that would have been a debit that would have been a debit to investment in sub for 280,000 credit cash to what an 80,000.

We know that we know when the dividend came in, that would have been a debit to cash 2,400 and a credit to the investment account. 2,400, it's a return of capital. And we know what December 31 parent would have automatically picked up their sheriffs of income or 12,000, 20% of 60,000. And that would have been a debit to investment in South 12,000 credit equity and subheadings 12,000.

If you post the entries to the T account and you do out the math right now, after all that activity investment in sub is that 289,600. In other words, this investment would be on the parent's balance sheet at 289,600. That is generally accepted accounting principles. Now. You see, seen your viewers guide that we also have to do a Goodwill calculation.

I want to make sure you're good at this going into that exam, you've got to be able to do a Goodwill calculation. Let's do the Goodwill calculation. The S the key to the Goodwill calculation is the second line down in the problem. They told us that the fair market value of the subs net assets on the day of acquisition, total, a million.

Now you stop and think what percent of those net assets that has the parent purchased 20%. I'm sure you know, that if I buy 20% of your outstanding voting shares, I just bought 20% of your net assets. One follows the other like day follows night. And the point is that a 20% interest, a million is worth 200,000.

What did the parent pay for that stock? To what? An 80,000. So there is 80,000 of Goodwill here. Now, let me ask you a question now that we've proven that there is 80,000 of Goodwill and you've gotta be able to do that Goodwill calculation. But now that we've proven that there's 80,000 of Goodwill, does the parent set up a Goodwill account on their balance sheet for 80,000?

No. No. That 80,000 is in the two 89 six. In other words of the investment in South balance, 289,600. That's on the parent's balance sheet. 80,000 represents Goodwill. And they could ask you that how much of the investment balance is represented by Goodwill 80,000, but there's no separate Goodwill account.

All we're doing is applying an accounting method to an investment. And 80,000 of that investment represents Goodwill. Do we amortize that Goodwill? You know, we do not. Goodwill is not amortized. It's tested for impairment. At least annually, how do we test this Goodwill for impairment? Well, that, there's actually a fairly simple test if there's ever a permanent decline in market for that investment.

Notice how I put that. If there's ever a permanent decline in market for that investment, not a temporary decline. We, we know every day the stock market goes up. It goes down. That's not what we're talking about, but if there's ever a permanent decline in market for that investment in sub. Then you would take a loss to the income statement and you'd write the investment down.

That's how you test that Goodwill for impairment. If there's ever a permanent decline in market, a permanent decline in market, but that investment will then you take a loss to the income statement and write the investment down to market. But Goodwill, as you know, is not advertised. It's tested for impairment at least annually.

Now we're not done with this topic yet. I started by asking, well, how does. The parent report this investment in sob on their balance sheet. Well, let me ask, is this investment in solve this 289,600? Is that a held to maturity security? No, it's not never held to maturity. Securities are debt securities.

This is an equity security. So it's not held to maturity. Is it trading now? It's not a trading security. Is this an available for sale security? It is not on available for sale security. I want you to remember that. Equity investments are carried separately on the parents balance sheet. Remember that equity investments are carry separately on the parents balance sheet.

I'd like you to try some questions. I'd like you to shut the class down, do questions two, three, and four, and then come back and we'll go through them together.

Welcome back. Let's do these questions together. Number two says when the equity method is used to account for investments in common stock, which of the following affects the investor. In other words, the parents reported investment income. How about the first column? How about a change in the market value of the subs?

Common stock. Now, you know, we just went through the equity method, went through all the entries. Did I ever mention a change in market prices? No change in market prices would have nothing to do with the investors reported investment income from the investee, from the subsidiary, nothing to do with it at all.

So, no, in the first column, how about the cash dividends from the investee? How about cash dividends from the subsidiary? Does that affect. The parents share of investment income. The parents reported investment income, no cash dividends from the investee are a debit to cash and a credit to the investment account.

It's a return of capital cash dividends are return of capital. They don't affect income at all. So be careful, don't make a sloppy mistake. Double knows the answer. D number three on January 2nd of the current year. Well purchased 10% of Ray's outstanding stock for 400,000. Let's stop right there. We know whatever method well is using, whether it's cost or equity, you always start the same way we know on January 2nd, well would have debited investment in REA for the cost of the shares 400,000 and credit cash.

400,000. We know on the day of acquisition, the cost and equity method are identical. Anyway, we haven't even nailed down the method. If you go right to the bottom, it says in the December 31 balance sheet, what amount would well report the investment in REA? Well, you see why answer C is there now? I don't think he fell for this.

We just talked about it, but a lot of students would go for answers. See, because what are they thinking? They're thinking, well, owns 10% of Ray's stock. That's below 20%. They just are under the cost method. They're just trying to fool me. The investment would be kept. It cost 400,000, but we know that the 20% is just a guideline.

If there's no evidence to go by and they gave you evidence, they went on to say, well, is the largest single shareholder in REA and Wells officer's are a majority on Ray's board of directors when there's evidence of significant influence. It doesn't matter what percent of the stock you own. Equity method is required.

So let's apply the equity method. We know that well would automatically pick up their share of raise income, raise income for the year 500,000 well would pick up this year, 10%. What's the entry we know. Well, it was going to debit investment in REA for 50,000 credit equity and suburb innings were investment income, 50,000 also there's a dividend during the year, the sub Ray.

Declared and paid 50, 150,000 in dividends. Well, you've got to assume that if well, owns 10% of REA shares, well, would've got 10% of that dividend or 15,000. So what did well do for that? They would have debited cash, 15,000 and you know, credit investment and sub 15,000 because dividends are treated not as income, our return of capital.

So if you look at those entries, What happened to investment in sub well, investment in sob started at 400,000. It went up 50,000. When the well picked up this sheriffs of income went down 15,000 because the dividend is a return of capital. The answer is B investment in Ray at December 30. One is now reported at 435,000.

And let me just quickly say that I'm showing you the entries. Because I'm trying to make my thinking as clear as possible, but I'm not saying you have to do entries in the exam. You could, you could say, well, Bob, I'm getting comfortable enough with this. I knew it was a plus 50, a minus 15. It's going to be four 35.

I don't have to do entries. That's fine. As I say, I'm just showing you entries to try to make my thinking as clear as possible. Number four, purchase 30% of sled companies outstanding stock on December 30, one of the current year for 200,000. On that day, the sub stockholders' equity was 500,000. The fair value of the identifiable net assets, 600,000.

And on December 31, what amount of Goodwill would Burke attribute to this acquisition? This is why I mentioned earlier that you can't really go in the FAR CPA Exam and not know how to do a Goodwill calculation because they can ask. All right, what's my starting point here. If I'm going to work out Goodwill, I to actually calculate it.

Do I use the, as my starting point 500,000 or 600,000 that's right. 600,000. The fair value of the subs net assets on the day of acquisition remains by definition. Goodwill is defined as what someone's willing to pay over fair value for net assets, not over book value. It's what someone is willing to pay over fair value for net assets.

So we know that the fair value. Of the subs net assets on the day of acquisition, total 600,000. And you say, and you think to yourself, well, what percent of those net assets did Burke purchase? 30%. And the point is that a 30% interest in 600,000 is worth 180,000, but Burke paid 200,000 for the stock. If Burke paid 200,000 for the stock, there is 20,000 of Goodwill in this acquisition.

And the answer is B. Make sure you know how to do a Goodwill calculation. What I'd like you to do is shut the class. Now do number five and then come back.

Welcome back. I hope you tried this question. And I have a question for you. You're in the exam. You've got number five. My question is, how do you know what's an equity question I'm asking because the word equity is nowhere mentioned in the question. They never say anything about the equity method. So my question again is you're in the exam.

You've got this question. How do you know it's an equity question at all? They never said equity that's right. All you know, is that Denver? Owns 3000 of Eagle's 10,000 outstanding shares. That's 30%. If I've got no evidence to go by, I've got my guideline. If Denver owns 20% or more here, it's 30% of the subs voting shares.

Well, then I just assume significant influence equity would have to be used and notice they didn't remind you that he even mentioned the equity method, but it is an equity question. Now during the year Eagle paid the sob Eagle paid 40,000 in dividends on the common. Well, you've got to assume if Denver owns 30% of Eagle's shares, Denver would have gotten 30% of that dividend or 12,000.

So we know Denver would have debit and cash 12,000. Right? We know that. What do they want here? The bottom, it says in the current year income statement, what amount of income from this investment would Denver report? You know, what I'm asking is an answer C. Of course it's not safe because the credit would be to what investment in sub that dividends return of capital has no effect on income at all.

Right. That's how the dividend would be handled debit to cash 12,000 credit, the investment account, 12,000 it's a return of capital has no effect on income at all. You know, it's not answers C but what we do know is that under the equity method, Denver would automatically pick up their share of Eagle's income.

Eagle's income for the year was 120,000 Denver would pick up 30% or 36,000. And that's answer a and a is wrong, but it's tempting. Isn't it? You see how somebody could go for a it's very tempting answer, but it's wrong now? Why is it wrong? Let me just say that. If you did pick a and I'm not accusing you, but if you did pick a.

I think that once you see this, you'd never make this mistake again. Let me have you think about something in this problem when to Denver acquire Eagle shares. That's right. July one. Oh, July one. Remember under the equity method, the parent is entitled to pick up their share of sub income since the acquisition.

Not for all time. Remember that under the equity method, the parents are entitled to pick up this year because of income since the acquisition. So in this problem, Denver's entitled to pick up this year of Eagles income for the last six months. Now, did you notice this? They said that Eagle's income for the year was 120,000 and it was earned evenly while if it was earned evenly.

It would be 60,000 for the first six months, 60,000 for the last six months. So for the last six months from July, first on Eagle are in 60,000 of income. Denver picks up 30% their share. So debit investment in sub for 18,000 credit equity and suburb innings or investment income, 18,000. And the answer is B.

So I had to show you that because dates do matter. In an equity problem. And as I said, I think what you see that I think it's the kind of thing that will always be on your mind. Let me ask you this. What if they had not said Denver earns their income evenly? What if they had not said that? You'd have to assume it you'd have no choice.

You cannot solve this problem. If you don't know the subs income for the last six months. So if they were silent, I'd have to assume that the suburbs, their income evenly 60,000 for the first six months, 60,000 for the last six months, and Denver picks up their 30% share. In my opinion, this is just my opinion now, but in my opinion, in a well-written exam, a student should never have to make an assumption.

That's my opinion. I think in a really well-designed well-written exam. A student should never be in the position of having to make an assumption. And I think that the CPA exam is really very good about that, but this is one of those cases where every now and then they'll put you in a position where you have to make an assumption you have to, because I can't solve this problem if I don't know the subs income for the last six months.

So if they were silent, I'd have no choice, but to assume it's 60,000 for the first six months, 60,000 for the last six months and Denver picks up their 30% share. Let's do number six MOS owns 26 of do bros preferred stock and 80% of their common stock. Then they give us the subdue bros stockholders' equity section at December 31 or a portion of it.

Notice the sub is showing 10% cumulative preferred with a par of a hundred thousand common with a par of 700,000. The subdue bro reported net income of 60,000 for the year ended December 31. What amount would Moss the parent record as equity in the earnings of do bro for the year ended December 31.

Now, before we solve this together, you see what they were hoping you'd do. They were hoping it's sitting the FAR CPA Exam and go, Oh, wait, I see it. I see it MOS owns 80% of Dubose common stock Moss would pick up. 80% of that income, 80% of 60,000 hell low B. I'm looking at your answer B it's not B. Now why isn't it B well, I'm sure you see it.

What do we have in this problem that we haven't had before in any problem? That's right. The sob has common and preferred stock outstanding, and the parent has an investment in both the common and the preferred stock of the sub. So that complicates this let's solve it together. We know that the subs income for the year do bros net income for the year was 60,000.

We know that, but remember, common can't get anything until the preferred dividend is taken care of. And notice this preferred is cumulative. Now you may remember that with preferred stock, the annual dividend is a fixed rate on par value. So I'm going to take that fixed dividend rate, which is 10% times the par for preferred a hundred thousand.

The current you'd prefer a dividend is 10,000. If you back out that 10,000 that tells you the net income available to common stockholders is 50,000 gross. I have to make that adjustment. And again, I have to make that adjustment because the preferred is cumulative. So even, even if that dividend is not declared, it goes into a rears and common can't get anything until you settle the dividends in arrears.

Anyway. So when you see it's cumulative you back it out, you just have to back it out. As I say, if it's not declared, it goes into a rears and common can't get anything until your ears are settled. Anyway. So we back out the 10,000 and that tells us that the incumbents available to common stockholders is 50,000.

Now what percent of that income is available to common stockholders can Mohs pick up 80%. If you take 80% of 50,000, that gives you 40,000 and notice that's not an answer choice. Why? Because Moss. Also owns 20% of the subs preferred stock. So Moss also has a 20% claim on the 10,000 preferred dividend. So pick up another 2000.

So the bottom line is that Moss's total ownership, interest, total equity interest in all the subs earnings would be answer a 42,040,000 of common earnings. And they're also, they also have a claim on. 20% of the preferred dividend 2000. So Moss has total equity interest, total ownership interest in all of the subs earnings would be 42,000.

I'd like it, the shut the class down and do seven through 10, please do seven through 10 and then come back.

Welcome back. Let's do these questions together in number seven. We, once again, have the question, how do we know it's an equity question? And of course we know it's an equity question because green owns 30% of actual shares. So they're in the guideline and they do say that. Green has significant influence over axle.

So we know it is an equity question. Now, during the year axle, the sub pay dividends of a hundred thousand on the common. Well, you've got to assume if green owns 30% of actual shares, green would have got 30% of that dividend or 30,000. So we know that green would have debited cash, 30,000. We know that.

And what do they want here? The bottom, it says. What amount of dividend revenue, the very precise here, what amount of dividend revenue would green report in their income statement for the Q the current year ended December 31? Well, you know what I'm asking is an answer be, well, of course it's not answer B because yes, they would have debited cash 30,000, but they would credit investment in sub 30,000 under the equity method, which we know they use.

Green would treat any dividends from Axel as a return of capital, not dividend revenue. So, you know, it's not B. Now the sub also declared a $60,000 dividend on the preferred. What percent of that would green get all of it? Green owns a hundred percent of the preferred stock. So we know the green would debit cash 60,000.

So let's look at our answers here. We know that there's no way it can be answered B. And if it's not B it can't be D because D is the 30 plus the 60. And we already know that the 30,000 is not dividend revenue. So what you're down to is a versus C and of course the answer is C. For that dividend on the preferred.

Yes, they'll debit cash 60,000 and they will credit dividend revenue, 60,000. The answer is C. Why? Because investments in preferred are always accounted for under the cost method. Remember that investments in preferred are accounted for under the cost method. The equity method is for investments in common, and I'm sure you know this.

Why would it not be possible to exercise significant influence? Over another company by holding their preferred that's right, because there's no voting rights. Remember the whole idea behind preferred stock is you gave up your voting rights. You give up your voice and management and you get preferential treatment.

You get privileges that other shareholders don't receive. So you can't really exercise significant influence over another company when you're holding their preferred, because the preferred has no voting rights. So just remember that. Investments in preferred are accounted for under the cost method. So that 60,000 dividend would be a debit to cash and yes, or credit to dividend revenue of 60,000.

That's what they wanted. And the answer is C. Now in eight, nine and 10, we have a set and it says that grant acquired 30% of South they're in the guideline. They also said that. Grant exercises, significant influence over South. So we know this is an equity set now because they're asking for the carrying value of the investment.

I like to set up a T account. So if we set up a T account for investment itself, let's start filling in the information we know on January 2nd, year three, when grant acquired 30% of South shares, but 200,000, they would have debit it investment in itself, 200,000 credit cash, 200,000. Then at December 31, the sub South earned 80,000 of income and pay dividends of 50,000 for year three.

Well, we know under the equity method grant would automatically pick up their share of that income. So if Saltz income for the year was 80,000 grant would pick up 30% or 24,000. Let's put that in the T account. Grant would debit investment in South 24,000 credit equity and suburb innings or investment income, 24,000, when the sub paid a $50,000 dividend, you've got to assume that grant owns 30% of the shares.

So grant would get 30% of that dividend or 15,000. So they would debit cash 15,000 credit the investment account because it's a return of capital. Those are the entries that have been made. Number eight says before taxes. What amount would grant include in their year three income statement as a result of this investment what's on the year three income statement.

You know what I'm asking a or B, well, not a, the dividend, the 15 thousands return of capital, but the 24030% of the subs, 80,000 of income would be a debit to the investment account, credit equity, and Suburbans or investment income that would go to the parent's income statement. The answer is B. 24,000.

Now in number nine, they say in grants, December 31 year three balance sheet, what would be the carrying amount of this investment? Well, we have the T account. It would be 200,000 plus 24 minus 15. Answer B 209,000 would be the carrying value of the investment at the end of the year three. Now the main reason I wanted us to do this set is because of question number 10.

On July 1st year four grant goes out and sells half the shares, half their shares in South for 150,000 and a number 10, they say in the year for income statement, what amount would grant report has gained from the sale of the investment gain from the sale of the stock? Well, can we agree that the carrying value of investment in South at the end of year three, That was the question.

Number nine was 209,000. So the carrying value at the end of year three becomes the opening carrying value for year four, two Oh nine. I think we agree on that. Carrying value the investment at the beginning of the year for 209,000. And here's the main thing I want you to remember from this set. If you sell off an investment that's been accounted for on the equity method.

If you sell off on investment, that's been accounted for under the equity method. You must apply the equity method up to the date of sale. That's really what they're testing here. Anytime you sell off an investment that's been accounted for under the equity method, you must apply the equity method up to the date of sale.

If you don't, you won't have the proper carrying value and you won't get the proper gain or loss. So let's apply the equity method up to the date of sale. We agree that the carrying value of investment in South at the beginning of year four would be 209,000 notice. They said that the income. For year four was 200,100,000 for the first six months.

That's what we need. So if the income for the first six months was a hundred thousand grant would pick up their 30% share. So debit investment in South 30,000 credit equity and some earnings or investment income, 30,000. Were there any dividends before the date of sale? No, there was a dividend, but that was not until October, but there were no dividends.

Before the date of sale, if there were you'd have to work the dividend and as a return of capital, you must apply the equity method up to the date of, so if we started using before with the carrying value of two Oh 209,000 grant picked up there, 30% said, share of South income for the first six months of the year for 30,000.

Let's agree that the carrying value of investment itself. On the date of sale, 239,000. Now we can handle the sale. If grant goes out and sells half the shares for 150,000, we know they're going to debit cash for what they collected 150,000. We know they're going to credit investment itself for half of the carrying value.

They sold half the shares. So credit investment itself for half of two 39 or 119,500 and credit gain on sale for the 30,500. So the answer to number 10 is also bait. There's the gain on sale. So don't forget that lesson, that if you sell off an investment that's been accounted for under the equity method, you must apply the equity method up to the date of sale.

If you don't, you won't have the proper carrying value, you won't get the proper gain or loss. You must apply the equity method up to the date of sale. And isn't this another example of a problem where you might have to assume that the sob earns their income evenly here. They broke it down for you. They said the income for year four was 200,000, a hundred thousand for the first six months.

If they had said nothing like that, I'd have no choice, but to assume that the sub earns their income evenly through the year. So if their income for year four was 200,000, it must've been a hundred thousand for the first six months, a hundred thousand for the last six months, I can't solve this problem.

If I don't have the parent pick up their sheriffs of income for the first six months, I have to know the subs first six months income. So if they're silent, I'd have no choice, but to assume the sob earns their income evenly. Just another example of a problem where you may have to make that assumption.

Let's go to question number 11. We'll do it together. 11 says that Sage. Bought 40% of Adam's outstanding stock January 2nd of the current year for 400,000. So you read that first sentence, you're sort of thinking of the equity method. It's not nailed down, but they did by 40%, Sage did purchase 40% of Adam stock it's in the guideline.

So we're thinking significant influence equity. Then it says the carrying amount of Adam's net assets on the purchase date, total 900,000. Fair values and caring amounts were the same for all items except for the plant and for the inventory. For which fair values exceeded carrying amounts by 90,000 and 10,000 respectively, the planet has an 18 year life.

All inventory was sold during the year. Goodwill, if any, will be tested for impairment each year during the year Adams reported. Net income of 120,000 and pay 20,000 in cash dividends. The bottom, it says, what amount would Sage the parent report in their income statement from this investment and Adams for the year ended December 31.

Well, before we solve it together, you know what they wanted you to do. They wanted you to sit in the FAR CPA Exam and go, Oh, I say it say Jones, 40% of Adam stocks. So Sage would pick up 40% of that income, 40% of 120,000 hell low, a. I'm looking at your answer a but somehow you knew it just wasn't that simple.

It's not, let's do an excess calculation. They said that the book value the carrying amount of Adam's net assets on the purchase date, total 900,000. Now you stop and think what percent of those net assets did Sage purchase 40%. If you take a 40% interest of 900,000, that comes out to 360,000, but. Sage paid 400,000 for the stock.

So there is a $40,000 excess here. Let me ask you a question. Is that Goodwill? No. Remember Goodwill by definition is what someone's willing to pay over. Fair value for net assets. This 40,000 is what Sage was willing to pay over book value for net assets. This is an excess of cost over book value. Now you have to stop and think why.

Why was Sage willing to pay a premium over book value to acquire these net assets? Because this company has undervalued assets. I'm talking about the plant and the inventory. What you're dealing with here is undervalued assets. Let's start with the plant. They said that the fair value of the plant is 90,000 higher than it's caring about.

The plant is undervalued on the books. The plant has a fair value 90,000 that it's carrying them out. And if you stop and think about it, if I buy 40% of your net assets, I just bought a 40% interest in that plant. So take 40% of 90,036,000 of my 40,000 excess is traceable to the plant. By the way, if you have any doubts, this is a very difficult, multiple choice question.

In my opinion, this is about as difficult. Of a multiple choice as you'd ever see on the equity method, but it's something you've got to be ready for. Let's let's deal with the inventory. The inventory has a fair value, 10,000 higher than its book value. It's undervalued on the books. And once again, if I buy 40% of your net assets, I just bought a 40% interest in that inventory.

So 4,000 of my 40,000 excess is traceable. To the inventory. That's how the excess breaks down. I hope you see how we trace this excess to undervalued assets. You might want to just write this in your notes. Just remember this difference when there's an excess of cost over fair value, we call that Goodwill again.

Anytime there's an excess of costs over fair value, we call that Goodwill. And as you know, it's not amortized, it's tested for impairment at least annually, but if there's an excess of cost over book value, If there's an excess of cost over book value, you've got to trace that excess to undervalued assets.

I hope you see how we trace that excess to undervalued assets. So why do we do this? Why do we trace the excess to undervalued assets? Because when you can trace your excess to undervalued assets, this excess is amortized. Over the remaining useful life of these assets. I'll say it again. When you can trace your excess to undervalued assets, this excess is amortized over the remaining useful life of these assets.

Let's start with the plan. Well, no, let's back up. We know they're asking what's on Sage's income statement for the year ended December 31 while we know, first of all, that Sage would automatically pick up this year. If so I've income, Sage would automatically pick up 40%. Of Adam's income of 120,000. So we know they would debit investment in sub 48,000 credit equity and Suburbans or 40 or investment income, 48,000.

That's how we would start. But again, we know it's not answer a, let's make our adjustments. When you can trace your excess to undervalued assets. This excess is amortized over the remaining useful life of these assets. I'll say it again. When you can trace your excess, the undervalued assets as we did here, this excess is amortized over the remaining useful life of these assets.

So I'm going to start with the 36,000 of excess that I traced to the plant. And I'm going to amortize that over the remaining useful life of the plant, which is 18 years. So I take that 36,000 over 18 straight line years. I'm going to take 2000 of amortization on that part of my excess what's the entry.

Well, this is very important. Don't debit, amortization expense. If you debit amortization expense, it's going to get you down the wrong path in the CPA exam. They always take this amortization as a direct reduction of investment income. Again, don't debit, amortization expense. It'll get you. It'll get you messed up in the CPA exam.

They always take this amortization as a direct reduction of equity, some earnings. So I'm going to debit equity and subheadings or investment income, 2000 credit, the investment account. 2000. How about the 4,000 of excess that I traced to the inventory? How much of that? Should I amortize all of it? Why?

Cause they said they sold it all. If they sold half I'd amortize half, if they sold a quarter at advertise a quarter, but they said they sold it all. So I advertise all of it. And once again, I take this amortization as a direct reduction of equity in Suburbans. So I'm going to debit equity and sub earnings.

4,000 don't debit, amortization expense. It's just going to get you down the wrong path. Take this amortization as a direct reduction of equity, it's earnings or investment income. So I'm going to debit equity and suburb innings or investment income, 4,000 credit, the investment account 4,000. So now that I've made my adjustments, when they asked me at the bottom, what am out with Sage report and their income statement from this investment in Adams?

Well, we started with 48,000 equities have earnings. But we lowered it by two and we lowered it by four because of my amortization. And the answer is B it's a hard question, but as I said, you've gotta be ready for it. If there's an excess of cost over fair value, we call that Goodwill. But if there's an excess of cost over book value, you've got to trace that excess to undervalued assets because when you can trace your excess to undervalued assets, this excess is amortized.

Over the remaining useful life of these assets. I'd like you to try number 12, try number 12, get your answer, and then come back.

Welcome back. Let's look at this question together. They say on January 2nd keen purchase a 30% interest in pod for 250,000. And at the bottom, they're saying in the December 31 year-end balance sheet, what amount would keen report this investment in sub. Well, because they want to know the carrying value of the investment at year end.

I think, you know, I like a T account, so we're going to set up a T account for investment in pod and we'll work it through. We know on January 2nd, when Keene purchased a 30% interest in pod for 250,000, they would debit investment in pod 250,000 credit cash, 250,000. Now we know this is an equity question because first of all, they're in the guideline.

Keene does own 30% of pods shares that's 20% or more I'd assume significant influence anyway, but here they did say it keen accounts for this investment under the equity method. So it is an equity question. Let's apply the equity method. We know under the equity method that keen would automatically pick up their share of pods income pods income for the year, a hundred thousand keen would pick up 30% and put that in debit investment in pod 30,000.

Credit equity and Suburbans or investment income, 30,000, but you can't stop there. Let's do an excess calculation. They said that pod stockholders equity totals 500,000. That's the book value of pods, net assets, book value 500,000. Now keen acquired a 30% interest in that. So you take 30% of 500,000 that comes out to 150,000, but Keene was willing to pay 250,000 for the shares.

So there is a a hundred thousand excess in this problem. It's not Goodwill because as you know, Goodwill is an excess of cost over fair value for net assets. This, this a hundred thousand is an excess of cost over book value. Now, why was. Keen willing to pay a premium over book value because there are some undervalued assets, the plant and equipment, the plant and equipment have fair values, 200,000 higher than book values.

And if you think about it, if I buy 30% of your net assets, I just bought a 30% interest in that plant and equipment. So take 30% of 200,000, 60,000 of my a hundred thousand excess is traceable to that plant and equipment. The other 40,000 must be Goodwill. Because there are no other undervalued assets.

So the other 40,000 must be what I paid over. Fair value for that assets. That 40,000 would be Goodwill. Now, as you know, we don't advertise Goodwill. We tested for impairment at least annually, but the 60,000 of excess I traced to the plant and equipment will be amortized over the remaining useful life of the plant and equipment.

And that's 10 years. So I'm going to take that 60,000. Of excess that I traced to the plant equipment divide by 10 straight line years. And you know what? My entry is, I don't debit amortization expense. I debit equity and sub burnings, 6,000 credit, the investment account 6,000. And when I put that in the investment account as a credit for 6,000 investment in sob at December 31 year end comes out to 274,000 answer D.

Now there's one more thing that we have to discuss with the equity method before we leave the equity method. And that is how you handle a step-by-step acquisition. Now, what is a step-by-step acquisition? Well, what you're looking for in the exam, Is a problem where it takes more than one purchase of stock to acquire significant influence over the sob.

Again, a step-by-step acquisition is a situation where it takes more than one purchase of stock to acquire significant influence over the subsidiary. Let me give you an example. Let's say on January one year, one parent company purchased 8% of a, some shares. So what would be your assumption in the exam?

Well, parent purchased 8% of the sub stock. They're below 20%. I've got no other evidence to go by. I'd have to assume they do not have significant influence. I have to assume they'd be on the cost method. Now we're going to assume some time goes by. And then on July 1st year two, the parent purchased an additional 6% on additional 6% of the subs voting shares.

So as of July one year two, Now the parent owns 14% of the subs voting common stock. They're still below 20%. I have to assume there's no significant influence. As far as I know, they'd still be on the cost method. Now we're going to assume some more time goes by. And then on July 1st year, three parent company purchases, an additional 11% of the subs voting shares as of July 1st year three, what percent of the sub stock does the parent now owned?

8% plus 6% plus 11%. Now the parent owns 25% of the sub shares. Now it's 20% or more. I'd have to Sue him. There is significant influence, so they would switch over, but to the equity method, July 1st year three. So this is the time a problem that you're looking for. It's a problem where it takes more than one purchase of stock to acquire significant influence over the subsidiary company.

So, what do we do in a case like this? Well, I'll give you a note in a step-by-step acquisition. Once you determine that the parent does have significant influence over the sob, I'll say it again in a step-by-step acquisition. Once you determine that the parent does have significant influence over the subsidiary company, as we have here, we must retroactively.

Apply the equity method all the way back to the first purchase of shares. So that's what you're up against here in a step-by-step acquisition. Once you determine that the parent does have significant influence over the sub, you must retroactively apply the equity method all the way back to the first purchase of shares.

So that's our job here. We have to go back in time and retroactively. Apply equity all the way back to January one year one. Now I don't know if you see the wrinkle yet. That bothers a lot of people look at the situation, look at the problem. We know that if we're going to retroactively apply equity all the way back to January 1st year one, now the parent has to pick up their share of sub income for those years.

So what percent do you pick up? 8%, 6%, 11%, 25%, 14%, 17%, 19%. I just want you to appreciate that. There's all these percentages floating around in there, and that's where a lot of students seem to freeze. So I'm going to give you my rule. I always tell my students, if you can just know this rule, this rule will take you through any step-by-step acquisition.

Here's the rule. The rule is. When you retroactively apply equity, when you retroactively apply equity, always make your adjustments based on the ownership percentage that existed at the time the income was earned. When you retroactively apply equity, you always make your adjustments based on the ownership percentage that existed.

At the time the income was earned, you make your adjustments based on the ownership percentage that existed at the time the income was earned. So let's apply the rule. We go back to year one. What percent of the sub stock did the parent owned all through year one, 8%. So the parent would be entitled to pick up 8% their share.

8% of the subs net income for year one, you make your adjustments based on the ownership percentage that existed at the time, the income was earned since the parent owned 8% of the sub shares while the Saab was earning their year, one income parents are entitled to pick up their share. 8% of that income.

How about year two? What percent of the sub stock did the parent owned for the first six months of year two? That's right. It was still 8%. So the parents are entitled to pick up 8% of the sobs. First six months income. What percent of the subs doctor the parent own for the last six months of year to 14%.

So the parent's entitled to pickup 14% of the sobs. Last six months income, you make your adjustments based on the ownership percentage that existed at the time the income was earned. And of course, this is what the FAR CPA Exam will do to you. No doubt. They'll have the ownership interest change through the year like it did here.

Parent owned. 8% of the subs stock while the sub was during their first six months income in year two, parents are entitled to pick up their share 8% of the subs for six months income. This is the parent owned 14% of the sub stock while the sub was earning the elastics month's income. And your two parents are entitled to pick up 14% of the subs last six months income.

And isn't this another type of problem. When you may have to assume that the sub earns their income evenly through the year, half and half. It's another one of those situations. We have to break the income out. How about year three? What percent of the sub stock that the parent owned for the first six months of year three?

It was still 14%. It didn't change till halfway through the year. So because the parent owned 14% of the sub stock was the sob. While the sub was earning their first six months income in year three, parents entitled to pick up their share 14% of the sobs. First six months income. What percent of the subs stock did the parent over the last six months of year three, 25%.

So the parents entitled pickup 25% of the subs. Last six months income, you make your adjustments based on the ownership percentage that existed. At the time the income was earned, it's an important rule. And as I say, if you remember that rule, it really takes you through any step-by-step acquisition. And as I mentioned, when these exam gets into this, you'll probably have the ownership percentage change through the year.

I'd like you to try questions 13 and 14 and then come back.

Welcome back. Let's look at these questions together. Number 13 says on January one of the current year point purchase, 10% of I own is common stock. So what you're thinking in the exam, you read that sentence. You say, well, point owns less than 20% of I own a shares. I've got no evidence to go by. As far as I know, point would not have any significant influence point with the under the cost method.

They below 20% then point purchased additional shares, bringing its ownership up to 40% on August one. Well, now they brought their ownership interest up to 40%. Now it is 20% of more. I've got no evidence to go by. Now I have to assume point does have significant influence. So they switch over to the equity method.

As you know, this is a step-by-step acquisition. And once you determine that point does have significant influence. We must retroactively apply equity all the way back to the first purchase of shares all the way back to January one. How much income from Nayana investment would point. With point TRN income statement report.

Well, you know, the answer is a yes. Make your adjustments based on the ownership percentage that existed at the time the income is earned. So the parent would pick up 10% of own income from January one to July 31. You make your adjustments based on the ownership percentage that existed at the time, the income was earned since point on 10% of our owners shares while Iona was earning the income from January one to July 31.

Points entitled to pick up their share. 10% of the income from January one to July 31 and 40% of the subs income from August 1st to December 31, the answer is a, they also said that I own a declared and paid a cash dividend on all the chairs. Why don't I worry about the dividend? They mentioned the dividend.

Why don't I worry about that? That's right, because if it's the equity method, dividends are return of capital. They lower the investment account. They have no effect on investment income, no impact on the question at all. Number 14, because they're asking what amount would the parent report in it's December 31 balance sheet as investment in taut, because they want the carrying value of the investment.

You know, I like to set up a T account, so let's set up a T account for investment in taught. We know that the parent purchase 10% of taught shares. On January 2nd for 50,000. So let's put that in the T account. We don't want January 2nd. They would debit investment in taut 50,000 credit cash, 50,000. Now of course you're thinking in the FAR CPA Exam is that as of January 2nd, the parent only owns 10% of the subs shares 10% of taught they're below 20%.

I have no evidence to go by. I'd have to assume. Because they're below 20% that the parent does not have significant influence. As far as I know, the parent would be under the cost method at that point. But then on December 31, parent purchased an additional 20,000 shares on additional 20% of taught for 150,000.

So let's put that in the T account. So December 31, they'd be a debit to investment and taught 150,000 credit cash. 150,000 as of December 31. Now the parent owns 30%. I've taught shares. Now I'd have to assume they do have significant influence. They would switch over to the equity method. And because this is a step-by-step acquisition because it took more than one purchase of stock to acquire significant influence over the sub.

We have to retroactively apply equity all the way back to January 2nd, all the way back to the first purchase of stock now. The subs income for the year was 300,000. And they're asking me what amount would the parent report in the December 31 balance sheet for investment and taught? Here's my point, if you think that, because we're retroactively applying equity, because we have to retroactively apply equity all the way back to the first purchase of shares, which is January 2nd.

If you think that. The parent should pick up 10% of that income. 10% of 300,000. The answer would be see if you think that the parents would pick up 30% of that income, the answer would be D isn't that what we are. Can we agree that a and B are just there for decoration? Nobody's thinking about AUB. I know you're not, but if you think that the parents should pick up 10% of toxin gum, 30,000.

The answer would be see if you think that the parents should pick up 30% of the tots income, 90,000, the answer would be D you're down to two plausible answers. So how do you get from two to one? How do you get it down to the answer? Well, my point is I gave you a rule and what I'm hoping is that my rule would answer anything.

They dream up. What's my rule. Say, you make your adjustments based on the ownership percentage that existed at the time. The income was earned. So let me ask you what percent of taut did the parent own while talk was earning the income that's right while taught was earning the income. It was 10%. The ownership interest didn't change till December 31 while taught was earning the income parent owned 10% of taught shares.

So the parents are entitled to pick up their share 10% of that income or 30,000. And the answer is C not D. You make your adjustments based on the ownership percentage that existed at the time the income was earned

now sort of summarize a little bit about what we've learned so far in this CPA Review FAR course now. Assuming we have no other evidence to go by now, listen carefully. Now, assuming that there's no other evidence to go by. Here's our basic guidelines. Don't we know that if a parent owns less than 20% of a subs voting shares, then we assume what the parent does not have significant influence.

The parent would be under the cost method. True. And if the parent owns between. 20 and 50% of the subs voting shares. We assume the parent does have significant influence over the sob equity method would be required, but I want you to recognize that once you cross that 50% threshold, now you're no longer talking about significant influence.

You're talking about control. It's a whole new world. It's a whole new universe because when you cross that 50% threshold, Now we are no longer talking about significant influence. Now the parent has control over the sub and when a parent company has control over a subsidiary company, consolidated statements are required.

And that's what I want to get into next. What we're going to get into is how to prepare consolidated financial statements. And I want you to know that there is only one only one acceptable method. Of preparing consolidated statements. It is the acquisition method. Now, when you prepare consolidated statements under the acquisition method, your goal, and I think it's important, never lose sight, never lose sight of this.

Your goal in the acquisition method is to present the parrot and the subsidiary companies as if they were one company in a nutshell, that's what you're trying to do. Present the parent and the subsidiary companies as if they were one company. Now, why, well, I want you to be ready for this basic argument.

The basic argument is this. Once a parent company owns more than 50% of the son's voting chairs. Once a parent has control over subsidiary company, once a parent company controls the operations of the sub, the actions of the sub, the assets of the sub, the financial policies of the sub. In legal form.

There are still two companies. Legally, there are still two companies, but in substance, in substance, there is only one economic entity in substance. There's only one company because one company makes all the decisions. One company makes all the policies. One company controls all the operations who we kidding in substance.

There is only one company, only one economic entity. And I want you to know that the CPA exam refers to the principal. I just went over as the single entity concept. That's what this is called. The idea that in legal form, there might be two companies, but in substance there's only one. And I know that you're aware of where this is all leading.

If in substance there's only one company, how do intercompany transactions make any sense at all? How can the parent sell something to the sub and make a profit? If there's only one company than in substance, you just sold something to yourself and made a profit. How can there be intercompany, payables, intercompany, receivables, intercompany dividends, intercompany profits, intercompany losses, intercompany bonds.

It's all ridiculous. If you buy the original premise that once a parent company has control over a subsidiary company in substance, there's only one company. So the bottom line is this your job in a consolidation. Is to identify and eliminate all the intercompany activity. That's what you have to do. And to get us into the type of elimination entries that you have to make in a consolidation problem, we're going to, we're going to go right to a simulation because let's be honest, you know, some topics in accounting, just make a good simulation and consolidation.

Is a classic topic that just lends itself to be tested through a simulation. So we're not going to start in the minor leagues here. We're going to start in the major leagues. Let's do a whole simulation on consolidation. So I'd like you to go to your viewers guide and take out the simulation for Jarad and Munson.

Let's look at Jara and Munson together. It says on April one of the current year, Jared purchased 80% of the common stock of months and manufacturing for $6 million. So let's agree that if. Jara had purchased 80% of the common stock of Munson. Then the other 20% of the stock is owned by what they call the non-controlling interest.

What used to be called the minority interest. So the non-controlling interest owns the other 20% of the capital stock of the subsidiary at the date of purchase the book and fair values of months and assets and liabilities were as follows. So they give us the book values and the fair values of the sobs net assets on the day of acquisition on April one, it says by year end, December 31, the following transactions that occurred during the year, the balance of months is net accounts receivable.

April one had been collected the inventory on hand April one had been charged to cost to sales months and used as a perpetual inventory system in accounting for inventory. Prior to the year Jared had purchased at face amount, 1,500,000 of Bunsen, 7% subordinated to ventures or bonds. The debentures mature seven years in seven years on October 31 with interest payable annually on October 31 as of April one, the day of acquisition.

The machinery equipment had an estimated remaining life of six years months and uses straight line Munson's depreciation expense calculation for the nine months ended December 31 was based on the old depreciation rates. The other assets consistent entirely of long-term investments made by Munson do not include any investment in Jarad during the last nine months of the year from April 1st on the following intercompany transactions occurred between Jaren and Munson.

And we can see that jar has been selling the Munson. Munson's been selling the jar ed. Some of that merchandise is included in the purchasers inventory at December 31. There's a balance unpaid at December 31. Jared sells merchandise to months in a cost but months and sells merchandise at Jarad. Munson sells merchandise to jarred at a regular selling price, which includes a normal gross profit margin of 35%.

There were no intercompany sales between the two companies prior to April one. Accrued interest on the intercompany debt is recorded by both companies and their respective accounts receivable, not interest receivable and accounts payable, not interest payable. So I have to keep that in mind. And then at the bottom it says this business app, this business combination is being accounted for under the acquisition method, complete the worksheet to prepare the consolidated trial balance Pajaro and sub Munson.

At December 31 Jared's revenue and expense figures over the 12 month period while Munson's are only for the last nine months of the year, you may assume that both companies made all of the adjusting entries required for separate statements, unless stated to the contrary round, all computations to the nearest dollar ignore taxes.

So if you look at the trial balance, look towards the bottom of the assets. You'll see, the Jara does have investment in Munster manufacturing at 6 million also jar. It has investment in months in bonds for that million five. And this is what we're presented with. There's a lot going on here, a lot going on in this simulation.

Well, I want you to know that when you see a simulation like this, it's a little intimidating because there is so much going on. But just at the outset, I want you to know that there are two major steps to breaking this down. Two major steps to really solving just about any simulation on consolidation, where they give you a spreadsheet like this.

The two steps are number one. You have to eliminate that investment account on the trial balance. They have investment in months and manufacturing and 6 million. That account has to be eliminated in consolidation. Why because Jarden and Munson represent, represent only one economic entity. There's only one company.

There's no other company to invest in, in essence, you're investing in yourself. So there's no question in consolidation, that account has to be eliminated. So that's the first thing. That's the first big thing you have to do is eliminate that investment account. And then the other step, which is critical is to go through all the additional information they gave you quite a bit here and see if there's any intercompany activity.

That needs to be eliminated. So if you do those two things, you'll break this down. If you eliminate the investment account and number two, if you eliminate all the intercompany activity that's mentioned in the additional information, you go through the tabs, they give you all the tabs of information and look for any intercompany activity that has to be eliminated.

And if you do those two things, you'll break the simulation down.

Jared has on their trial balance investment in Munson $6 million. And as I say, that account has to be eliminated. Now, before we eliminate that account together, I want to do a couple of preliminary calculations. Don't we know. That Jarad paid $6 million for 80% of Bunsen shares. So what's a hundred percent of months in shares worth.

Well, you set up an equation, you say 80% of X, 80% of the total value of Munson shares. X must be worth 6 million. So as you know, Whatever you do to one side of an equation, you have to do to both sides. So we're going to divide both sides by 80%. So what you end up with is that X the total value of months in stock must be worth that 6 million divided by 80%.

So if you work it out the total value of months and stock the value of a hundred percent of months in shares must be worth 7 million, 500,000. That's the 6 million divided by 80%. So the total value of all the months in shares, The value of a hundred percent of months in stock must be worth 7,000,005.

Now that I've got that 7,000,005, I can work out a couple of things. And again, I want to emphasize, I'm just doing a couple of preliminary calculations before I begin. Now that I've got that 7,000,005, I can do a Goodwill calculation. If the fair value of a hundred percent of months in stock is 7,000,005.

What's the fair value of Munson's net assets. We'll go back to. The first page of the problem. Notice the fair value of all the assets adds up to 10 million, seven 15, the liabilities add up to 5 million, five 15. So what's the fair value of the subs net assets on the day of purchase 10,000,007, 15 minus 5,000,005 15 5,000,002.

So now let's work it out. If the total fair value of a hundred percent of months in shares equals 7,000,005. And the net assets have a fair value of only 5 million to than the total Goodwill. The total Goodwill in this problem comes out to 2 million, 300,000. In other words, if someone were to buy all of months and shares, they'd have to pay 7 million, 500,000 cash for net assets that only have a value of 5 million too.

So. The implied fair value of total Goodwill in this problem is 2,000,003. We can also work out the total fair value of the non-controlling interest. The non-controlling interest owns 20% of the capital stock of Munson 20% of the net assets of months. So if the total value. Of a hundred percent of the shares of months and adds up to 7,000,005, and the non-controlling interest owns 20% of that 7,000,005 take 20% of the 7,000,005.

The fair value of the non-controlling interest on the day of acquisition on April. One comes out to 1 million, five. Hope you see where I got that number. If a hundred percent of months in stock is worth 7 million, 500,000 and the non-controlling interest. Has a 20% interest in that 7,000,005 take 20% of 7,000,005.

The fair value of the non-controlling interest on April one, the day of acquisition is 1,000,005. Remember that under the acquisition method, we have to value that non-controlling interest at its total fair market value. And we now know that the non-controlling interest has a fair value on the day of acquisition of 1,000,005.

All right, was with those preliminary calculations out of the way that gives me a couple of numbers to play with.

Now, let's do the first major thing that we have to do in any consolidation problem. The main elimination entry that you make in any consolidation problem is to eliminate that investment account. On Jarad trial balance. They're showing biggest life invest investment in Munson manufacturing, 6 million.

We're going to have to eliminate that investment account. Now I'm going to give you a little checklist here, because this is a little bit involved to eliminate that investment account. It's going to take three steps. Let me list them down is a little checklist and I'd memorize it. His little checklist that you'll need to eliminate the investment account.

Number one. You have to record the Goodwill. Number two, you have to write the subs net assets to fair market value. And number three, you have to eliminate the capital structure of this up. If you do those three things, you'll eliminate the investment account. Again, you have to record the Goodwill. You have to write the subs net assets to fair value.

And number three, you have to eliminate the subs capital structure. Do those three things. You'll eliminate the investment account. And also by doing those three things. You will also record the total fair value of the non-controlling interest. So let's go through the three steps. Step one, we have to record the Goodwill.

Didn't we work out that if the total value of a hundred percent of months in shares is 7 million, 500,000 for net assets that only have a fair value of 5 million to then total Goodwill in this business combination comes out to 2,000,003. So let's record that Goodwill. My first entry, I'm going to debit Goodwill 2 million, 300,000.

I'm going to record that Goodwill. I'm going to debit Goodwill 2 million, 300,000, and that Goodwill that's going to be on the consolidated balance sheet. That's the Goodwill and the purchase. So I debit Goodwill 2 million, 300,000. Now, how do I finish the entry? I'm going to credit investment in sub. I'm going to credit investment in Munson for 80% of that 2,000,003, which is 1 million, eight 40.

I'm starting to eliminate the investment account now. So I'm going to credit investment in monster manufacturing for 80% of 2 million, three, 1,840,000. And I'm going to credit the non-controlling interest for 20% of the Goodwill, 20% of 2 million, three or 460,000. That's my first entry. I have to record the Goodwill.

I credit investment in Munson for 80% of 2,000,003, which is 1 million, eight 40. That's the first step to getting the investment account down to zero. And I credit non-controlling interest for this year of Goodwill, 20% of 2 million, three or 460,000. All right, that's the first step. Now the second step is to write the sub's net assets to fair value.

This is an adjustment that you have to make in the acquisition method. The subs net assets have to be written to fair value. So let's look at the first page of the problem again. There's no difference between book and fair value. For course, the cash, the notes receivable, the accounts receivable let's go to the inventory.

Notice the inventory has a book value of 828,000 and a fair value of 700,000. And if you remember in the additional information, they said that the inventory on hand April one had been charged to cost to sales months and uses as a perpetual inventory system in accounting for inventory. So that.

Beginning inventory, April one is now been charged to cost to sales, and it was overstated that would be charge the cost of it sold at 828,000. The entity should have charged the cost of goods sold and its fair value, 700,000. So if the beginning inventory was overstated by 128,000 cost of goods sold is overstated by 128,000.

Cause that's been charged to cost of goods sold. So I'm going to credit cost of goods sold. 128,000. How about the land? The land has a book value of 1 million, five 60, a fair value of 2,000,001. So I'm going to debit land 540,000. I write the land to its fair value. So debit land, 540,000. That'll bring land from a book value of 1 million, five 60 up to a fair value of 2,000,001.

Machinery equipment. I have to write from a book value, 7 million, eight 52, a fair value of 10,000,006. So I'm going to debit machinery and equipment, 2,000,007 50 accumulated depreciation. We're going to write from a book value, 3 million, two 52, a fair value, 4 million. So I'm going to credit accumulated depreciation 750,000.

Now, if you really look at that, what I'm doing is writing the machinery and equipment up 2 million up to fair value, but here they decided to actually. Work out a fair value figure for the accumulated depreciation, which is a little bit odd, but we're just going to do what we're instructed to do. So I debit machinery and equipment for 2,000,007 50 credit accumulated depreciation, 750,000.

How about other assets? Other assets have a book value of 140,000, a fair value, 50,000. So I'm going to credit other assets, 90,000. I write up the fair value or down to fair value, but an adjustment you make in the acquisition method is to write the subs net assets to fair value. All right now, if you add it all up, what did I just do?

Didn't I write the subs assets from book value, 8 million, three 93 to fair value. Tevin, 10 million, seven 15. I just wrote the subs assets up 2 million, three 22. That's what I just did only I did it piece by piece, but I just wrote the subs assets up 2 million, three 22. So I'm going to credit investment in sub for 80%.

Of that adjustment, 80% of 2 million, three 22 or 1,857,600. Again, I'm going to credit investment in Munson. It's another step in getting the investment account down to zero. I'm going to credit investment in Monson for 80% of 2,000,003 22. I just wrote the subs assets from book value, 8 million, three 93 to fair value, 10,000,007 15.

I wrote the subs assets up 2 million, three 22. To fair value. So I'm going to credit investment in Munson for 80% of that adjustment, 80% of 2 million, three 22 or 1,857,600. And I'm going to credit non-controlling interest for 20% of that adjustment. 20% of 2 million, three 22 or 464,400. That's the entry where I write the subs net assets to fair value.

As I say, this is an adjustment you have to make in the acquisition method. And then finally, one more adjustment. To get the investment account down to zero. I have to eliminate the capital structure of the sub. So if you go back to the first page of the simulation, you'll see that the sub is showing common stock, a million additional paid-in capital 872,000 retained earnings, 1,000,006 thousand.

If you look on the spreadsheet, did the same numbers. For the four months and manufacturing, common stock is a million API. C is 872,000 and retained earnings is 1,000,006 thousand. The numbers are the same. Why the number's the same, because they're not going to change until, I mean, those are, those are the beginning balances, April one in common stock, additional paid in capital and retained earnings.

Those are the beginning balances, April one, still on my spreadsheet, December 31. And of course those numbers will change when I work out. The net profit or net loss for the year, that'll change retained earnings, but this is just a trial balance. So we still have those beginning balances, but in my third adjustment to get rid of the investment account, I have to eliminate the capital structure this up.

So now I debit the subs, common stock, Amelia. I debit the subs additional paid-in capital 872,000. I debit the subs, retained earnings, 1,000,006 thousand. I have to eliminate 100% of the capital structure of the sub. Why there is no sub it doesn't exist. Remember the whole premise of this problem is that Munson has been consumed by Jared Munson doesn't exist anymore months and has been consumed by Jarad.

The parent has consumed this up. That's the way to look at this. So Munson doesn't exist anymore. I'll put it this way. There's only one capital structure. Only one capital structure that you'd ever carry over to the consolidated balance sheet. And that's the capital structure of the parent. The parent is the surviving entity along with the non-controlling interest, which again, we're in the process of building.

All right. So I'm going to debit the subs, common stock, a million I'm going to debit the subs API C 872,000. I'm going to debit the subs, retained earnings, 1,000,006 thousand. I always in my main entries eliminate 100%. Of the capital structure this up now, what do I do? Well, I'm going to credit investment in months in manufacturing for 80% of this adjustment.

Now, what does it all add up to? Well, common stock is a million API. C is 872,000 retained earnings is 1,000,006 thousand. So the total net assets of the sub add up to 2,878,000. So I'm going to credit investment amounts of manufacturing for 80%. Of 2,878,000 or 2,302,400. I'm going to credit investment in monster manufacturing by 80% of this adjustment, 80% of 2,878,000, the total net assets of the sub.

So credit investment months manufacturing 2 million, 302,400. And I'm going to credit the non-controlling interest for 20%. Of the net assets, 20% of 2,878,000 or 575,600. Those are the three entries that I need to eliminate the investment account. I have to record the Goodwill. I have to write the subs net assets to fair value, and I have to eliminate the capital structure of the sub.

All right. Now let's make sure that this comes out. Let's just do this as a check. What did I credit the non-controlling interest? Well, in the first entry. Didn't I credit non-controlling interest when I recorded the Goodwill. Didn't I credit non-controlling interest for 460,000 in the second entry. When I wrote the subs net assets to fair value didn't I credit non-controlling interest for 464,400.

And in the third entry. When I eliminated the capital structure of the sub didn't, I credit non-controlling interest for 575,600. If you add up 460,000 plus 464,400 plus 575,600, what's it add up to 1,000,005 didn't. We know when we started that non-controlling interest has to be recorded and its full fair value, which is 20% of 7,000,005, 1,000,005, but we recorded it in those three pieces.

Record the Goodwill, right? The subs net assets to fair value. Eliminate the capital structure, the sub. All right, have I, have I eliminated the investment account? Well, what have I done to the investment account? Didn't I credit investment in months in manufacturing for 1,000,008 40. When I recorded the Goodwill.

Didn't I credit investor investment in monster manufacturing for 1,857,600. When I wrote the S sub's net assets to fair value, I didn't. I credit investment month's manufacturing for 2,302,400. When I eliminated the capital structure of the sub. If you add up 1,000,008, 40 plus 1,857,600 plus 2 million, 302,400, what's it add up to 6 million.

I have eliminated the investment account. It just took those three steps. But again, not only dike, I think what I've done in those entries I've eliminated the investment account because you can't invest in yourself. I wrote the subs net assets to fair value and I recorded the Goodwill. That Goodwill will be carried over to the consolidated balance sheet in a formal consolidated balance sheet.

You'll show that Goodwill 2 million, 300,000 under intangible assets. It's the Goodwill in the purchase. The non-controlling interest is now recorded at its full fair value. 1,000,005 that will be carried over the non-controlling interest will be carried over to the consolidated balance sheet and shown within stockholders' equity in the consolidated balance sheet.

It's the non-controlling interest in the entity and it will be it's recorded as of April one at 1,000,005 it's recorded as of April one at, at 1,000,005. But of course this year, the non-controlling interest will pick up their share of the sub income from April one to December 31. If there are any dividends, the non-controlling interest, their share of dividends will lower non-controlling interest for their share of dividends as well.

But as of April one, non-controlling interest will be recorded at 1,000,005, and we've recorded that now. So there's a lot going on in those first three entries. So just remember record the Goodwill, right? The subs net assets to fair value, eliminate the capital structure, the sub. If you do those three things, you've accomplished a lot.

You've recorded the Goodwill. You've in the subs net assets to fair value. You've eliminated the investment account and you've recorded non-controlling interest at its full fair value. Now, once you've done that once you've done these, these three steps. Now there's only one step remaining where you go through the additional information, one item at a time, and look for any intercompany activity that has to be eliminated.

And if you do that, you'll have checked everywhere in the simulation where there's some grading points and you've done everything that needs to be done.

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So if we turn our attention to the additional information, it says by year end, December 31, the following transactions that occurred, the first bullet says that the balance of Munson's net accounts receivable at April one had been collected. So there's nothing there. Next bullet the inventory on hand, April one had been charged to cost of sales.

We had to know that because when we wrote the inventory to fair value, we had to go through cost of goods, sold or cost of sales. The first bullet that gets us into some intercompany activity is the third bullet. It says prior to the year, Jared had purchased at face value. 1,500,000 of Munson's, 7% subordinated to ventures or bonds.

These the ventures mature in seven years on October 31 with interest payable annually on October 31. So what we have, as I say is some intercompany bonds. And before we start dealing with them, I'll just give you the bottom line. The bottom line with intercompany bond holdings is that for consolidation purposes, for consolidation purposes, intercompany bond holdings must be retired.

So that's our objective here. Intercompany bond holdings have to be retired for  purposes. And I have another checklist for you. Now, listen to me carefully. It does not matter. It does not matter whether the parent buys the subs bonds or the sub buys the parents bonds. And I mentioned this because students get all hung up on that.

And it doesn't matter whether the parent buys the subs, bonds, or the sub buys the parent's bonds. When you see this, you've got to do three things. I have a little checklist for you. Let me give you the checklist. Three things have to be done here. Number one, you must eliminate the investment and the debt that's step one, eliminate the investment and the debt.

Step two, you must eliminate any intercompany interest payable, interest receivable, and step three, we must eliminate any intercompany interest, revenue, interest expense. Those are the three things that must be done. And, you know, I think you should memorize these checklists because it's a way of knowing that you've taken care of everything that must be done when you see intercompany bonds.

So let's do the first item on the checklist. We have to eliminate the investment in the debt. So they don't want on the exam. You've seen this item and he said, well, Bob said, step one, eliminate the investment and the debt. I have to eliminate the investment and the debt. How do I do that? Well, if you go to the spreadsheet, And you look down in the liabilities, notice that months and has as a liability, subordinated to ventures.

In other words, bonds payable of 5 million debit, subordinated to ventures, debit that bonds payable 1,500,000 notice. I don't eliminate all of it. Not all 5 million. Just the intercompany portion. Remember your, your job, your objective in all these adjustments is to eliminate the intercompany portion of something.

So I'm not going to, I'm not going to debit here. Subordinated ventures for 5 million. The other 3 million, five of bonds must be held by outsiders. Our job as always is to eliminate the intercompany portion of something. So I'm going to debit subordinated ventures, basically bonds payable, 1,000,005. Why, why am I doing that?

Because jarred and Munson are now one economic entity. Don't forget the single entity concept Jarden and Munson are now one economic entity. And this entity can not have an outstanding debt to itself. That's the problem with intercompany bonds. Now this entity has a debt to itself, so we're going to debit subordinated ventures, 1,000,005.

And again, if you look back on the spreadsheet, Just below investment in months in stock with a balance of 6 million, they have biggest life investment in months and bonds, 1,000,005. We're going to credit investment in Munson bonds. 1,000,005. Why? Because this entity can not invest in its own securities.

Jarred and Munson are one economic entity. It cannot have a debt to itself. That's why debit, subordinated ventures 1,000,005, and cannot invest in its own securities. So we credit. Investment in months and bonds for 1,000,005. So that's step one of my checklist. You have to eliminate the investment and the debt.

All right, now let's go to step two. We have to eliminate any intercompany interest payable, interest receivable, and there's an odd item that you have to keep in mind towards the bottom of the additional information. It said accrued interest on intercompany debt is recorded by both companies. In their respective accounts receivable and accounts payable accounts.

So for some reason, just an odd point, they don't have interest payable and interest receivable. They have accounts payable and accounts receivable who knows just a little item they threw in the problem. So let's eliminate any intercompany interest payable, interest receivable. Now, when you go to eliminate accrued interest, the first question is.

When was the last time interest was paid. Always ask yourself that question. When was the last time interest was paid notice in this case, interest is paid annually on October 31. So the last time interest was paid was October 31. What's the date of our consolidated statements, December 31. So as of the date of our consolidation, December 31, there must be two months of accrued interest.

November December it's from the last time interest was paid October 31 up to the day of consolidation, December 31. So as of the day of consolidation, there must be two months of accrued interest. So let's work it out. I'm going to take the interest rates 7% times 1,000,005, that's 105,000 of interest for a full year.

I'd want a full year. I just want November, December two twelfths, one sixth of a year. It comes out to 17,500. So what's my entry. Debit accounts payable. I think, you know what I'm really debiting is interest payable. I'm going to credit accounts receivable. And I think, you know, what I'm really crediting is interest receivable, 17 five, but the point is Jara and Munson are one economic entity and this entity cannot have payables and receivables with itself.

That's the problem with this item? So I took 7% of 1,000,005. It's 105,000 of interest for a full year. We're just talking about two twelves, November, December one sixth of that 17 five debit accounts payable, really interest payable, 17 five credit accounts receivable, really interest receivable, 17 five, and that'll take care of it.

The third step on my checklist. Now we must eliminate any intercompany interest, revenue, interest expense. Let me ask you a question. When did Jarret acquire Munson's bonds notice it said prior to the year. So Jared bought Munson's bonds maybe years ago, but even though they bought them years ago, we can't allow these bonds to be in the consolidated statements.

Because again, you can't have a debt to yourself. You can't invest in your own securities. You can't have payables and receivables with yourself. It doesn't matter when you bought the bonds. But Jared let's agree, bought the bonds perhaps years ago. So it didn't jar ed own Munson's bonds for all 12 months of the current year, all 12 months, but listen carefully, any interest revenue earned by Jara, from Munson, any interest expense that Munson had to Jarad for January, February, and March was before the parents, our relationship began.

So you can't forget. That in this simulation, the parents, our relationship began on April one. That's the day that jarred required months and shares, but all the interest revenue, interest expense for January, February, and March, we're not worried about because. They were two independent companies back then, but all the intercompany interest, revenue and expense for April, may, June, July, August, September, October, November, December for no those nine months.

That's a problem because you can't earn revenue with yourself. You can't incur expenses with yourself. So let's work it out. I'm going to take the interest rate 7% times 1,000,005. And again, that's 105,000 of interest for a full year, but I don't want a full year. I just want nine twelves from April 1st on nine 12, three quarters of a year.

It comes out to 78,007 50. I'm going to debit interest revenue, 78,007 50. Why? Because you can't earn revenue with yourself. Interest revenue is overstated on. Jarrod's books. I'm going to credit interest expense 78,007 50. Why? Because you can't incur expenses with yourself. It's all one entity now. So interest expense is overstated on Munson's books.

So that's your third adjustment, debit interest revenue, 78,007 50 credit interest expense, 78,007 50. And that'll take care of it. Make sure you know that checklist. You see intercompany bond. Eliminate the investment and the debt eliminate any intercompany, interest payable, interest receivable, and step three, eliminate any intercompany interest, revenue, interest expense.

That'll that if you do those three things, you know, you've done everything you need to do with intercompany bonds. And that's why I give you a checklist because consolidation is that kind of area where you leave the FAR CPA Exam going. Did I do everything I was supposed to do you follow that checklist? There's nothing they can throw at you.

On bonds and consolidation that won't be covered by that checklist. You do those three things they're done.

Now let's read on, is there more intercompany activity? It says the other assets consists entirely of long-term investments made by Munson. Do not include any investment in Jara, so there's nothing there. But the bullet above that says, as of April one, the machinery and equipment had an estimated remaining life of six years, months and uses straight line Munson's depreciation expense calculation for the nine months ended December 31 was based on the old depreciation rates.

The reason why this information is given to us is because when we wrote. The subs that assets to fair value didn't we write the subs, machinery and equipment to fair value. When you write fixed assets to fair value. And we did that in this problem. When we wrote Munson's net assets to fair value, we had a right Munson's machinery and equipment to fair value.

Anytime you write depreciable assets to fair value, that requires a depreciation adjustment. So let's work out the depreciation that the entity should take. If you look back at the machinery and equipment didn't we write machine and equipment to 10,000,006, that's the fair value. And we wrote accumulated depreciation to 4 million.

So take 10 million, six minus 4 million. Isn't the fair value of the machine equipment, 6,000,006. So I'm going to take that 6,000,006 divide by six straight line years. The remaining life of that machine and equipment is six years divide by six straight line years. That would be what 1 million, 100,000 depreciation for a full year.

I don't want a full year. Just April 1st on for the entity would working out the depreciation expense that the entity should take. So take 6 million, six divided by six straight line years. That's 1 million, 100,000 of depreciation for full year, but I don't want a full year. I just want April through December nine, twelfths of that.

It comes out to 825,000. The depreciation expense for the entity is 825,000. Now look back at the spreadsheet towards the bottom, find depreciation, expense, depreciation, expense machine and equipment under Munson. They took five 88, seven 50 based on the old rates. We don't even know how that was calculated, but the point is depreciation expense on the spreadsheet for machinery equipment for Munson.

What they took was five 88, seven 50. What should that number be? That number should be 825,000. The depreciation expense that the entity should take. So that's our job. We have to adjust that from five 88, seven 50 up to 825,000. In other words, we have to take an extra 236,250 of depreciation. So our adjustment, we're going to debit depreciation expense.

236,002 50. We're going to raise that expense from what they took based on the old rates, five 88, seven 50. That was based on the old rates. However, they worked that out five 88, seven 50. We're going to raise that up to 825,000, the true depreciation expense for the entity based on fair value. So I'm going to debit depreciation expense 236,002 50.

And I'm going to credit accumulated depreciation 236,002 50. And that'll take care of this. This adjustment has to be made any time you write depreciable assets to fair value in a consolidation. And in the acquisition method, you are required to do that. You are required to write all the subs, net assets to fair value.

And if it's depreciable assets, you have to make a depreciation adjustment because now the depreciation should be based on fair value.

We've already seen that the other assets consistent tiredly of long-term investments made by months and do not include any investment in Jarad. And then it says during the last nine months, which is what we're focused on. The following intercompany transactions occurred between Jared and Munson. Notice Jarrod's been selling merchandise to Munson.

Munson has been selling merchandise to jar ed. There's still a balance unpaid for both companies. And some of that merchandise is still included in the purchaser's inventory at December 31. Then they go on to say, Jarryd sells merchandise to months and the cost. So there's no intercompany profit in the jar to Munson column, but Munson sells merchandise to jar.

Ed. At a regular selling price, including a normal gross profit margin of 35%. So there is some intercompany profit in the months and the jarred column. There were no intercompany sales between the two companies prior to April one. Hey, before April one, we're not worried if there were any intercompany sales before April one.

We're not worried about that because they were independent companies before April one, but from April 1st on its apparent selling to a sub it's a sub selling to a parent. In other words, as of April one, You're selling your merchandise to yourself. That's what doesn't make any sense. I have another checklist for you.

You knew I would. When you see this item, you've got to do three things. I'm in love with threes in this FAR CPA Exam course, you see this, you've got to do three things. Now, listen carefully. I don't care whether the parents sells merchandise to the sub or the sub sells merchandise to the parent because some students worry about that.

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hello and welcome to the Bisk CPA review course My name is Bob Monette and I'll be your instructor in this FAR CPA Exam prep course and in this FAR CPA Exam course. Our focus is going to be on balance sheet issues. Specifically, what we're going to be talking about is liquid assets, cash accounts, receivable, notes, receivable, marketable securities.

Before we begin, let me advise you that the way to get the most out of this FAR CPA Exam study course is to treat it like any other class. Don't you sit back and watch the class passively. Be an active participant. Take good notes later in the, in the class, when we do problems, it's important to shut the class down, work on the problems, get the, get your answers first before you come back to the class and we discussed the problems together.

I think you'll find that if you do those simple things, you'll get much more out of the class. And obviously it's what we both want. So let's dive right in and let's start with cash.

Now there, there's not a lot to remember about cash, but a couple of things I think we should talk about first. Remember what we put on a balance sheet under the heading cash must be money that is free and clear. And available to be spent in current operations. That's what cash represents. When you put cash on a balance sheet, it has to represent money that is quote free and clear and available to be spent in current operations.

So with that definition in mind, what do you have to be careful about? Well, when you're in the exam, always be careful. If there's some reason the company can't spend the cash. For example, if they have a security deposit on a long-term project, Well, they can't spend that. So it's not cash, it's not free and clear.

It's not available to be spent in current operations. So you got to back that out. It's not cash. It belongs on the balance sheet as a security deposit, you know, watch out for a compensating balance on a bank loan. You know, a company has a loan outstanding at a bank. Some banks require that the company keep a certain minimum balance in their account.

Well, the point is if you have to keep a certain minimum balance in your account, you can't spend that. So it's not cash, it's not free and clear. It's not available to be spent in current operations. So you check that out. That's really a short term investment. It's not cash. Why watch out for a bond sinking fund?

I'm sure you know what that is. A corporation has bonds outstanding. They agree with their bond holders. They'll turn say a hundred thousand cash. Every year over to the hands of a trustee. So that 15 years from now, when the bonds mature, the investors know the cash will be there to pay them back. Well, the point is, if there is a bond sinking fund, that cash is in the hands of a trustee, it's not free and clear.

It's not available to be spent in current operations. It's not cash. It belongs on the balance sheet, under bond sinking fund. So just be careful what you put on a balance sheet under the heading cash. Also in terms of cash, be careful of the three month rule. Sometimes the FAR CPA Exam likes this let's go over it.

The three month rule relates to highly liquid securities, highly liquid certificates of deposit. Treasury bills, any commercial paper with an original maturity of three months or less. So we've got certificates of deposit, treasury bells, any commercial paper with an original maturity of three months or less three months or less.

You see security like that. You can treat it as cash. They're called cash equivalents. You can just lump that into your cash balance. It's the same as cash. Let me ask you a question. Let's say I have a six month CD. It's going to mature in two weeks. Is that a cash equivalent? No, because the original maturity six months, remember the rule works by looking at the original maturity.

No, the original maturity has to be three months or less. That's what makes the cash equivalent. If I have a six month CD, it's going to mature in three minutes. It's not a cash equivalent. It's not because the original maturity was six months. That's how the rule works. The original maturity has to be three months or less.

So be careful of that. Now you'd probably guess what, what I'm going to say next to anyway, and that is that the primary thing that the FAR CPA Exam likes to hit with cash is bank reconciliations. Now I know that you've done bank reconciliations at some point in school. Maybe in your job every once in a while in your personal checking, in your personal checking account, accountants are notoriously bad at doing it in their own account, but I know you've done this before, so I don't want to give you a lot of notes on bank reconciliations, but I think we should do some, you should see what they're like in the exam.

So let's go right away in your viewers guide. Let's look at question number one. Let's do it together.

Question number one says in preparing the August 31 year to bank reconciliation, apex corporation has the following information. We know that the balance per bank statement. August 31, 18,850. And we're told there were deposits in transit August 31. Our return of the customers of a customer's check for insufficient insufficient funds.

They were outstanding checks August 31 and a bank service charge. And if you go to the bottom, the simple question is at August 31. What is apex is correct cash balance. In other words, their basic question is if we're doing a balance sheet on August 31, What is the correct amount to put on that balance sheet under the heading cash?

Well, let's do it together. We know the bank statement. We know the bank statement on August 31 is showing a balance of 18,850. Now let's go through the reconciling items. How about the deposit in transit? Do I have to worry about that? Sure. You know what that is? That's a deposit I put in the bank I've recorded in my, I recorded it in my checkbook.

But it's in transit. It hasn't cleared the bank yet. It's not reflected my bank statement. So we'll add that 3000 to 50. We'll add that in. How about the return of the customer's check? Do I worry about that? No, don't worry about that because don't forget. We started with bank balance. That return check is already reflected in your bank balance.

That that recheck, that check was returned to the bank. So don't, don't forget. We started with bank balance here and that. Return to the customer's check that would have gone back to the bank. It's already reflected in your bank balance. How about the outstanding checks? Of course, we worry about that.

Those are checks that we've written, we've mailed them, but they haven't cleared the bank yet. So we'll back up about that

thousand seven 50. How about the bank service charge? No, don't worry about that because you started with bank balance. The bank service charge is on your bank statement. That's already reflected in the 18,000, over 50 bank balance. So don't worry about that. And if you add it up, it gives what it gives us what we need, the correct cash balance on our balance sheet, August 31 would be answer a 18,005 50.

And you'll find that when you start to do a few of these, the same things, come up again and again, outstanding checks, deposits, and transit return checks, bank service fees, interest. And once you've done a few, I think you certainly feel more and more comfortable with this. Let's do another one. Let's do number two.

Number two says the following information pertains to gray company. December 31, we know the checkbook balance 12,000. We know the bank statement balance December 31, 16,000. And then we also have this information about a check, but the basic question at the bottom is in Gray's December 31 balance sheet.

What amount would be reported this cash? So that's the question again, if we're doing a balance sheet, On December 31. What is the correct amount to put on that balance sheet under the heading cash? Well, I have a question for you. You're in the exam. You've got this question. If I'm trying to figure out what is the correct amount to put on my balance sheet as cash on December 31.

What's my best starting point. Should I start with the checkbook balance 12,000, or should I start with the bank statement balance 16,000. You may have noticed that there's answers whichever way, whichever way you go. If I start with the 12,000 there's answers there for me, if I start with the 16,000, this answers there for me.

So your starting point matters a lot here. So I guess what I'm asking you is, you know, theoretically. If I'm given a choice and I am here, what's theoretically stronger to start with checkbook or bank statement, checkbook bank statement. Definitely checkbook, definitely checkbook. You want to start with the 12,000 and why is that?

Why have you given a choice between checkbook and bank statement? Is it theoretically stronger to start with checkbook? Why is that? Well, let me ask you another way. Give me some big things. Think about some big things that could be missing from bank statement. Well, shore with bank statement, couldn't there be a lot of outstanding checks that haven't cleared yet.

It could be a lot of deposits in transit. And if you just think about your personal checkbook, doesn't your personal checkbook, reflect all the deposits you've made. All the checks you've drawn. I mean, you may mess up here and there, but your personal checkbook does reflect at least all the deposits you've made.

All the checks you've drawn. The problem with starting with bank statement is there could be a lot of deposits in transit. A lot of outstanding checks. At least your checkbook reflects all the deposits you've made. All the checks you've drawn. Now. Checkbook's not perfect either. Is it because what could be missing from checkbook return checks?

Bank service fees, interest, you know, checkbook's not perfect because what's missing from checkbook would be bank service fees, interest return checks bought those items tend to be immaterial. That's the argument. Those items tend to be a material. So the bottom line is if you given a choice between checkbook and bank statement, it's always good to start with.

Checkbook. So we're going to start with the 12,000, but then there's another issue we have to deal with. They say that a check was drawn on grays accounts, payable to a vendor dated and recorded December 31, but not mailed until January 10th. So it was dated and recorded December 31 year three, but they didn't mail it till January 10th.

Year four. All right. So let's think about this, that payment of 1800. Is that already reflected in the $12,000 checkbook balance? Yes. Cause they said it was dated and recorded. Recorded means it was booked. It was booked. So your $12,000 checkbook balance reflects that $1,800 payment. So of course the question is if we didn't mail that.

Until January 10 year four. Should we add it back? If you think you should it's answer B if you don't think you should, it's answer a that's where we are. Right? If you think you should add that back, you're looking at answer B. If you don't think you should add that back, you're looking at answer a, so should you add it back?

Yes, of course you should add it back. The answer is B you do add it back, but why, why do we add it back? What's the thinking there, because if we didn't mail that till January 10th, then on December 31, that cash was free and clear and available to be spent in current operations. Again, if I didn't mail that for January 10th, then on December 31, the data, my balance sheet.

That cash was free and clear. It was available to be spent in current operations. You have to add it back. And if this bothers, you just think about what adjusting entry I'd have my client make here. We know when they dated and recorded it, they would have debited accounts payable, credit cash, 1800. That's what they did when they recorded it.

On December 31, they would have debited accounts payable, 1800 credit cash, 1800. That's why it's reflected in your checkbook balance. But if I'm the auditor on a job like this, and I say, well, you didn't mail it until January 10th. So on December 31, you had the cash, the adjusting entry I'd have my client make his debit cash 1800, put the cash back because they had the cash on December 31.

That's why the answer is B and credit accounts payable. The liability goes back on the books. The liability goes back on the books because the liability was outstanding on December 31. So that's the adjusting entry that you'd met, debit cash, 1800 credit accounts payable, 1800, and put the liability back on the books as well.

You know what the issue is here, cut off. This is an issue of cutoff. The balance sheet is dated December 31. You didn't mail that to January 10th. We had the cash. I'd like you to try some questions now, and I'd like you to try. Three four, five and six do three, four, five, and six, shut the class down, do those problems and then come back and we'll go through them together.

Welcome back. Let's look at these problems together. In number three, they say at October 31, Dingo had cash accounts in three different banks. And that is the key that it's in three different banks. They say one account is segregated solely for November 15th payment into a bond sinking fund. The second, the second account used for branch operations is overdrawn.

The third account used for regular operations has a positive balance. How would these accounts be reported in the October 31 balance sheet? Well, I want you to look at answer. C C says the segregated account. The bond sinking fund is a non-current asset and the regular account would be a current asset net of any overdraft.

I just want you to know answer C is fine. If it's all one bank. If it's all one bank C works just fine. Why? Because banks have the right of offset. If you have two accounts at a bank, one has a positive balance. The other's overdrawn banks have the right of offset, but because this is three different banks, it's a, the segregated account.

The bond sinking fund is a non-current asset. The regular account is a current asset. And if you're overdrawn at another bank, that is a liability. Yeah, it has to be paid back. It has to be settled in the answer is a now in four and five, we're back to a more traditional sort of reconciling problem. They give us a basic reconciliation.

We know the balance per bank statement, March 31, and we can see how they added the deposits in transit. At the end of March, took out the loans, outstanding checks at the end of March, giving us. The proper balance, March 31. Then we also know what happened in April, the deposits during April, the disbursements during April and four says, what is the cash balance per books?

April 30th. What's the cash balance per books on April 30th? Well, let's work it out. We know that the. Bank statement balance on March 31 was 46,500. Okay. We work. Can we figure out what the bank statement balance must've been on April 30th? We know the bank statement balance on March 31 was 46, five that's given, can we work out what the bank statement balance was on April 30th?

They didn't give it to us, but we can work it out because we know all the deposits during April. We add 58,400. We know all the disbursements in April back out 49,700. So the bank statement balance on April 30th must be 55,200. That's the bank statement balance April 30th, 55,200, but they want to know the cash balance per books on April 30th.

So what else do we have to worry about? How about the outstanding checks at the end of April, there's still 7,000 of outstanding checks that haven't cleared yet. In April, those are checks. I've written, they're reflected in the books, just haven't cleared the bank yet. So back out the 7,000 outstanding checks notice there are no deposits in transit at the end of April.

So just back out, the outstanding checks of 7,000, there's your balance per books? April 30th, answer a 48,200. How about number five? What would the cash disbursements per books in April? Well, we know. The total April disbursements were given at 49,700. That's given the, as you're told disbursements for April per the bank, 49,700.

Now, does that represent all April disbursements? No, because of that 49 seven 12,600 represents checks that were outstanding at the end of March, that cleared in April. I hope you're with me on that point. When you look at the 49,700 of disbursements per bank in April, that's not all April disbursements because 12,600 of that would be the outstanding checks at the end of March clearing in April.

So back out the 12th six, that brings you down to 37,100 and the other disbursements per books. Yeah. How about the 7,000 outstanding checks at the end of April? There's another 7,000 checks on the books that we've. We've written, we've mailed them, just haven't cleared the bank yet. Not reflected in the bank disbursements.

So add another 7,000 of disbursements on the books. Haven't cleared the bank yet. You told disbursements on the books would be answered again. 44,100. Let's look at number six, June 30th. This company's cash balance was 10,000 Oh one, two. And they're asking what's at the bottom. What is the adjusted cash balance for this company?

June 30th. So what adjustments do we have to make? Well, their books are showing a cash balance of 10,000 Oh one two, but there's a problem with check one Oh one. The actual amount of the check was $95. That was the actual amount of the check one Oh one $95. But somehow it was recorded in the books at 59.

The numbers were transposed. So the difference between. 59 and 95. We're going to come back out another $36. So the book balance is wrong because that $95 check that was the correct amount was recorded on the books at 59, the numbers were transposed. So that $36 difference. We back out. How about the interest that we earned?

Well, that's not reflected in our books yet, so we add the interest. We earn $35 and then the. $50 a service charge on the bank statement. That's not reflected in the books yet. Back out the service charge of 50 and the correct cash balance per books, June 30th would be answered B 9,009 61. So you can see the type of problems that the FAR CPA Exam can have with cash.

The issues that come up with cash, but the most heavily tested thing. Having to do with cash in the CPA exam, our bank reconciliations. So as I said before, once you get a little experience with bank reconciliations, the way the FAR CPA Exam comes at bank reconciliations, and you do a few in your homework, which I know you will, I don't think you'll have any problem there at all.

On to accounts receivable. And let me say right off the bat, that the primary thing that the FAR CPA Exam hits with accounts receivable is accounting for bad debts. So let's dive right into it.

There are. Two methods of accounting for bad debts. There is the direct write-off method and there is the allowance method. So that right away, that's what you're up against. There are two methods of accounting for bad debts. You've got the direct write-off method and you've got the allowance method.

Let's start with the direct write-off method. Just remember this basic point under the direct write-off method, a company makes no entry for bad debts until something happens. Until a customer actually defaults. And when the customer defaults the account is written off at that point, that's what we mean.

When we say the direct write-off method, the company's not making any entry for bad debts. They do nothing for bad debts until a customer defaults. And as I say, when the customer defaults, the account gets written off at that point, let me give you a quick illustration. Let's say that a company does use the direct write-off method, and let's say that.

Back in year one, the company made a $900 sale on account. So back in year one, if the company made a $900 sale on account, we have to assume they would make, they would have made the normal entry. They would debit accounts receivable 900. They would credit sales 900, the normal entry. Now we're going to assume that this company has hasn't collected a dime on this account in year one, year two, year three.

And then finally in year four, the company decides to give up their collection efforts. You know, maybe the customer has left the country. Maybe the customer's declared bankruptcy. the FAR CPA Exam won't give you lots of detail. But the basic point is that in year four, for whatever reason, the company decides to give up their collection effort.

Here's my point. If the company uses the direct write-off method. In my example, there would have been no entry for bad debts in year one, no entry for bad debts in year two, no entry for bad debts in year three, but in year four, When the company gives up their collection efforts, they would book an entry.

They would bet they would debit bad debt expense, 900. They're going to debit bad debt expense 900. And that expense goes to the income statement for year four. And what would they credit accounts receivable 900. They would write off that account. And that's pretty much all there is to it. That in a nutshell is the direct write-off method where a company makes.

No entry for bad debts. They do nothing for bad debts till the customer defaults. And when the customer defaults the account is written off at that point. And as I'm sure, you know, from a theoretical standpoint, the direct write-off method is extremely weak. And I know you're aware what the problem is.

The matching concept. Just look at this example, when I do my year for income statement, what I end up matching year for sales. With an expense. I really incurred back in year one. See, that's a problem because of course the whole objective of the matching concept on an income statement is to match current revenues with current expenses.

That is our basic objective onto the matching concept where on an income statement, our attempt is to match as best as we can. Current revenues with current expenses, we'll notice the direct write-off method distorts that. If you just think of the example we just went through. When this company does the year for income statement, don't they end up matching year for sales, with an expense.

They really incurred back in year one. They didn't know it at the time, but the direct write-off method from a theoretical standpoint is extremely weak because of the matching concept is the direct write-off method acceptable under generally accepted accounting principles. It is, as long as the company's bad debt expenses are an immaterial item on the income statement.

So I'll say that again, a company can use the direct write-off method under GAAP, as long as the company's bad debt expenses are an immaterial item on the income statement and you know exactly what I'm going to say.

If a company's bad debt expenses are a material item on the income statement. If bad debt expense is a material item on the income statement, the company is required to use the allowance method to account for bad debts. Let's get into that. What you're much more likely to see in the exam. Under the allowance method, a company is going to estimate the accounts that they think will go bad and set up a provision on allowance for bad debts and allowance for the accounts they think will go bad on their balance sheet.

It's a very different approach. That's the allowance method, where we estimate the accounts. We think we'll go back and set up a provision on our balance sheet, on allowance, on our balance sheet for the accounts we think will go bad. Now I'll say this right off, right, right off the bat, the big, the thing to remember about the allowance method and it messes a lot of people up.

You have to remember about the allowance method, that there are two approaches to the allowance method. There is an income statement approach. And there is a balance sheet approach. You have to remember that about the allowance method, that there are two approaches to the allowance method. There is an income statement approach, and there is a balance sheet approach to the allowance method.

And once you get that in your, in your mind, this really is the key to the FAR CPA Exam on this. Once you're solid on that point, this becomes a lot easier. Let me show you what I mean. Let's go to question number seven.

They say the following information pertains to oral corporation. We know the credit sales for the year ended December 31, 450,000. We know that the allowance account had a credit balance back on January one of 10,800. We also know during the year they wrote off 18,000 of bad debts. That's the information we're given.

Now. You'd probably think of this anyway, but I'll just give you this advice, an excellent approach to allow us for bad debts questions. When you get them in the FAR CPA Exam is to grow, go to your scrap paper right away and put down a T account for the allowance count. It really helps. So try to remember that.

Anytime you get a question on the allowance method, just right away, go to your scrap paper, they give you a scrap paper and the exam, use it and put down a T account for the allowance council. Let's say we do that. We'll put down our T account for the allowance account and let's put in what we know about it.

We know that back on, back on January one, The allowed scout had a $10,800 credit balance. We also know during the year they wrote off 18,000, the bad debts. So you just kind of mentally put that in. If they wrote off 18,000 of bad debts, why did we do that? They make, when they, when they, when an account goes bad, they would have debited the allowance account 18,000 credit, the individual accounts receivable, 18,000.

Remember in this approach, when accounts go bad, we debit the allowance account. We have a provision on our balance sheet, on allowance, on our balance sheet for the account, we think we'll go bad. So when an account goes bad, we're going to debit the allowance account. In this case, 18,000 and credit, the individual accounts receivable 18,000.

Just write off those counts. Here's my point. After that activity, there is now a $7,200 debit balance. It allows for bad debts. I hope you're with me on that. So, if you look at that T account right now, there is a $7,200 debit balance in allowance for bad debts. Now let's read on, they say, according to past experience, 3% of Oros credit sales have been uncollectable.

You might want to underline 3% of credit sales and just right above that income statement, approach, noticing this problem, they're basing their estimate on the income statement. See, when you say, you know, 2% of gross sales tend to go bad. 1% of net sales tend to go bad. Or in this example, 3% of credit sales tend to go bad.

You're basing your estimate on the income statement. You know, 1% of gross sales tend to go bad. 2% of net sales tend to go bad. In this example, 3% of credit sales tend to go bad. You are basing your estimate on the income statement. And here's the point when you base your estimate on the income statement?

It does not matter that there's a $7,200 debit balance in allowance for bad debts, that'll have no bearing on your adjusting entry every year. You just take 3% of credit sales. So when they get to December 31, they're going to take 3% afforded and 50,000 and they're going to debit bad debt expense.

13,500 and they're going to credit allowance for bad debts, 13,500. So we'll put that in our T account, but the basic point is when you base your estimate on the income statement, when you use the income statement approach to the allowance method, it does not matter that there's a $7,200 debit balance in allowance for bad debts.

That has no bearing. On your adjusting entry, whether there's a debit or credit balance in allowance for bad debts, that will have no bearing on your adjusting entry every year. You just take 3% of credit sales. So as I say, I'm going to take 3% of four 50 at year end debit, bad debt, expense 13 five credit allowance for bad debts, 13 five.

And when I put that in the T account and they asked me at the bottom, after the provision is made for bad debt expense for the year, what is the balance in the allowance account? Well, if you look at your T account, Now the balance in the allowance account, after that adjustment is a credit of 6,300 and the answer is

let's look at question number eight, based on an aging of receivables. You should circle that word aging and right above it, balance sheet approach. See, this is a completely different approach. Now we're going to base our estimate on an aging of receivables on analysis of receivables. This is the balance sheet approach to the allowance method based on an aging of receivables at December 31, Terry company determined that the net realizable value of the receivables at that date.

Is 190,000 additional information follows. We know the accounts receivable at December 31, 220,000. We know back on January one, the allowance account had a $32,000 credit balance. And during the year they wrote off 24,000 of bad debts. Well, you know, me, I get a question on allowance for bad debts right away.

I'm going to go to my scrap paper in the exam, put down a T account. For allowance for bad debts. Now let's put in what we know about it. We know back on January one, the allowance account had a $32,000 credit balance. Put that in. We also know that during the year they wrote off $24,000 of bad debts. So you just kind of mentally put that in.

What they would have done is debit. When accounts go bad, they debit the allowance count. In this case, 24,000 credit, the individual accounts receivable 24,000 right off the accounts. We'll put that in. You see my point after that activity, there's now an $8,000 credit balance in allowance for bad debts.

That's where we are. But I want to go back to the point. This is the balance sheet approach. Now they're basing their estimate on the balance sheet on aging of receivables on analysis of receivable. So we're going to have, do a little side calculation. What do we know about the receivables? Well, don't we know that they're gross accounts receivable at December 31 totals 220,000.

So we put that down a little side calculation. What do we know about the receivables? We're analyzing the balance sheet. It's the balance sheet approach. We know that gross accounts receivable at December 31, total is 220,000, but they said based on an aging of receivables, they only expect to net one 90.

They expect the net realizable value of receivables, just to be one 90. So take that two 20 back out one 90. What are aging is tele telling us is that we need a $30,000 provision for bad debts. If our gross accounts receivable at December 31, total is 220,000, but based on an aging Whaley expect to net one 90.

What our aging is telling us what our analysis of the balance sheet is telling us is that we need a $30,000 provision for bad debts. Now go to your T account. What do we have as a balance in the allowance account? Now 8,000, I have to adjust that up to 30,000. So I'm going to debit bad debt expense, 22,000.

I'm going to credit allowance for bad debts, 22,000. And that'll bring the allowance account from 8,000 up to 30,000, which my agent says I have to have. So when they asked me at the bottom, what is Terry's doubtful accounts expense. December 31. They want to know the expense on the income statement and that's answer B, excuse me.

That's answer D 22,000 answer date. That's the expense on the income statement? Right before I made my adjustment, there was an $8,000 credit balance in allowance for bad debts. My agent says I need a $30,000 allowance for bad debts. So I have to adjust for the difference. I debit bad debt expense 22,000.

That's why the answer is D. And credit allowance, bad debts, 22,000. That'll bring the allowance account from 8,000 up to 30,000, which my agent says I have to have he see the difference in the balance sheet approach to the allowance method. Your job is to adjust the allowance account to its proper balance.

So on the balance sheet approach, you have to consider whether there's a debit or credit balance in the allowance account before you make your adjusting entry, because your job in the balance sheet approach is to adjust the allowance account. To what's required balance.

Let me show you something else that comes up with the allowance method. Let's say that a company does use the allowance method, and let's say that $300 account has gone bad. So a company does use the allowance method. And let's say that a $300 account has gone bad. Well, if a $300 account has gone bad, we have to assume the company would make the normal entry.

They would debit the allowance account 300 credit, the individual account receivable 300. That's the normal entry in the allowance method. When an account goes bad, you know what the FAR CPA Exam likes, what happens in this method? If two weeks go by two months, go by. And now the check comes in. What if you collect on account that you've written off, you know, let's say six months later, you go to your mailbox, the check is there.

What do you do in the allowance method? If you collect on account that you've written off? Well, let me just quickly say that there's more than one way you can handle this. I'll just show you what I think works the best. If you collect an account that you've written off, all, we start by reversing. The entry that you made when you wrote it off, just think reverse.

You've got to reverse the entry that you made when you wrote it off. So now I'm going to debit account receivable 300. Re-establish the account credit, the allowance account 300. And then I simply record the payment, like any other payment, debit cash, 300 credit accounts receivable, 300. That'll always work.

Just reverse the entry that you made when you wrote it off. So I'm going to debit account receivable. Re-establish the account. Credit the allowance account 300. And then as I say, record the cash, the payment, like any other payment debit cash, 300 credit accounts receivable, 300. That'll always work, reverse record the payment, reverse record the payment reverse record the payment.

It's not the only way to do it, but I think it's a good, clean, easy way to handle that situation. I'd like you to try some problems on this, please do nine, 10, and 11, and then come back.

Welcome back. Let's do these questions together in number nine, we're talking about Inge company and you know, the way I feel about this you're in the exam. You get a question on allowance for bad debts, right away. Go to your scrap paper. Put down a T account for the allowance account. Let's assume you did that.

And let's put in what we know about it. We know that the allowance account started a year ago with a $30,000 credit balance. And we're also told that during the year they wrote off 18,000 of bad debts. So you kind of put that in mentally. We know when accounts go bad, we would have debited the allowance count 18,000 credit, the individual accounts receivable, 18,000, and then you see what they threw in.

Uncollectible accounts recovered during the year. That 2000 bothers a lot of people, but I'm hoping you always remember. Anytime you see this reverse record, the payment reverse record the payment, you always start by reversing the entry that you made when you wrote it off in the first place. So now just mentally you reverse the entry that you made when you wrote it off, you would debit accounts receivable.

Re-establish the account. Credit the allowance account 2000. And then as I say, you just simply record the payment, like any other payment, debit cash, 2000 credit, the account receivable 2000, which we don't really have to put down because it doesn't affect the allowance account. But here's my point in terms of the allowance account after all that activity.

If you work it out, there's now a $14,000 credit balance in allowance for bad debts. And you know what I'm going to ask you because I would ask you every time in this problem, are they using an income statement, approach, or a balance sheet approach, a balance sheet approach. They base their estimate on an aging of receivables on an analysis of receivables.

Now, what do we know about this? We know at year end, December 31. They're gross accounts receivable totals 350,000 based on an aging. What do they expect to net? Just 325,000. So what your aging is telling you is that you need a $25,000 provision for bad debts. You need a $25,000 allowance for bad debts.

Now look at your T account. Since you already have 14,000, you have to adjust it by 11. So you're going to debit bad debt expense, 11,000. Credit allowance for bad debts, 11,000. And that'll bring the allowance account from 14,000 up to 25,000, which your aging says that you require because that's your job and the balance sheet approach to adjust the allowance account to what's proper balance.

That's why in the balance sheet approach, you have to consider whether there's a debit or credit balance in the allowance account. Before you make your adjusting entry. Because your job again, is to adjust the allowance account to what's required balance. So when they say at the bottom for 2003, what would be inges uncollectable accounts, expense.

What's the expense on the income statement for bad debts? You know, it's 11,000 answer B. Let's go to number 10, January 1st Jaymin company. Had a credit balance of 260,000 in allowance for bad debts, go to your scrap paper, put down a T account. We know a year ago, January one, they had a $260,000 credit balance in allowance for bad debts notice during the year they wrote off 325,000.

The bad debts we'll put that in. They would have debited the allowance account 325,000 credit. The individual accounts receivable 300 and twenty-five thousand. So after that activity, there is now a $65,000 debit balance. In allowance for bad debts. You'll know what I'm going to ask. Does Jaymin use an income statement, approach, or a balance sheet approach to the allowance method, income statement, approach.

They base the rest of it on the income statement. They expect 2% of their credit sales to go bad. Now their credit seal, their credit sales for the year were 9 million times 2%. So we know they're going to debit bad debt expense, 180,000 credit allowance for bad debts, 180,000. Because, you know, in the income statement approach, it doesn't matter whether there's a debit or credit balance in the allowance account that has no bearing on your adjusting entry every year.

You just take 2% of credit sales. So when they get to December 31, they'll take 2% of 9 million debit, bad debt expense, 180,000 credit allowance for bad debts, 180,000. And when you make that adjustment, that brings the balance in the allowance account up to answer a. A credit balance of 115,000. And that's what they wanted the balance in the allowance account, December 31 at the end of the year, answer a 115,000 number 11 haul company right away.

We'll set up a T account for the allowance account. A year ago, January one, they had a $24,000 credit balance in allowance for bad debts during the year. They wrote off 96,000, the bad debts we'll put that in. They would debit the allowance account 96,000 credit, the individual accounts receivable, 96,000 we take, or that after that activity, there's a $72,000 debit balance in allowance for bad debts.

Is this the income statement approach or the balance sheet approach? It's the balance sheet approach. They based their estimate on an aging of receivables on analysis of the balance sheet. Now, what do we know about the balance sheet we know at year end? That based on an aging, they need a hundred thousand dollar allowance for bad debts.

Well, since they already have a $72,000 debit balance in allowance for bad debts, and our aging says we need a hundred thousand dollar credit balance, it allows for bad debts. We're going to have to debit bad debt expense, 172,000. And we're going to have to credit allowance for bad debts, 172,000 to bring the allowance account from a debit of, of 72,000 to a credit of 102, a credit of a hundred thousand.

That's our job here. Adjust the allowance account to what's required balance to bring that allowance account from a debit balance of 72,000 to a credit balance of a hundred thousand, which our aging says we need just remember in the balance sheet approach. You have to consider whether there's a debit or credit balance in the allowance account before you make your adjusting entry, because your job in the balance sheet approach is to adjust the allowance account to what's required balance.

So when they ask us at the bottom, what is the uncollectable accounts expense for the year? It is answer a 172,000.

Now, before we leave accounts receivable, I want to go through a couple of terms that you might see in the exam. What does it mean to pledge receivables factor receivables, assign receivables. Let's talk about these terms. When a company pledges, their accounts receivable. What that means is that they are using their accounts receivable as security for a loan.

And the big thing to remember about pledging receivables is that when you're pledging your receivables, anytime you've pledged your receivables, anytime you're using your receivables as security for a loan, you have to footnote that shareholders creditors are the interested parties have to know about that.

If you've used your receivables as security to get alone. So just remember if you pledge your receivables, that is a required footnote. What does it mean if a company factors their receivables without recourse? Well, if a company factors their receivables, what that means is that they have actually sold their receivables to a factor.

That's what it means to factor receivables. The companies actually sold the receivables to a factor, and if they sell them without recourse, Without recourse means if the customer's default, the factor has no recourse to come after the company for additional funds. In other words, when you factor your receivables without recourse, the sale is final.

The sale is final. If the customer defaults that's the factors problem, the factor has no recourse to come after the company for additional funds. So in terms of the entry, if a company factors their receivables without recourse, The sale is final. Just treat it as a sale. The company will debit cash for whatever the factor gives them.

Credit accounts receivable for the book value, and they'll recognize a gain or loss on sale. It's almost always a loss because the factor will give you a discounted price. So debit loss on sale, but because the sale is final, the company will recognize a gain or loss on sale. The factory has no recourse to come after the company for additional funds.

All right. Now, one other possibility. What if a company factors their receivables with recourse or assigns their receivables with the recourse, will I know you're ahead of me. When you see with recourse, it means the sale is not final. That's exactly what it means. The sale is not final. If the customer defaults now the factor or the assignee has recourse to come after the company for additional funds.

Just think of it this way. If you factor your receivables with the recourse who collects the receivables, the factor or the company, the company still collects the receivables, the sales not vinyl. So if you factor your receivables without recourse, you factor your receivables without recourse sale is final.

You've sold your receivables. The factory will collect the receivables. That's their problem. But if you factor your receivables with recourse or assign your receivables with recourse, the sale is not final. So the factor is not going to click the receivables. The company is going to collect the receivables.

And when you really analyze it, when you factor your receivables with recourse or assign your receivables with the recourse, it's really just another way of. Using your receivables as security for a loan. So in terms of the entries, they're pretty, they're pretty straightforward. When you factor your receivables with recourse or assign your receivables with recourse.

Since the company is still going to collect the receivables, the sales, not final on their balance sheet, they're going to separate the receivables they factored, or the receivables they've assigned from all their other receivables. So they're going to debit accounts receivable, factored or accounts receivable assigned.

And credit accounts receivable that way on their balance sheet, they've separated, the receivables they factored, or the receivables they've assigned from all their other receivables tends to be their large ones, some of their larger accounts. And as I say, it's really just using the receivables as security for a loan.

So now they'd make another entry where they debit cash and credit notes payable. And then what basically happens is the company collects the receivables because the sales not final, the companies still collect the receivables. And as the company collects the receivables, they pay off the note with interest.

We don't have to go through all those entries, but that's now what happens. The company still collects the receivables and as they collect the receivables, they pay off the note with interest. Whereas if you factor without recourse, the sale is final. The factor collects the receivables. The receivables are the factors problem.

Now. That is the difference. All right, now we're done with accounts receivable and what we're going to get into next is notes receivable

in the area of notes. The first thing I want to get into. Is how you discount a note. And of course, you know, when I say discount a note, I mean, we take a note to the bank and we get cash for it. So how do you discount a note? Let's go to a problem. Number 12 says Rand excepted from a customer, a $40,000 90 day, 12% interest bearing note dated August 31, 2007.

Then on September 30th, 2007, Rand. Discounts the note at apex bank and notice the bank's discount rate is 15%. However, the proceeds were not received until October one. We're doing a balance sheet on September 30th. You're doing a balance sheet on September 30th, the amount receivable from the bank based on a 360 day year would include interest revenue of how much let's get into how you discount a note.

And. The secret to discounting a note is you always start by calculating the maturity value of the note. That's always your first step. You've got to figure out the maturity value of the notes. Let's do that. I'm going to take the $40,000 note from this customer. It bears interest to 12%. So what is that?

40,000 times 12%. That's 4,800 of interest for a full year, but it's not a full year note. It's a 90 day note. So I'm going to multiply by 90, over three 60. They said, they said it's based on a 360 day year. So the point is there's $1,200 of interest due at maturity. Plus the 40,000 of principle, the face value of the note, that means that the maturity value of the note would be 41,200.

That's what my customer has promised me. If I'm Rand, my customer has promised to pay me $41,200 90 days from now. And the reason you have to start by calculating that maturity value is that's the amount the bank works with. The bank is going to take that maturity value. 41,200 times, the banks discount rate 15% now times how long the bank holds the note.

So a lot of people make a mistake. You've got to take that maturity value. 41,200 times the bank's discount rate, 15% times how long the bank's going to hold the note. This was a 90 day note. It was dated August 31. When did rang, when did Randy go to the, when did Rand go to the bank? September 30th, after 30 days.

So if it's a 90 day note and ran, went to the bank after 30 days, how long is the bank on a hold the note? 60 days. So I'm going to multiply by 60, over three 60. The bank is going to keep $1,030. So remember that little twist there it's the maturity value times the bank's discount rate times how long the bank's going to hold the note times 60 over three 60.

So the bank is going to keep $1,030. So take that maturity value. Forty thousand forty one thousand two hundred, the maturity value minus what the bank keeps 1,030. What the bank's going to give Rand when they discount. The note is the difference 40,001 70. Now we have this odd thing where the proceeds are not received until October one.

We're doing a balance sheet on September 30th. So we're going to debit receivable from bank 40,001 70. We're going to credit the note receivable 40,000 and credit interest revenue, $170. So the answer is a, the amount that's going to be collected from the bank. It's going to include. Interest revenue of $170.

So just make sure when you win the exam, you'll know how to discount a note. Now we're going to stay on notes. And what I want to get into next is how you handle a note that has no provision for interest. A big tip, big tip off in the FAR CPA Exam is when you see the phrase non-interest bearing note, when you see that phrase, non-interest bearing note, you know, there's something wrong.

Why? Because. Notes are supposed to bear interest. Remember accounts receivable, accounts payable do not bear interest, but notes receivable notes payable are supposed to bear interest. So that's my point. You're in that exam, you see that phrase, non-interest bearing note, you'll know this, something wrong.

And here's the bottom line. When you see a non-interest bearing note, your job in that exam is to impute or Infor. The interest that must be in that note. That's your job in that exam to impute or infer the interest that must be in that note, let's go to a problem. Number 1313 says on January 1st, 2005, Eliya sold.

Now notice we're on the seller side here. And you have to know with non-interest bearing notes sometimes in the exam, your, on the seller side, sometimes on the exam, you're on the buyer's side here we notice we're on the seller side, Eliya sold a building which had a carrying amount of 350,000 receiving $125,000 cash down payment.

And notice as additional consideration, a $400,000 is the phrase non-interest bearing note due January 1st. 2008. Now, as I say, when you see that phrase, you know, that something wrong, we're going to have to impute or infer the interest that must be in this note, they go on to say there was no established exchange price for the building.

What does that mean? When you see that sentence, that there was no established exchange price for the building that tells you, you don't know the building's cash price, you don't know what the building would sell for in cash. So what do you use. The discounted present value of the payments let's read on, they say the prevailing rate of interest for note of this type is 10% present value of a dollar.

A 10% for three periods is 0.7, five. And at the bottom they say, what amount of interest income would be included in ileus 2005 income statement? What is the interest income for Ilias 2005 income statement. You see why answer a, is there. Because they hope you sit in the FAR CPA Exam and go away. They're just trying to trick me.

It's a non-interest bearing note. There is no interest. We know it's not that simple. Again, our job here is to impute or infer the interest that must be in this arrangement. Let's do a couple of entries because I think it helps. Let's go back in time. Let's go back to January 1st, 2005. If I'm Ilya in this problem, what three would I make when I sell the building?

Well, you know, I'm going to debit cash 125,000 because I got the debt, the cash down payment. Now listen carefully. If there's a secret to non-interest bearing notes, it's this always remember to record the note at its discounted present value. That's the secret with non-interest bearing notes. You have to remember to record the note at its discounted present value.

So they said the prevailing rate of interest for note of this type. It's 10% present value of a dollar 10% for three periods. Point seven five. I'm going to take that factor 0.75 times the face amount of the note, 400,000. And I'm going to debit note receivable for it's discounted present value 300,000.

That's really the secret here. Record the note at its discounted present value. Now, if I'm Ellie, I'm going to credit the building. Remember I'm selling a building, I'm going to credit building for its carrying value. 350,000. And I'm going to credit gain on sale 75,000. That's the entry that Iliya should make back on January one.

Now, before we continue this problem, I just want you to think about something they said in this problem that this is a non-interest bearing note. That's what they said. If you had the document, you would see the way that the lawyers drew it up. It says it all over it. This is a non interest bearing note.

It says beautiful gold script. Non-interest bearing notes, written all over it. Here's my question, in your opinion, is there any interest in this note? Of course there is how much, how much interest exactly is there in this note? A hundred thousand. Why? Because a promise to pay me 400,003 years from now is worth 300,000 today.

Why am I getting that extra a hundred thousand? Because I'm willing to wait three years. We call that interest. That's the thinking here. A promise to make, to pay me 400,003 years from now is where 300,000 today. The reason I'm getting that out a hundred thousand is because I'm willing to wait three years.

We call that interest. We impute, we infer the interest that must be in this arrangement. All right, let's go ahead a year. It's now December 31, 2005, follow up email, you would do. Eli is going to take. The going rate of interest for note of this type 10% times, the carrying value of the note 300,000, remember to use carrying value, not face value when you're doing these calculations, always use the carrying value of the note, not face value.

So Ellie's is going to take the going rate of interest for note of this type 10% times, the carrying value of the note, 300,000 Ilias going to debit note receivable, 30,000 and credit interest income, 30,000. And that's why the answer is B. Not a, we impute, we infer the interest. That must be in this arrangement.

Let's go ahead another year. Let's say it's December 31, 2006. What ill you make the same entry? No, be careful when Eliya gets to December 31, 2006, the interest rate is still 10%, but the carrying value of the notice changed because of our adjustment back on December 31st, 2005. Now the carrying value of the note is what.

330,000, right? Because of our adjustment back on December 31 Oh five, the carrying value of the notes gone up 30,000 to 330,000 times, 10%. So Isla would debit note receivable, 33,000 credit interest income, 33,000 watch out for the second year. Sometimes they'll ask for the interest for the second year, and you've gotta be aware that as you go from payment to payment, the payment.

The interest rates not going to change, but the carrying value, the note keeps changing. Let's stay on this problem. What if I'm the buyer here? Same problem. What if I'm the buyer? What would I do back on January one? Well, if I'm the buyer back on January one, I'm going to credit notes payable for it's discounted, present value.

Hey, face value notice 400,000 bucks. Prevailing rate of interest for note of this type is 10% present value of a dollar 10% for three periods is 0.75. If I'm the buyer, I'm going to take that factor 0.7, five times the face amount of the note, 400,000. And I'm going to credit notes payable for it's discounted present value 300,000.

I'm going to credit cash for the down payment, 125,000. And I'm going to debit the building 425,000. That's what the building does. I mean, that's what the buyer does of the building. Debit building 425,000. I just want you to be confident that we impute interest, whether we're on the seller side or the buyer's side equally, let's go ahead a year.

What's the buyer going to do December 31, 2005. While the buyer just like the seller has to take the going rate of interest for note of this type 10% times, the carrying value of the note 300,000. Debit interest expense, 30,000 credit notes payable, 30,000 notice the buyer has to recognize interest expense, and let's just carry it through what happens on December 31, 2006, while the interest rates still 10%.

But because of our adjustment back at December 31 Oh five, now the carrying value of the note is 330,000 times 10%. So the Bible debit interest expense, 33,000 credit notes payable 33,000. As I say, watch out for the second year, because as I say, as you go from payment to payment, to payment, the effect of interest rates, not going to change, that's a one-time determination and it doesn't change over the life of the note.

But what keeps changing of course, from payment to payment to payment is the carrying value of the note because that's always what you work with. Carrying value, not face value. I'd like you to try a couple of these. I'd like you to do a set. 14 and 15, so please do 14 and 15 and then it comes back and then come back.

Welcome back. Let's do the set together. They say that on January 2nd, 2000 2:00 AM sold. So you notice right away we're on the seller side. M sold equipment with a carrying amount afforded 80,000 in exchange for $600,000. There's the phrase non-interest bearing note due January 2nd, 2005, then they say there was no established exchange price for the equipment.

We know what that means. We don't know what the equipment would sell for in cash. We don't know what's cash price. So we're going to use the discounted present value of the payments and they go on to say the present value. They say the prevailing rate of interest for note of this type. It's 10% present value of dollar or 10% for three periods.

Again is 0.7, five, and they ask us two questions. Now, before we answer the two questions, you know me, I like entries. Let's go back to January 2nd. What entry would M make when em made that sale? Well, we know that the secret to non-interest bearing notes, if there is one is to remember to record the note.

At it's discounted present value. So if you're M you're going to take the going rate of interest, but no, to this tight 10%, we know that the PR the present value of a dollar 10% for three periods is 0.75. So you'll take that factor 0.7, five times the face amount of the note, 600,000. And Emma's going to debit note receivable for its discounted present value 450,000.

And we'll credit the equipment for its carrying value. 480,000 and debit a loss on sale of 30,000. And if he got that entry down, now you can answer number 15, 15 says in M's 2002 income statement, what amount would be reported as gain or loss on sale? Well, you know, it's a, there is a $30,000 loss on sale.

And not only that, but when a year goes by and it's December 31, 2002, which is what question number 14 is all about. What's I'm going to do well. AMA is going to take the difference between the face amount of the note, 600,000 and it's discounted present value 450,000 M takes that $150,000 discount. And amortizes it to interest revenue over the life of the note.

And you know how to do that at December 30 1:02 AM is going to take the going rate of interest for note of this type 10% times, the carrying value of the note. 450,000. And that was going to debit note receivable 45,000 and credit interest income, 45,000. That's why 14 is B. I think if you do a couple of entries, the answers, hopefully just shake out for you.

Try number 16 and come back.

Welcome back in number 16, they say on January one of year three, millets changed equipment for a $200,000. There's the phrase non-interest bearing note due January 1st, year six. The prevailing rate of interest for note of this type 10% present value of a dollar or a 10% for three periods, again, 0.7, five, and they want to know interest income.

Well, once again, let's think about what mil would do back on January one. We know that mill would record the note at its discounted present value. So mill would take that factor 0.75 times the face amount of the note, 200,000 mill would debit note receivable for its discounted present value 150,000. And we'll just credit sales, 150,000.

We don't know the carrying value of the equipment. We'll just credit sales, 150,000. The point is that we're not going to let mill overstate their sales. The real sale for mill is 150,000. The rest is interest. We don't care how the lawyers drew it up. We impute, we infer the interest that has to be in this note.

Now a year goes by it's December 31 year three. What mill is going to do is take the going rate of interest for note of this tight 10% times, the carrying value of the note, 150,000 and debit note receivable, 15,000 and credit interest income, 15,000. They wanted interest income. So the answer is B, right?

No, B would be fine if they want the interest income for year three, but they don't. They want the interest income for a year, for the second year. That's why I warned you on this earlier in the class. Sometimes in the exam, they want the interest for the second year. You know what I'm saying? If you pick the answer be you certainly know what you're doing, but watch out for dates.

They want the interest income for year four. So let's carry through to year four. When mil gets to December 31 year four, the interest rate is still 10%, but because of the adjustment in year three, now the carrying value of the note is 165,000 times, 10%. So Millville debit note receivable, 16 five, and credit interest income, 16 five.

And that's why the answer C I'd like you to try number 17 and then come back.

Welcome back in number 17, they say on December 30th year for Chang sold run the seller side, chatting, sold the machine to door in exchange for a non interest bearing note. Requiring 10 equal annual payments of $10,000 each. So for the first time, in a problem like this, we have an annuity, a series of equal periodic payments over a specified number of periods.

They go on to say that DOR made the first payment on December 30th year for the first day, the market rate for similar notes, 8%. Then they give us present value factors. Together. Let's think about this. What entry would Chang make the seller on December 30th, year four when Chang makes the sale, what will Chang do?

Well, just think of this. When does Chang get the first 10,000 today? They said the first payment was made right away. December 30th, year four. So Chang we know is going to debit cash 10,000. And now we know the Chang should always record the note at its discounted present value. So let's get our interest factor.

You know, I don't want the first table. I don't want present value of a single dollar. I want present value of an ordinary annuity at 8%, but what bothers some students? I don't want the factor for 10 periods. I want the factor for nine periods. 6.25. Why? Because our job here is to discount the other nine payments after all.

Chang has received the first payment. This is an annuity and advance. We got the first payment immediately at the beginning of the first period. So as I say, our job here is to discount the other nine payments. So you see why we'd want the factor for nine periods, 6.25. Take that factor. 6.25 times the equal payments in the note, 10,000 Chang is going to debit note receivable.

For it's discounted present value 62,500 and credit sales, 72,500. That's the entry for Chang. So when they ask us at the bottom in the December 31 year for balance sheet, what amount with Chang report for the note receivable it's answer. See it's discounted present value on that day. 62,500.

We're going to get into next are notes that do have interest. These are interest bearing notes, but the interest is too much or it's too little. What you have to be careful about in the FAR CPA Exam is a note. That has unreasonable interest. Let's go to a problem. Number 18 says on December 31 year one jet received two $10,000 notes receivable from customers in exchange for services rendered.

So right away in this problem, there are two notes we're going to have to deal with. They say on both notes, interest is calculated on the outstanding principal balance at the annual rate of 3%. So notice. Both notes, do bear interest at 3% and everything's payable at maturity. There are no periodic payments.

The note from Hart made on the customer trade terms is due nine months. The note for max is doing five years, and then they say the critical point. The market rate for similar notes is 8%. See what you have here is unreasonable interest. How do I know that? Because both notes, bear interest at 3%, but a fair rate for similar notes.

Is 8%. So there is interest, but it's not enough. Then they give us present value factors. At 8% we know present value of a dollar at 8%, do a nine months 0.9 44 and present value of a dollar doing five years at 8%, which is 0.6, eight. Oh. They ask at the bottom at what amounts would these two notes be reported in jets December 31 year one balance sheet?

Well, let's start with a note from heart. Let me show you what jet wants to do if I'm jet and I get that $10,000 note from heart for services, I don't want to worry about the 3% and the 8%. I want to have a simple, uncomplicated life. You know what I want to do. If I'm jet, I want a debit note receivable, 10,000 and credit sales, 10,000, a simple uncomplicated life.

Let me just debit note receivable, 10,000 credit sales, 10,000. In other words, what Chad is saying is, Hey, in my book, That's a $10,000 sale. Now here's the question, considering that the note from heart bears interest at 3%, but a fair rate of interest with this kind of note is 8% can jet do that? Yes, there's no problem.

Why? Because when a note is made under customary trade terms, if a note is made under customary trade terms and is doing less than a year, notice the note from heart is doing nine months. That's really the critical point. So if a note is made under customer trade terms, and it's doing less than a year, there's no requirement to impute interest on that note.

So there is no requirement to impute interest on the note from heart. So what I'm saying is when jet gets the note from Hart, Jack can just debit note receivable, 10,000 and credit sales, 10,000, that can be treated as a $10,000 sale. So if you look at the answers, now we know it has to be C or D because the note from heart.

Does get recorded by jet as a $10,000 note. Now, obviously the note from max is more complicated because the note for max has unreasonable interest, but it's doing five years. So now what I want to show you is how to handle unreasonable interest when it's due more than a year out. Here's what you have to do.

If you see a note within reasonable interest, do more than a year out. The first thing you have to calculate is the maturity value of the note. Start with maturity value. Let's do it together. We're going to take the $10,000 note from max. It bears interest at 3%. So what is that? That's $300 of interest due every year for five years.

So at maturity, what has max promised me if I'm jet max has promised to pay me 1500 of interest, 10,000 to principal. So at maturity. I'm going to receive $11,500. I'm jet. That's what max has promised me, $11,500, five years from now. Now we're going to discount that note back to today at a fair rate of interest, which is 8% for this kind of note.

So we get our factor present value of a dollar at 8% due in five years, 0.6, eight. Oh, we multiply that maturity value, 11,500 times 0.6, eight. Oh. The discounted present value of that note is 7,008 20. So what Jett should do for the note from max is debit note receivable at a discounted present value 7,008 20 and credit sales, 7,008 20.

In other words, what we're saying to jet is we're not going to let you overstate your sales. The real sale here is not 10,000. The real sale is 7,008 20. The rest. His interest. We don't care how your lawyer drew it up. A fair rate of interest with this kind of note is 8%. So the rest is interest. So now we know the answer is deep because the note from heart would just be reported as a $10,000 note.

But the note from heart should be reported that it's discounted present value, and that is 7,008 20 answer date. Now we're done with notes and what we're going to get into next. Is a huge topic and that is how to account for a company's investments.

Now, as we get into this discussion, let me just quickly say, we're going to have a discussion now. On how we account for companies investments, except one, what we're not going to talk about in this discussion is investments that are accounted for under the equity method. We're not going to cover that because we covered the equity method as part of our class on consolidation.

That really is something that should be discussed in conjunction with consolidation. So that's the one thing we're not going to get into in this CPA Review FAR course investments in common stock. That are being accounted for under the equity method. We're not going to worry about that, but other than that exception, let's talk about how a company accounts for their investments.

And generally speaking, a company should divide their investments into three categories. Three, three portfolios. Here we go. The first category, the first portfolio would be held to maturity securities. Now what, what investments go in this category? Well, just remember that held to maturity investments are for investments in debt, securities, only debt securities, only like bonds where management has both, both the intent and the ability to hold the debt until maturity.

That's a held to maturity investment investments in debt, securities only buy bonds where management has both the intent and the ability. To hold the debt until maturity. That's what goes in this category? Now, a couple of things to remember about this portfolio point number one, how do you classify these investments?

What a held to maturity investment, be a current investment or a non-current investment. I always tell my students that maybe they don't think classifications a big deal, but the FAR CPA Exam does. It's very important to know classification. When you go in the exam. So held to maturity. Would it be a current investment or non-current you have to go by 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 debt matures less than 12 months from the balance sheet date, it's a current investment. That's the only way to classify these investments. You have to go by the maturity date. I think you see my point.

If the debt matures more than 12 months from the balance sheet date, it's a non-current investment. If the debt matures less than 12 months from the balance sheet, date and investment, that's how you classify these investments. Point number two held maturity investments will be carried on a company's balance sheet at amortized costs.

Remember that held to maturity investments always get carried on the company's balance sheet at amortized costs. Now what is amortized cost? You've definitely had this before. Amortize cost is the method. Everybody gets taught in school where you advertise discounts and premiums on bonds. As part of the interest adjustment.

Let's do a simple example.

The example in your viewers guide says corporation, a purchased bonds with a face amount of 500,000. And a stated interest rate of 9%. Remember the stated rate that's printed right on the bonds. That's the stated rate of interest printed right on the bonds, but notice a bought $500,000 worth of bonds at a discount.

They only paid 469,500 for the bonds because they want the bonds to yield 10%. That's why you buy bonds at a discount because you want them to yield a little bit more than the stated rate here. The bonds are going to yield. 10%. That's why there's a $30,500 discount here. The difference between 500,000 and what they paid for 69 five, there is a $30,500 discount here.

And again, the reason there's a discount, we want the bonds to yield a little bit more than the stated rate. Now the investment was on January one and let's assume that the bonds pay interest annually on December 31. What adjustment? Would a, the investor make on December 31. Well, first of all, we know this, that the interest check that a will collect is always based on the stated rate of interest printed on the bonds.

Time-space value. Remember that with a bond, the interest check is always the stated rate of interest printed on the bonds times face value state of time-space. So I'm going to take the stated rate 9%. Times the face amount of the bond is 500,000. We know a is going to debit cash 45,000. Now there's two ways to do the amortization.

There's the straight line approach. And there's the effective interest approach. What you see most often in the FAR CPA Exam is the effect of interest approach. Here we go. Under the effect of interest method, the way you calculate the income that a earned for this period. Is by multiplying the effective yield of the bond.

The effect of yield is 10% times carrying value. What's the carrying value of the bonds. The face amount, 500,000 minus the unimmunized discount, 30,500. The carrying value of the bonds is 469,500 times. The effect of yield 10%. We know that age is going to credit interest income for 46,950. That's the income that was earned for that first period.

Now the entry doesn't balance. The next number is a plug. I need a debit of 1,950 to balance the entry out you debit investment bonds, 1009 50. That 1009 50 is the amortization of the discount for that period. That would be the effective interest approach to amortize costs. Held to maturity. Investments are always accounted for under amortized costs.

Let's apply the straight line approach just to make sure you see the difference. If you use the straight line approach. When it gets to December 31 here again, they know that the interest check they're going to collect is always based on the stated rate of interest 9% times the face value of the bonds, 500,000.

So they're still going to debit cash 45,000, but in straight line, it's a little different, let's assume these a ten-year bonds. All right. Let's assume these bonds mature in 10 years in straight line, they would do this. They would take the $30,500 discount divided by 10 straight line years. And take 3000 Oh 50 of discounting emiratisation they would debit investment in bonds, 3000 Oh 50 and credit interest income, 38,000 Oh 50.

That's the straight line approach to amortize cost. So that's the bottom line held to maturity investments are always accounted for under amortized costs and notice there's the straight line approach to amortize costs. And there's the effect of interest approach to amortize costs.

All right now, the second portfolio would be trading securities. What investments go in this category? Well, trading securities are for investments in stocks or bonds, equity or debt, securities equity, or debt security stocks, or bonds that are held for the purpose of selling in the near term. That's a trading security investments in equity or debt, securities stocks, or bonds that are held for the purpose of selling in the near term, held for the purpose of selling in the near term.

Now three big things to remember about trading. Let's start with classification cause it's easy. Trading securities are always classified as a current asset. Always point number two, trading securities are carried on the balance sheet at fair value. Trading securities would always be carried on the, on the balance sheet at their fair market value.

It's fair value accounting here. Now. I think you see what's coming for point number three. If I'm going to write trading securities up to fair value, then I'm going to have an unrealized holding game. If I write trading securities down to fair value, well, then I'm going to have an unrealized holding loss and that's the third point.

Any unrealized holding gain or loss, any unrealized holding gains or losses? From the trading portfolio belong on the income statement. These gains and losses are included in earnings and he unrealized holding gains and losses from the trading portfolio belong on the income statement they're included in earnings.

Let's do an example again, if you look in the viewers guide, you'll notice we get to December 31st, 2005. I'm looking at my trading portfolio and I've got investment. In a cost 8,000, but at year end has a fair value of 12,000. So what am I going to do at year end? I'm going to debit investment in a $4,000.

I'm going to write that security up to fair value, and I'm going to credit. And I don't realize holding game 4,000 and take that to the income statement. It's trading B cost 10,000 with a fair market value at year end of 5,000. So I'm going to debit an unrealized holding loss of 5,000. That loss would go to the income statement and I'll credit investment and B 5,000.

I'll write it down to fair value. Notice I write up the fair value or down to fair value. How about C? It costs 20,000, but at year end 2005 has a fair value of 27,000. So I'm going to debit investment in C 7,000 and credit and unrealized holding gain. Of 7,000. And again, we know that game would go to the income statement because it's trading.

Now, let's say we get into year six and we actually go out and we sell investment in C for five, for $25,000. So now we get into another year, year six. Now we actually go out, we sell investment in C for 25,000. And remember, that's what's happening with trading. We buy and sell these securities all the time.

That's the nature of trading. So if we go out, we actually sell investment in C. For 25,000, you know, you're going to debit cash for what you collected 25,000. What would you credit to investment in see 20,000 or 27,000? That's right. 27,000. At the end of last year, we wrote that security to its fair value.

It's being carried in the financial statements at 27,000. So now if we sell it, we credit investment and see 27,000 and we debit our realized loss of 2000 and that realized loss of course, would go to the income statement. Realized gains and losses always go to the income statement. It doesn't matter what portfolio you're in realize gains and losses always go to the income statement.

The issue we're really discussing is what do we do with these unrealized holding gains and losses? Well, the unrealized holding gains and losses for the trading portfolio go to the income statement also, but I want to point out again that realize gains and losses always go to the income statement as they always have.

The third portfolio is called available for sale securities. Now, what investments do we put in this category? Well, available for sale securities are for investments in stocks or bonds, stocks, or bonds. Equity or debt securities that are not categorized as held to maturity or trading. So you see how this works.

Any investment that we don't put in the first two portfolios just automatically falls to the third and it's on our balance sheet available for sale. And if we need cash, we'll get rid of it. So investments in equity or debt, securities stocks, or bonds that are not categorized as held to maturity or trading, that's what we consider.

Available for sale. Now there's three big things to remember about available for sale. Let's start with classification. You know, I've got to talk about it. What's a little tricky here available for sale. Securities could be current or non-current why I bet you see it because if I have debt securities in this portfolio, I've got to look at the maturity date.

If the debt matures more than 12 months from the balance sheet date, and they intend to hold onto it, it's a non-current investment. If the debt matures less than 12 months from the balance sheet date, it's a current investment. Doesn't that make sense? You could have debt securities in this portfolio, and you've got to look at the maturity date.

If the debt matures more than 12 months from the balance sheet date, it's a non-current investment. If the debt matures less than 12 months from the balance sheet dates, the current investment. Now, if I have equity securities in this portfolio, which I, no doubt will I look at management's intentions if management intense.

To sell the investment often a short period. It's a current investment. If management intends to hold onto it indefinitely, it is a non-current investment. You look at management's intent. What I'm saying is there's nothing to prevent a company from having both a current and non-current portfolio of available for sale.

Let's do a little problem on available for sale and your viewers guide. We get to December 31st, 2005. We're looking at our available for sale security. We've got Q we've got our, we've got S and Q cost 3000, but ERN is a market of 10, our cost 5,000, but ERN has a market of 15 as cost 7,000, but a year, and just has a market of one.

Now listen, carefully. The available for sale portfolio is carried on the balance sheet. At its aggregate fair market value. The available for sale portfolio is carried on the balance sheet at its aggregate fair market value. So at year end, at the end of 2005, I would look at the aggregate cost of that portfolio, 15,000 compared to the aggregate market, 26,000.

I'm going to adjust this portfolio by $11,000. Notice I'm going to do it in aggregate. Not security by security. And if you're not sure why I'm doing available for sale in aggregate, not security by security. You'll certainly see why in a minute. But the avail retail portfolio does have to be carried on the balance sheet at its aggregate fair market value.

And then that leads to the third point, which is that any unrealized holding gains or losses, any unrealized holding gains or losses? From the available for sale portfolio, don't go to the income statement. They go directly to stockholder's equity as an item of other comprehensive income. So any unrealized holding gains or losses, any unrealized holding gains or losses from the available for sale portfolio simply will not go to the income statement.

Now, these gains and losses flow directly to the balance sheet. They go directly to stockholder's equity as an item of other comprehensive income. So at year end, if we say, well, the aggregate cost is 15,000. The aggregate market is 26,000. We're going to debit an account called market adjustment, 11,000, that market adjustment.

That's a balance sheet account. That's a valuation account for the balance sheet. And what do I credit OCI? This game? Wouldn't go to the income statement. It goes directly to stockholder's equity as an item about the comprehensive income. So notice I would credit OCI. Now let's say we go, let's say we do a balance sheet.

At December 31 Oh five. If you do a balance sheet at seven 31 Oh five, probably in non-current assets, you don't have enough information here, but probably a non-current asset. You'd see this avail for sale securities at cost 15,000, plus the market adjustment account because it's a debit plus market adjustment 11,000.

So the available for sale portfolio is on the balance sheet at 26,000 it's aggregate fair market value. You can see that what's required. For trading and available for sale is fair value. Accounting. Let's go ahead another year. Let's say it's now December 31, 2006. You get to December 31, 2006. Now you're looking at your avail for sale portfolio.

Now notice the cost is still 15,000, but the market's come down to 14,000. So what do I do? Well look at last year at the end of year five didn't we set up a balance in market adjustment of an $11,000 debit. What do I need as a balance and market adjustment at the end of year six, a $1,000 credit cause now market's below cost.

So you see the problem. At the end of year five, we had set up a market adjustment account with an $11,000 debit balance, but now a year later, because the market values have changed. What I need in market adjustment is a $1,000 credit. So what am I going to do? I'm going to, I'm going to have to credit market adjustment for $12,000.

I'm gonna have to credit that market adjustment account for 12,000. I've got to bring my job here is to bring that market adjustment. From an $11,000 debit balance to a $1,000 credit balance. Cause now markets below costs. I right up to market or down to market spare fair value accounting. And that's my job here to bring that market adjustment account from an 11, from an $11,000 debit balance to a $1,000 credit balance.

So I'm going to credit market adjustment 12,000 and I'll debit OCI 12,000. And by the way, if this is the only item of OCI they have, they could have other items. But if this is the only item of OCI they have, then down in stockholders' equity, accumulated OCI just went from $11,000 credit to a $1,000 deficit.

This is all taking place on the balance sheet. And I'm sure you see that because if this is the only item of OCI, they have, they could have others. But if this is the only item of OCI they have, then down in stockholders' equity cumulated, OCI, just one from $11,000 credit to a $1,000 deficit. From that adjustment.

Let's get into your seven for a minute. Let's say when we get into year seven, now we actually, what we sell investment in AR for $8,000. So now to your seven, we go out, we sell investment in R for 8,000. So if I sell investment in R for 8,000, I'm going to debit cash 8,000 and I'm going to credit investment are for its original cost 5,000 not it's market value, 3000.

It's original cost 5,000 and I'm going to debit a realized loss. Excuse me. I have a realized gain here of 3000. I'm going to credit a realized gain of 3000 and that realized gain of course, would go to the income statement because as we've already said, realize gains and losses always go to the income statement.

It doesn't matter what portfolio you're in. So I got, we sell investment in R for 8,000. Of course, I'll debit cash, 8,000. And I'll credit investment in R for its original cost. That was never adjusted 5,000 and I'll credit a realized gain 3000 and naturally that realized gain would go to the income statement as they always do.

So I hope that gives you a better idea of why we do avail for sale in aggregate, because if we ever sell a security out of that portfolio, we've got to go back to the original cost of the security to work out any gain or loss that's realized for the income statement.

Another thing I want to mention, they might mention in the FAR CPA Exam that there's been a permanent decline in market for security. What if they say there's been a permanent decline in market for security? Well, I want you to know. That we only care about permanent declines. If we're dealing with held to maturity or available for sale, never trading, we don't care about the issue in trading.

So again, only care if a decline is permanent. If you're dealing with held to maturity, securities or avail for sale securities, it doesn't matter. The issue is not important in trading. Now, you know, when I say there's been a permanent decline, this is something extreme, a company going bankrupt. We know that every day the stock market goes up, it goes down.

It's not what I'm talking about. Those temporary increases temporary decline decreases. That's not, we're talking about this is something unusual, a company going bankrupt like Enron. Well, here's the point. If the FAR CPA Exam says there's been a permanent decline in market, then you're going to debit a realized loss.

They're going to have to tell you, but if the FAR CPA Exam specifies there's been a permanent decline in market, Then you're going to debit a realized loss, take that loss to the income statement and credit investment and Enron. You're going to write it off. That's how you handle a permanent decline. Debit realized loss.

Take that loss to the income statement it's considered realized and credit investment in Enron. Just write it off. And as I say, we only care about the issue of permanent declines. If we're dealing with avail for sale securities or held to maturity securities, it's not an issue. In trading, I'd like you to try question.

I'd like you to try number 19 and come back.

Welcome back in 19, they say at year end rim company held several investments with the intent of selling them in the near term. So, you know, it's trading. That's what trading securities represent equity or debt securities that are held for the purpose of selling in the near term. And they want to know what the bottom, what amount would rim report as trading securities and it's year end balance sheet?

Well notice they have the investment in the bonds. The investment in the bonds costs 92,000, but an ERN have a market value of one Oh five with the bond, be on the balance sheet at 92 it's cost. Or market one Oh five market one Oh five, because if it's trading security trading securities are accounted for under fair value, we would actually write that investment bonds to 105,000 at year end.

Why it's trading now that we're held to maturity, it would be an amortized cost. We wouldn't care about the fair value of the bonds, but it's trading. So we would write that investment to its fair value at the balance sheet date, 105,000 same thing with the equity security. It costs 35,000 year-end has a market of 50.

Well, that would be written to 50,000. So what's on the balance sheet for trading one Oh five plus 50 answer D 155,000. Please try number 20 and come back.

Welcome back. And number 20, they say during year nine, Scott purchased marketable equity securities classified them as available for sale. We get to year end, we've got security, D E and F. Remember, we don't do available for sale security by security. We do it in aggregate. So at ERN we'd look at the aggregate cost 96,000, the aggregate market, 86,000.

And what would we do? We would debit OCI 10,000, that loss wouldn't go to the income statement. It would go right to stockholders' equity as an item of OCI. So we would have it OCI 10,000 and credit market adjustment, 10,000. That would be our adjustment when they ask at the bottom. The amount of unrealized loss from these securities in Scott's year, nine income statement, you know, with zero answer D because unrealized holding gains and losses from the available for sale portfolio, don't go to the income statement.

They go directly to stockholders' equity. As an item of OCI, please try number 21 and come back.

Number 21. They say that the following information pertains to smoke smoke has two securities. Notice these securities are classified as available for sale. The first security has a cost of 70,000, but at year end is a market of 50,000. The second security has a cost of 50,000, but at year end as a market of 60,000, now I hope this didn't bother you.

They said about the second security that smoke believes that the recovery from an earlier lower fair value was permanent. I hope you recognize that's nonsense. There's no such thing as a permanent recovery, we would care if a decline is permanent. That would matter if a decline was permanent, but how could you ever say a recovery is permanent?

You mean that security could never go down and market value again, for the rest of time, that's really nonsense. Our recovery could never be permanent because that's the rest of eternity. We don't know that, but as I say, a decline could be permanent. We'd have to care about that, but here's the point. If you add this up, The aggregate cost of the veil for sale portfolio is 120,070 plus 50.

The aggregate market is 110,050 plus 60. So what entry would you make? You would debit OCI 10,000. That loss wouldn't go to the income statement. It would go directly to stockholders' equity as an item of OCI. So they would debit OCI 10,000 and credit market adjustment, 10,000. So when they ask at the bottom.

What is the effect on the market adjustment account? You know, it's deep. It creates a $10,000 credit balance. Please try number 22 and then come back.

Welcome back. Number 22 says during year seven wall purchased 2000 shares of hemp for 31,500. It's available for sale security. The market value of this. Investment at the end of year seven was 29 five. But remember we wouldn't do avail for sale security by security. We would do it in aggregate and then they sell the investment at $14 a share.

So what happens if they go out and they sell the investment? The 2000 shares at $14 a share aren't they getting $28,000 for that investment? Minus the 1400 in brokerage commissions. What they needed out of that sale was 28,000 minus 1400 26,600. They're going to debit cash 26,600. They're going to credit investment in him for its original cost 31 five, and then debit a realized loss of 4,900.

And the answer is a, because we know, realize gains and losses always go to the income statement. It doesn't matter what portfolio you're in, that never changes, but. The issue that, that you have to remember is what you do with unrealized holding gains and losses. But once the gain or loss is realized by actually selling the security, it always goes to the income statement.

Please try number 23 and then come back.

Welcome back in number 23, they say at the end of year, one lane company held trading securities that originally cost 86,000. But at the end of year, one had a market value of 92,000. So remember at the end of year one, Those securities would have been written to their fair value. 92,000 because we know trading securities are accounted for under fair value.

We write them up to fair value down to fair value. We would have written these trading securities to the fair value. 92,000. Then in year two, all the securities were sold for 104,500. Well, if all the securities were sold for 104,500, they're going to debit cash 104,500 credit to securities. For the amount they're being carried on the balance sheet, fair value, 92,000 and credit a realized gain of 12,500.

That's a realized gain because they actually sold the securities. And the realized gain of course, goes to the income statement as it always does. Then it says at year end, at the end of year two, Lane had acquired additional trading securities that cost 73,000, but at year end had a market of 71,000. So what would they do?

They would debit an unrealized holding loss of 2000 and credit the securities 2000. They'd write those securities to fair value. And that unrealized holding lots of 2000 would go to the income statement because it's trading. So when they ask at the bottom, what is the impact? Of the stock activities on the income statement, while you've got to realize gain of 12,500, that's on the income statement and unrealized holding loss of 2000, that's on the income statement because it's trading.

The answer is B it's a net gain on the income statement of 10,500. Let's do 24 and 25 together.

It says son had investments in equity, securities classified as trading, and they cost 650,000. Then on June 30th year five son decided to hold the investments indefinitely. And then reclassify them from trading to available for sale. On that date, the investment's fair value was 575,000, December 31 year for 530,000, June 30th, year five and four to 90,000, December 31 year five.

Let's do this year by year when son got to the end of the year for when son got to December 31 year four, we know the cost of these securities was 650,000. The market value was 575,000. So what would they have done at the end of year four? They would have debited on unrealized holding loss of 75,000.

That loss would go to the income statement in year four because it's trading and they would credit the securities. 75,000. What I'm saying is they would have literally written those securities down to 575,000 at the end of year four, because it's trading, trading securities are accounted for at fair value.

And again, that's $75,000 loss would have gone to the income statement. That's what happened in year four. Now these two questions are asking about year five. So let's get into your five on June 30th, year five, when the market value was 530,000, they transferred this investment from trading to available for sale.

And that's why we're going to do this set together because you have to know how to deal with. Tra transferring investments from one portfolio to another. And I want you to know that when you see this in the exam, because they do like this, when you see in the FAR CPA Exam that they're transferring investments from one portfolio to another, what you're dealing with is a rule.

It's not a hard rule, but you have to be aware of it. Here's the rule. When you transfer investments from one portfolio to another, on the day of the transfer on the day of the transfer. Right. The individual's security too. It's fair market value on the day of the transfer, right? The individual security to its fair market value.

Why? Because the effect they want, they always want a security to enter its new portfolio at fair value. That's the effect they want. So they say it again. The simple rule is on the day of the transfer on the day of the transfer, you always write the 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. All right. So let's just follow that through on June 30th, year five, when they transfer this investment from trading to available for sale, the market value is now 530,000. So they're going to have to write the security from 575,000.

That's the carrying value on the balance sheet right now from 575,000 down to five 30. So what would they do? They would debit and unrealized holding loss. Of 45,000 and they would credit the security 45,000. They would literally write that security from 575,000 down to 530,000. That way the security Andrew's its new portfolio at 530,000 it's fair value.

So they would debit when unrealized holding loss of 45,000 and credit the security 45,000. And that loss would go to the income statement because trading's involved. So now we can answer number 24, 24 says what amount of loss from investments would sound report in its year five income statement? The answer is a 45,000.

That loss would go to the income statement because trading's involved. And I want you to know that that entry, we just looked at where we debit the unrealized, holding loss 45,000 credit, the investment 45,000. That's the entry you make. If trading's involved, if you're going to, or from trading, if you're going to are from trading, that's the entry that you would make.

What if you're going? Same problem. What if you were going from available for sale to held a maturity or held to maturity to available for sale while the rule would be the same? You have to write the security to its fair value. Because they always want a security to go to its new portfolio at fair value.

So in this problem, if we were going held to maturity to available for sale or available for sale to held to maturity, if trading's not involved, we would still credit investment in securities for 45,000. I would still have to write the securities from 575,000 down to five 30. But the difference is if trading's not involved, I would debit OCI 45,000.

Now the loss wouldn't go to the income statement. I would debit OCI 45,000, and that shows you every mathematical possibility. But buddy, in this problem, trading is involved. So that's why the answer to number 24 is a, the loss would go to the income statement because trading was involved. You're going to from trading, the gain of loss would go to the income state.

Now let's get into the end of. 2005. When we get to the end of year five, now I'm looking at my available for sale portfolio and the securities in the portfolio at its fair value, 530,000 number. It went in at fair value, but at year end, the market value is four 90 490,000. So what would you do? You would debit OCI 40,000 and credit market adjustment, 40,000.

Remember now it's available for sale. So at year end five, you would debit OCI 40,000 and credit market adjustment 40,000. So when the asking number 25, what amount would sun report as net unrealized loss on investments in equity securities in OCI? The answer is also a, but the main reason we did that set of questions is so that you're comfortable with dealing with transferring investments from one portfolio to another.

As I say, it's not complicated. You always write the security to its fair value on the day of the transfer, because they always want a security to enter its new portfolio. At fair value.

I want to remind you that what we have not discussed. Our investments in common stock being accounted for under the equity method. Remember we discussed the equity method in great detail as part of our class on consolidated financial statements. What about investments in common stock being accounted for under the cost method?

Well, you may remember that the cost method is a pretty simple method. If a company purchases say 2000 shares in another company's stock. For $14 a share. Well, if they use the cost method, they're going to debit the investment for the cost of the shares. 2000 shares at 1420 8,000 and credit cash, 28,000, they would establish the carrying value of the investment for the cost of the shares.

That's why they call it the cost method. And then if the other company sends the investor company, a dividend, say of 2000, The investor company would debit cash 2000 and credit dividend income, 2000, because under the cost method, the company would treat any dividends coming from the other company as income.

It's a very simple approach. And as I say, in our class on consolidated financial statements, we get into much more detail about the distinction between the cost method and the equity method and the differences between the cost method and the equity method. But. I'll say one more thing about this and that is that any time an investment is being accounted for under the cost method, that's just carried as one of the companies available for sale securities.

So just keep that in mind, when an investment is being accounted for under the cost method, it's just carried as one of the companies available for sale securities. That's what it is. What we're going to get into next is something else that you have to be aware of. When it comes to accounting for a company's investments, and that is derivatives and hedging activities,

let's start with some definitions because that's really primarily what this area is about. Is understanding of definitions. What's a derivative, a derivative is an investment that derives its value from something else. That's where the word comes from derivative because it derives its value from something else.

For example, if you invest in grain futures, that's a derivative investment because the total value of that investment is derived from whether the price of wheat went up or down today. If you invest in foreign currency options, That's a derivative investment because the total value that investment is derived from whether the Euro got more expensive or cheaper today.

That's what a derivative investment is. It's an investment that derives its value from another security or another commodity. It derives its value from another security or another commodity. Now it's something that bothers people right away. So I want to say it. You've got to get used to this. Please remember.

That a derivative investment can be an asset or a liability. Keep that in mind a derivative investment can be an asset or a liability. Why? Because with a derivative, if you're in a gain position, clearly you're an asset position. But if you're in a loss position and it's big enough, it could be a liability.

So keep that in mind. Now what's hedging. Hedging is a strategy. It's a strategy where a company invests in a derivative for the purpose, for the purpose of counter balancing the potential loss in another security or another transaction. In other words, you're hoping that you make enough profit on this investment.

That'll counterbalance a loss that you're anticipating somewhere else. That's what hedging is. It's a strategy where a company invests in a derivative. For the stated purpose of counterbalancing, the potential loss in another security or another transaction, as I say, you're hoping that you make enough profit on this investment.

That'll counterbalance a loss that you're anticipating somewhere else. You're hedging your bets. Now the most important part of this, how do we account for derivatives and hedging activities? Let's start with how we account for derivative. That's not being used as a hedge. Not being used as a hedge.

What's actually pretty simple. If a company has a derivative investment, that's not being used as a hedge, then it will be on the balance sheet as either an asset or liability. If a company has an investment that is a derivative, but it's not being used as a hedge. It's a non-hedge derivative. That investment will be on the balance sheet as either an asset or a liability.

And it's accounted for at fair market value. So once again, what's required is fair value accounting. And if we're going to use fair value accounting, you know, what's, what's coming. If I write a non-hedge derivative up to fair value we'll then I'm going to have an unrealized holding gain. If I write a non-hedge derivative down to fair value, well, then I'm going to have an unrealized holding loss and that's the third point.

Any unrealized holding gain or loss, and he unrealized holding gain or loss from a non-hedge derivative belongs on the income statement. It that gain and loss that gain or loss would be included in earnings. Now, how we 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. The first type is called a fair value hedge.

A fair value. Hedge is a hedge against potential losses. That's what a hedge is. It's a hedge against potential losses from the change in the fair market value of something you're hedging against potential losses from the change in the fair market value of an asset or liability. That's what a fair value hedge is.

Hedging against potential losses from the change in the fair market value, the change in the fair market value of an asset or liability. Now, once you know what a fair value hedge is, it's actually pretty simple. A fair value hedge will be on the balance sheet as either an asset or liability. And yes, it is accounted for fair market value.

So once again, it is fair value accounting. And if I'm going to use fair value accounting, I could have unrealized holding gains and losses and let's make the point. And he unreliable holding gains or losses, any unrealized holding gains or losses from a non-hedge derivative. And he unrealized holding gains or losses from a fair value hedge belong on the income statement.

These gains and losses do go to the income statement. They're included in an earnings. So notice the accounting for a fair value hedge is exactly the same as the accounting for a derivative. That's not being used as a hedge because again, any unrealized holding gains or losses from a non-hedge derivative or any unrealized holding gains or losses from a fair value, hedge, those gains and losses, all of them belong on the income statement.

They are included in earnings. As I say, bottom line is we account for a fair value hedge. Exactly the same way we account for a derivative. That's not being used as a hedge at all. The second type of hedge is called a cashflow hedge. Now a cash flow hedge is a hedge against potential losses from the future cash flows from an asset or liability.

That's a cash flow hedge where you're hedging against potential losses from the future cash flows from an asset or liability hedging against potential losses from the future cash flows from an asset or liability. Now, once you know what it is, how do we account for cash flow hedge? Well, if a company has a cash flow hedge, it will be on the balance sheet as either an asset or a liability.

And yes, it's accounted for a fair market value. So if a company has a cash flow hedge, it's going to be on the balance sheet as a distinct asset or distinct liability. And yes, it will be accounted for at fair market value. So here again, what's required is fair value accounting. Now, you know, what's coming.

If I'm going to use fair value accounting, then I'm going to end up with unrealized holding gains and losses. So be careful how we account for the unrealized holding gains and losses. From a cash flow hedge depends on whether the hedge is effective or not. You got to listen carefully. Now this is the only little complicated part of this because how we account for the unrealized holding gains and losses from a cash flow hedge depends on whether the hedge is effective or not.

What do I mean by effective? I think, you know, effective means I am making a profit on this investment that is counterbalancing a loss somewhere else. That would be an effective cash flow hedge, right? If I'm making a profit on this investment that is counterbalancing a loss somewhere else, it's an effective cash flow hedge.

And here's the point. If you have an effective cash flow hedge that game's not on the income statement, that gain goes directly to stockholders' equity. As an item of OCI, if you have an effective cash flow, hedge the gain, doesn't go to the income statement. The gain goes directly to stockholders' equity.

As an item of other comprehensive income. What if it's ineffective? How could it be ineffective? Well, what if I take a loss on the investment? What if I take a bath on the investment? Who said I had to make a profit? Well, if you have an ineffective cash flow hedge, that loss goes directly to the income statement.

It does go to the income statement and it's included in earnings. So you see the difference. If I have. A derivative. That's not being used as a hedge, or if I have a fair value hedge, the gains and losses go right to the income statement. But if I have a cash flow hedge, how I handle the gains and losses depends on whether it's effective or not.

If I have an effective cash flow, hedge the gain, doesn't go to the income statement. It goes directly to stockholders' equity as an item of OCI. But if it's ineffective, the loss would go right to the income statement. It would be included in earnings. Now, I don't want to go over too many entries here, but I just want to show you a couple.

Let me give you an example. Let's say a company has an investment in X and it is a cash flow hedge. So a company has an investment in X. It is a cash flow hedge, and let's say it's effective. Let me ask you something. If it's effective, is it rising in value or falling? It's rising. Let's say it's going up in market value.

$10,000. So what would I do? I would debit investment in X, 10,000. I'd write that investment up 10,000 and I would credit OCI that game. Wouldn't go to the income statement. It would go right to stockholder's equity as an item of OCI, but here's, what's a little tricky. Now what happens is that when the loss that I was hedging against matter, I was trying to counterbalance loss.

When the loss that I was hedging against finally gets on the income statement. That could be a year and a half from now. When the loss gets on the income statement. Again, when the loss that I was trying to counterbalance, when the loss that I was hedging against does get to the income statement that could be a year from now.

Now I'll debit OCI, 10,000. I'll take that gain out of stockholders' equity and I'll credit gain on derivatives, 10,000, that gain. Now we'll go to the income statement because on the income statement, I want to show the loss and how I counter balanced it. That's what happens. So again, when the loss that I was hedging against finally gets on the income statement.

Maybe a year from now that I'll debit OCI, I'll take the $10,000 gain out of stockholders' equity and I'll credit gain on derivatives, 10,000. That gain would now go to the income statement that way on my income statement, I can show the loss and how I counter balanced it. Let me let's say this. Let's say the company also has an investment in Z.

It is a cash flow hedge. So the company also has an investment in Z, a cash flow hedge. And let's say it's ineffective. Well, that means it's dropping in market value. Let's say it's declined in market 3000. What would I do? I would debit loss on derivatives 3000. I would take the loss right to the income statement.

And I would credit investment in Z 3000. If you have an ineffective cash flow hedge, that loss would go right to the income statement. It doesn't go to OCI goes right to the income statement. Now, derivatives and hedging activities. Also com will come up in the area of foreign currency.

There are foreign currency hedges. You gotta be aware of these. If the FAR CPA Exam were to mention a foreign currency denominated from commitment, hedge, if they were to mention a foreign currency denominated. From commitment, hedge. In other words, it's denominated in the foreign currency, a foreign currency, denominated from commitment, hedge, or a foreign currency denominated available for sale securities hedge.

Either one of those, if they're mentioned a foreign currency, denominated from commitment, hedge, or a foreign currency denominated available for sale securities hedge, those are fair value hedges. That's what they are. They're fair value hedges, and you know how to account for them. However, if 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 a foreign currency, denominated forecast or transaction hedge, or a foreign currency net investment in foreign operations hedge, you mentioned the ones that either one of those, those are cash flow hedges.

So either a foreign currency, denominated, or a foreign currency, denominated from commitment, hedge, or a foreign currency, denominate avail for sales, securities, hedge. Those are fair value hedges, but a foreign currency denominated forecast or transaction hedge. Now you're talking about cash or a net investment in foreign operations hedge.

Now you going to cash. Those are cash flow hedges. So you just go right back to the notes that we went over and the entries we went over for a cash flow hedge. I'd like you to try some questions. I'd like you to try 26, 27 and 28, and then come back.

Welcome back in number 26, they say, which of the following financial instruments is not a derivative. What's not a derivative. Well, you know, an interest rate swap is a derivative currency futures, you know, foreign currency options, definitely a derivative investment. I stock index option. The value of that investment depends on what happened.

What happens to the S and P 500? What happens to the Dow Jones? Average? It is derived from something else, but a bank certificate of deposit is not a derivative investment answer. D. 27, if it is not practicable for an entity to estimate the fair value of a financial instrument, which of the following must be disclosed.

How about number one? Would you have to disclose information pertinent to the estimating of the fair value of the instrument? Yes, you'd have to disclose that. And also number two, you'd have to disclose the reasons why it's not practicable to estimate the fair value, why you're not able to do it. What are the factors you'd consider and why you're not able to do it?

Yes. They both have to be disclosed. And the answer is 28, which of the following risks are inherent unavoidable in an interest rate. Swap. How about the risk of exchanging a lower interest rate for a higher interest rate? Sure. That risk is inherent in the whole idea of the swap. You know, maybe interest rates will continue to go lower and here you've exchanged it for a higher interest rate because you thought they were going to go much higher.

It's it's inherent, it's baked into the cake. Nothing you can do about that. And also the second one, the risk of non-performance by the counter party, to the agreement, that risk is there as well. It's a risk you're taking with an interest rate swap. So the answer is C again. Both those risks would be inherent and unavoidable in that sort of swap.

That concludes our discussion of cash and receivables and investments. And from all of us at the Bisk CPA review, we want to wish you the best of luck on the exam. Keep studying.

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The CPA exam with best CPA review, you will have the confidence and knowledge to pass it warranty. Welcome to the Bisk CPA review course and our coverage of the financial accounting and reporting section of the CPA exam. My name is Bob Monette. I'll be your instructor in this FAR CPA Review course and in this FAR CPA Exam course. We're going to be covering a very heavily tested area in the financial exam, and that is state and local governmental accounting or fund accounting.

Now, before we begin, I want to say a few words about the way to get the most out of this FAR CPA Review course. The most important thing is to treat this like any other class, try to avoid just sitting back passively, watching the class, be an active participant. Take good notes later in the class. When we do problems from past exams, it's important to shut the class down.

You do the problems, get your answers before you come back and we discuss the problems together. If you do those simple things, you'll find you get much more out of this FAR CPA Exam study course. And that's what we both want. So let's talk about state and local, governmental accounting.

First thing I want to say is that governments, whether we're talking state government, city, government township, government borrow government governments, no matter how big, no matter how small governments exist to perform different services for our community. That's why governments exist to perform different services for the community.

And what a government is going to do is set up a different fund. They set up a different fund for all the different services they provide for the community. So maybe we should first ask this question exactly. What is a fund, a fund. Is an accounting and fiscal entity. That's what it is. It's an accounting and fiscal entity that keeps track of the money coming in and the money going out as the government performs different services for the community.

Now let's get some language down, a governmental unit, like a town, a governmental unit, like a city. Uses three types of funds. So you see how that works. Our governmental unit, like a borrow a governmental unit, like a town uses three types of funds. First they use governmental funds. Second, they use proprietary funds and third they use.

Fiduciary funds. So keep that in mind, a governmental unit, like a town uses three types of funds. They use governmental funds, they use proprietary funds and they use fiduciary funds. Now you're going to find when you do your homework in this area, when you start doing questions from past exams in this area, that a lot of grading points, a lot of questions in the FAR CPA Exam are really just testing whether or not, you know, the names of all the funds used by a government.

And what each one does. So that's actually where we're going to start. We're going to begin this CPA Exam FAR course by going over the governmental funds.

Let's talk about the governmental funds. The first governmental fund is called the general fund. The general fund. Accounts for the general day-to-day operations of the municipality. Let me say that again. The general fund accounts for the general day-to-day operations of municipalities. And I want to just give you a tip right at the beginning, as you're studying these funds, as much as you possibly can, let the name of the fund help you remember its purpose.

I think you see what I have in mind. We call this the general fund. Because of the counts for general operations. I think you have to do that. Let the name of the fund be more than just the name. Let the name of the fund, prompt you to remember its purpose. I think you'll find that helps a lot. So the general fund accounts for the general day to day operations of a municipality, the second governmental fund is called a special revenue fund.

The government sets up a special revenue fund when the government collects revenue, that's earmarked, it's restricted. For some special public purpose. Notice the revenue is special. The revenue is special. It can only be spent on some special public purpose. That's why we need a special revenue fund. What the name of the fund help you remember what it's doing?

Let me give you an example. And an example helps here. Why would a government need a special revenue fund? Let's say a town gets a state grant that's dedicated to highway maintenance, classic case. If a town gets a state grant, that's dedicated. For highway maintenance, that's going to be a special revenue fund because that revenue is special.

That revenue can only be spent on that special public purpose and no other and no other purpose. Now there's another important point. It's important to remember that a special revenue fund it's an expendable fund. It's an expendable fund. What does that mean? It means you can spend. The interest you can spend the dividends.

You can spend every dime I of the principal in this fund on that special public purpose. It's an expendable fund. Third governmental fund is called a capital projects fund. The government sets up a capital projects fund to account for the construction of it accounts for the construction of major capital assets.

So if a government's going to construct a new civic center, if a government's going to construct. A library, a police station, the government's going to account for project for a project like that through a capital project fund, because it accounts for the construction of major capital assets. Fourth, governmental fund is called the permanent fund.

Now the government sets up a permanent fund when the government collects revenue, that's earmarked, it's restricted for some special public purpose, but this fund is non expendable. It's a non expendable fund. What does that mean? You can never spend the original principal. The original principal can never be spent.

It sits there permanently. That's why it's called the permanent fund. You know, let's say bill Gates donates a billion dollars to the city of Seattle for scholarships, for needy students and bill Gates specifies it's up to the donor and bill Gates specifies. All Seattle can spend on scholarships are the interest and the dividends on the bill.

Yet the billion itself will sit there permanently. That would be a permanent fund. It's a non expendable fund. You can never spend the original principle. Let me ask you this. What if bill Gates said, no, you can spend the interest. You can spend the dividends. You could even spend the original billion on scholarships.

What kind of fund would that be? You know, that's a special revenue fund. That's special revenue fund, because now you need an expendable fund. Now you can spend the interest that dividends and every dime of the principle on scholarships. I just want you to recognize that when you boil it down, the only difference between a special revenue fund and a permanent fund is simply that the special revenue fund is an exp it's an expendable fund.

A permanent fund is a non expendable fund. Other than that, they're really identical. Now another point. Think about these four funds, we just talked about the general fund, the special revenue fund, the capital projects fund the permanent fund. These four funds have something in common. None of these four funds are allowed to carry their own long-term debt.

Remember this, these four funds, the general fund, the special revenue fund, the capital project fund. The permanent fund are forbidden to carry their own long-term debt. It's a rule. So let's think what happens here. If one of these funds actually issue some long-term debt, because it does happen. Let me give you an example.

Let's say the capital projects fund issued bonds, and let's be honest. What's likely to come up in the FAR CPA Exam is bonds. So let's say that the capital projects fund issue bonds to pay for the construction of a new civic center. Well, let's think what would happen if capital projects fund issues, bonds. You know, they're going to debit cash, but do you see my point?

They can't credit bonds payable. None of these four funds are allowed to carry their own longterm debt. They're forbidden to carry the longterm debt. So you can't credit bonds payable. So what do they credit? They credit an account that we're going to use a lot in this FAR CPA Review course, other financing sources. So they're not going to credit bonds payable.

They're forbidden to carry long-term debt, but what they would credit is other financing sources. Now, what do you think here? Do you think the government. Carries the debt somewhere. Does it report the debt somewhere? Of course, the government actually reports the debt in the government wide statement of net position, which we will talk about much later, but the government would actually report the debt in the government wide statement of net position.

And we'll get to that later. Now another point these four funds are not allowed to service their own long-term debt. So remember this, these four funds are forbidden to carry their own longterm debt. And these four funds are forbidden to service their own long-term debt. So my point is you're never going to see an account like interest expense in any one of these four funds because these four funds are not allowed to service their own long-term debt.

These four funds are not allowed to carry their own long-term debt. So we need another governmental fund. The fifth and final governmental fund is called the debt service bond. All the debt service fund does is accumulate money to make interest payments and principle payments on long-term debt of the first four funds.

That's all it does. I'll say it again. All the debt service pond. All it does is accumulate money to make interest payments and principle payments on long-term debt of the first four funds. In other words, all the debt service fund does is service debt. You've got to let the name of the fund help you remember its purpose.

It's really important that you do that. So now we have the five governmental funds. There are only five governmental funds, general fund, special revenue fund capital projects, fund permanent fund and debt service fund. Those are the five governmental funds.

We're going to talk about some things that all five governmental funds have in common. For example, all five governmental funds have what is called the same measurement focus. I want you to remember that the measurement focus. In all five, governmental funds is the flow of current financial resources.

It's the flow of current financial resources. Remember we said earlier in the class that you know, what these funds do is keep track of the money coming in and the money going out as the government perform different services for the community. Well, that's what we mean by their focus is the flow of current financial resources.

Another way to look at this, if you want to visualize what a fund funded. It's not a bad idea to think of each fund as a separate checking account. That works pretty well it's as if the government has set up all these different separate checking accounts that keep track of the money coming in and the money going out as the government performs different services for the community and what the FAR CPA Exam would call that is their measurement focus.

The flow of current financial resources. If I were to ask you. What is the measurement focus of your checkbook, your personal checkbook? I'm sure you've never thought about that before, but if I were to ask you, what is the measurement focus of your personal checkbook? You would agree. It's the flow of current financial resources, keeping track of the money going out and the money going in as you live now, these five governmental funds have something else in common.

All five governmental funds. Use modified accrual accounting, all five governmental funds use modified a cruel, and that's what we're going to get into next

modified approval is the most important thing we're going to discuss in this FAR CPA Exam prep course. It is the most heavily tested thing about state and local governmental accounting. You must understand modified accrual. Now let me say that modified a cruel is not the kind of thing you can cover in a couple of seconds.

This is going to take us some time and you have to start somewhere. So here's where I want to begin. When you boil it down, what's the major difference. What's the major difference in modified a cruel on the revenue side. And what's the major difference in modified a cruel on the expenditure side. So I want to begin to get us started.

Let's start with revenue now, you know that if we were talking about a profit making company, a profit making company under normal accrual accounting, which of course is what we're used to recognizes as revenue as it's earned. Right. That's what we're all used to. That's just normal, cruel accounting, recognizing profit as it's earned, recognizing revenue as it's earned.

Well, when you get into these five governmental funds, just stop and think what kind of revenue they're going to be collecting for the most part tax revenue. So I think you see the problem. You can't say that a government should accrue tax revenue as it's earned because they don't earn it. They just tax, they just take it.

So here's the point under modified accrual governments, accrue tax revenue, not when it's earned, when it's available and measurable. That's the phrase in modified a cruel governments, accrued tax revenue, not when it's earned. They don't earn it. No, they accrue tax revenue when it's available and measurable.

Now here's the point? What does available and measurable means? That's what's tricky. What does it mean? Let's say a government levies taxes. Does that make them available? The measurable? No. No. Remember that you don't look at the tax lovey. No, here's what you have to do. You have to estimate what you're going to collect from a tax levy within the current fiscal year and up to 60 days into the next fiscal year.

Why? Because what you estimate. You're going to collect from a tax levy within the current fiscal year and up to 60 days into the next fiscal year, all that tax money is considered available to pay off current expenditures. That's what we mean by available and measurable. It's what you estimate. You're going to collect from the tax levy within the current fiscal year and up to 60 days into the next fiscal year, because all of that tax money is considered available to pay off current expenditures.

Now there's more in modified accrual. There are only five types of tax revenue that would ever be accrued again in modified accrual. There's only five types of tax revenue that we would ever recruit. Number one, property taxes. Number two real estate taxes. Number three, income taxes. Number four, sales taxes again.

Number one, property taxes. Number two real estate taxes. Number three, income taxes. Number four, sales taxes and number five tax payments due. From other governmental bodies and number five would be tax payments due from other governmental bodies. I'll just give you a quick example. Let's say a town was anticipating collecting some sort of state matching funds.

Well, the town could accrue that because it falls into fifth category tax payments due from other governmental bodies, but in modified accrual, those are the only five types of tax revenue that you would ever accrue. Let me make sure you're with me. When do you accrue those five that's right when they're available and measurable now, all other tax revenue, parking meter, money, hunting, license fees, fishing, license fees, fines, penalties.

Anything else you can think of is recorded on a cash basis and you know what? That means nothing is recorded until it's collected. So that's a big part of modified accrual, only five types of tax revenue, or ever accrued all other revenue, parking meter, money, hunting, license fees, fishing, license fees, fines, penalties, anything, but the first five would be recorded on a cash basis.

Simply meaning nothing would be recorded until it's collected. Now that's the major difference in modified accrual on the revenue side. How about the expenditure side? Well, the major difference in modified a cruel on the expenditure side is to remember this none of the five governmental funds, general fund, special revenue fund capital projects fund permanent fund debt service fund.

None of those five governmental funds are allowed to carry their own fixed assets. Remember this, the five governmental funds are forbidden. To carry their own fixed assets. So if one of the five governmental funds does go out and purchase a fixed asset because it does happen, they can't debit machinery, they can't debit equipment.

They can't debit building. What they do is debit expenditures control and credit vouchers payable. It's important to remember that if any of the five governmental funds buys a for a fixed asset, they treat the purchase of a fixed asset, like an expenditure it's expense. And when you boil it down, that's the major difference in modified approval?

On the expenditure side, I should ask you, do you think the government reports the fixed assets somewhere? Of course they do. The government actually report the fixed assets in the government wide statement of net position, which again, we'll talk. How about later? And you're starting to see why this does get a little bit.

Complicated because the government wide statements as you'll see, are done under normal cruel accounting, while these funds are using modified accrual, I'd like you to shut the class down and do the first two multiple choice questions and your viewers guide. And you may notice that there are no answers to the questions in your viewers guide.

So don't look for them because I don't want them in there. I want you to answer the question. I know that if we put the answers in the viewer's guide, you'll go to look one up, notice the answer for the next five. Don't lie to me. That's exactly what you do. And I don't think that you test yourself the same way.

It's important that you get your answers. And then we go through the questions together. So please do the first two questions and then come back.

Welcome back. Let's look at these questions together. Number one, they say the following information pertains to property taxes, levied by Oak city for the calendar year one. While you're in the exam, you see it's property taxes. And the first thing you're thinking is, Hey, in modified a cruel, there are only five types of tax revenue that we would ever grew.

Property taxes, real estate taxes, income taxes, sales taxes, and tax payments due from other governmental bodies. So obviously property tax is one of the five. It should be a crude. When do we accrue it? When it's available in measurable notice the levee was 700,000 and they ask at the bottom. What amount would Oak report for year one net property tax revenue.

But the point is, it's not a it's, you don't look at the levy. No, you you're supposed to estimate what you're going to collect from that levy within the current fiscal year. So you pick up the 500,000 and even the a hundred thousand of that levy that you estimate you're going to collect within the first 60 days, days of fiscal year two, all of that money is considered available to pay off year one expenditures that's what's available and measurable.

And the answer is sick. Number two, which of the following fun types of a governmental unit has income measuring income determination as a measurement focus, general fund? No capital projects fund. No, the answer is C double. No, because remember the focus of all five governmental funds. Is the flow of current financial resources, not income measurement.

That's the measurement focus in all five governmental funds. These are two governmental funds, general fund capital projects fund the measurement focus and all five gold medal funds is not income determination. It is the flow of current financial resources.

The only way to understand modify the cruel is to do journal entries. Because as you'll see, when you do your homework in this area, modified a cruel, uses a whole different set of account names. You have to know what makes them increase, what makes them decrease? This is tested in the multiple choice.

This is tested in simulations. There's no way out of this and make no mistake right now. We could do, we could do, do a simulation on the general fund. We could do a simulation on the special revenue fund, the capital projects bond, the permanent fund, the debt service bond does. They all use modified rule, but to get us started.

I want to do a simulation on the general fund, where we have to go through the journal entries, the account names that are used in a general fund. And I should say before we start this, that the actual accountant in modified a cruel is very basic. That's not going to bother you. It really isn't. It's very basic accountant, but what does get a little bit tricky is you are going to have to learn a whole new set of account names.

And if you look in your viewers guide, you'll see we've set up T accounts. The simulation that we're going to look at is pine city. So if you go on your viewers guide, you'll see the simulation for pine city, the pine city general fund. And as I say, in that, in your viewers guide, you'll see that we've set up T accounts and there are 20 of them.

And it is very handy, I think, to have these T accounts because. It kind of gives you right away a list of all the account names you're going to have to be comfortable with anyway. So they're just a handy place to have them. These are all the account names that are used in modified a cruel, and you have to be comfortable with them anyway, but as we go through this simulation, we're going to do the journal entries under modified accrual.

But I want you to post these entries to this T accounts as we go through. I only make you do this once, but I think it's important to do this one time. Whereas we go through journal entries. You take the time, post the entries to the T accounts. Cause I think you will learn, modify to cruel much better if you do it that way.

So let's look at the simulation on pine city, the pine city's general fund, it says pine city's first year budget. So pine city just came into existence. And that helps because that means there's a zero on all these accounts. There's a zero balance in all these accounts because pine city just came into existence.

This is its first year pine city's first year budget is given in point number one, then an item's two through 13. We are given what the activity for the first fiscal year and notice there's two requirements requirement, a prepare the appropriate journal entries for the general fund. And there's also be.

Prepare the closing entries for the general fund. All right. So let's start the entries. If you go back to item number one, we're given the budget and you have to be aware that one of the major differences in modified a cruel is that under modified accrual, not only does the government have a budget, they actually make a journal entry to record the budget.

They actually make a journal entry to book the budget. I mean, you know that, you know, profit making companies have a budget, but. There's no journal entry for the budget, but in modified a rule, not only do they have a budget, they actually make a journal entry to record the budget. So let's get the, they say they're estimating that during the tax year, they're going to collect $110,000 of tax revenue.

So let's start our budget. We're going to debit. It's going to be a debit. To estimate it, notice the word estimated revenues control 110,000. So notice the budgeted revenues are a debit, do estimated revenues control of 110,000. And then they say they have legislative authority to spend up to $97,000 of that.

And you have to be aware that legislative authority to spend money. That's the definition of an appropriation. So we're going to credit appropriations control. 97,000. So remember legislative authority to make contracts in Corolla allegations, basically legislative authority to spend money. That's the definition of an appropriation.

So we're going to credit appropriations control 97,000. Now, once you've done that, now there are these estimated transfers notice there's an estimated permanent transfer from the capital projects fund of 7,000. There's going to be, and you might want to. Circle the word from estimated permanent transfer from the capital projects fund of 7,000.

There's also going to be an estimated permanent transfer to sort of that word, to, to the debt service bond of 2000. I want to talk about permanent transfers for a minute. What we're up against here is a rule that you have to be aware of. You have to know this rule, a permanent transfer of money from one fond or another, that word permanent important, a permanent transfer of money, not a temporary transfer.

Which we'll talk about later on, but a permanent transfer of money from one fund to another for operating purposes is always called other financing sources or other financing uses. Let me say that again, a permanent transfer of money from one fund to another for operating purposes is always called other financing sources or other financing uses and keep in mind the fund that receives the money.

It's a source. The fund that sends the money. It's a use. Remember that the fund that receives the money, it's a source, the fund that sends the money. It's a use. And I bring this up because when you're setting up your budget, if you're estimating that during the fiscal year, they were going to be permanent transfers, permanent transfers have to be budgeted for not temporary transfers.

Let me say that again. Permanent transfers have to be budgeted for. Not temporary transfers, which we'll talk about later. All right. So when you see in this budget listing that they're estimating during the fiscal year, there's going to be a permanent transfer from the capital projects fund of 7,000.

Well, if, if it's going to come from the capital projects bond to the general fund, that means the general is going to receive the money to the general fund. It's going to be a source. So when the budget they're going to debit estimated. Oh, the financing sources 7,000. Again, that's a debit to estimated other financing sources 7,000.

Now they also are estimating that during the fiscal year, there's going to be a permanent transfer to the debt service fund. Well, now that you have the general fund is sending the money. So the general fund that's going to be a use. So when the budget we're going to credit appropriations dash estimated other financing uses.

2000 again, credit appropriations dash estimated other financing uses 2000. Just remember permanent transfers have to be budgeted for not temporary transfers. Now, if you add it all up, the fee doesn't balance, this next number is a plug. I simply need a credit of 18,000 to balance the entry out. We're going to credit budgetary fund balance.

So credit budgetary fund balance, 18,000. That's the entry to record the budget. And you'll see, when you do your homework, lots of questions in the FAR CPA Exam about the entry to record the budget. You've got to know that entry like the back of your hand. And we'll certainly be looking at that entry again. It's not the only time you're going to see it in this FAR CPA Exam study course, but it's a very heavily tested entry in governmental accounting.

And I think, you know why, because there's nothing like this in profit making accounting. I think when you really. Boil it down. A lot of what the FAR CPA Exam focuses on is what's different between what a profit making company does and what a government does under modified a rule. As I said before, profit making companies have a budget.

Of course they do, but they don't make an entry to record the budget. This is unique to modify, to cruel that there's an actual journal entry to book the budget. So the FAR CPA Exam asks a lot of questions about it, make sure you know, that entry.

All right now that we've booked the budget. Now let's get into the actual activity. Number two, now, pine city levies real estate taxes. Of 108,000 and the estimate 8,000 will be uncollectable. Well, once again, we know that in modified a cruel, there are only five types of tax revenue that you would ever accrue.

Property taxes, real estate taxes, income taxes, sales taxes, and tax payments due from other governmental bodies. So, because this is real estate taxes, we are going to accrue. It's one of the five. Now, remember we got into. Well, what is available and measurable means we're going to accrue it once available and measurable.

We have to estimate what you're going to collect from this levy within the current fiscal year or up to 60 days into the next fiscal year. Notice in this simulation, they didn't give us all that detail, but since they told us what they estimate is uncollectable, we have to assume the rest will be collected within the first, within the current fiscal year or up to 60 days into the next fiscal year.

But here's the entry we're going to debit taxes, receivable current. But the important point is we're going to accrue it. It's real estate taxes. So we're going to debit taxes, receivable current for the, for the full levy, 108,000. We're going to credit estimated uncollectable taxes, 8,000. That's like your allowance for bad debts in a profit making company.

As I said earlier, the accounting is actually pretty basic. So we're going to credit estimated uncollectable taxes, 8,000 and notice we're going to credit revenues control a hundred thousand. So be aware of that. Actual revenue is a credit to revenues control. In this case, a hundred thousand item three.

Now people start to pay their real estate taxes and the city collects 106,000 real estate taxes. So I think, you know what they're going to do. They're going to debit cash for the 106,000. And they're going to credit the receivable credit taxes receivable current for the 106,000. Now, if you stop and look at it, you see the problem.

It turns out they've collected more in real estate taxes than they estimated they were going to. So we're going to have to make an adjusting entry, just a little wrinkle here. It turns out they collected more in real estate taxes than they estimated they were going to. So it's going to require an adjusting entry.

So what do we do here? Well, notice originally we thought that 8,000 of the real estate taxes would be uncollectable. Now apparently how much is uncollectable just 2000. So that account is overstated. So we're going to debit, we're going to debit estimated uncollectable taxes, 6,000. And what do we credit revenues control 6,000 because they didn't recognize enough actual revenue either.

So credit revenues control 6,000. That takes care of that item. Number four, the city collects 11,000. And parking meter receipts. Well, here again, we're back to the basic rule that in modified a cruel, there are only five types of tax revenue that would ever be accrued. Property taxes, real estate taxes, income taxes, sales taxes, and tax payments due from other governmental bodies.

All other tax revenue like parking meter money is recorded on a cash basis. Nothing is recorded until it's collected and here it's collected. So they're going to debit cash for the 11,000. And they're going to credit, you know, revenues control for 11,000 because actual revenue is a credit to revenues control.

All right. Now, if you, with me on the first four items, they've all dealt with revenue and now we get into item five. Now pine city has approved purchase orders for goods and services. Estimated. To cost 84,000 and included in that order is an order for a Xerox machine estimated to cost 6,000. Now, this is an important point we've hit.

And I want you to think about something. If a profit making company send out purchase orders, is there a journal entry at that point? I think, you know, the answer is no, no. Profit making companies. If they send out purchase orders, do not make a journal entry. Profit-making companies don't make any journal entry until when, until the goods and services are delivered until the company is billed.

Right? That's what we're all used to. Probably making company sends out a purchase order. There's no entry, profit making companies make no entry until the goods are delivered until we're billed until we're extended credit. And my point is, that's what we're used to. That's normal. Cruel accounting. Now listen carefully.

This is very important in modified a cruel, just the act of sending out a purchase order requires an entry because governments use an incumbent system. And that's what we're starting to get into here. And let me just say what I'm sure you're thinking the FAR CPA Exam loves the incumbent system because it's different to modify to cruel.

So in modified a cruel, just the act of sending out a purchase order requires an entry because governments use an encumbrance system. So let's do it. When those purchase orders go out in the general fund, they're going to debit encumbrances control for the 84,000 debit encumbrances control, 84,000 and credit budgetary fund balance reserve for encumbrances 84,000.

Notice the general fund would book an entry. Debit. Encumbrance is controlled for the 84,000 and credit budgetary fund balance reserved for encumbrances for the 84,000. Now a couple of things to keep in mind, always remember that an encumbrance is just an estimate of what we think goods and services are going to cost.

Right? And encumbrance is just an estimate of what we think goods and services are going to cost. We won't know the actual amount until we're built, but the important thing is governments use an incumbent system. Maybe I should ask you this. What is an encumbrance? What is it? It's a potential obligation, right?

That's really what an encumbrance is. It's a potential obligation. It's not an actual obligation until the goods and services are delivered until we're built until we're extended credit. But this is a major difference in modified a cruel and modified a cruel. Not only do we keep track of actual obligations, we keep track of potential obligations.

And that's what an encumbrance represents. And again, an encumbrance is just an estimate of what we think goods and services are going to cost. We don't know the actual amount. Until we're built

item six. Now the goods and services start to come in and the city is billed. Now there's a billing, 75,000 for goods and services. That they estimated would cost 73,000. In other words, this is 73 of the 84. And notice the note there. This does not include the Xerox machine that hasn't come in yet. All right, we've hit another important point.

Remember this the way the incumbent system works when the city is billed. They always start by reversing. You've got to reverse the original encumbrance for the original estimated amount. Again, the way the encumbrance system works when a city is built, they always start by reversing the original encumbrance for the original estimated amount.

So they said this bill for 75,000 was for goods and services that they estimated would cost 73,000. So we're going to start here by debiting budgetary fund balance reserve for encumbrances. And we're going to credit and conferences control not for 75,000, not for 75,073,000. What we estimated those goods and services were going to cost.

You always reverse the original incumbents for the original estimated amount. So we're going to debit budgetary fund balance, reserved for encumbrances, and we're going to credit and conferences control for the original estimated amount. And that's 73,000. Now that we've done that we booked the expenditure and the liability vouchers payable.

At whatever we're built more or less here, it was more so we're going to debit expenditures control and credit vouchers payable. 75,000. Then item seven says the invoices for 75,000 were approved for payment. So of course, we're going to debit vouchers payable, 75,000 credit cash, 75,000. That is a very important sequence of entries.

Don't go in that exam. And not be comfortable with the encumbrance system. You can see from those entries, it's not difficult, but you've got to know it because the FAR CPA Exam loves the incumbent system for the same, for the reason we talked about before, there's nothing like this in profit making accounting and a lot of questions in the exam, focusing on what's different between what a profit making company would do and what a government would do under modified cruel and encumbrance.

Accounting is unique to modify to cruel. Item eight. Now the Xerox machine comes in with a bill for 80 with a bill for 6,500. What are you going to do? That's right. Reverse. Right? You always reverse the original encumbrance for the original estimated amounts. We're going to start off by debiting budgetary fund balance, reserved for in conferences.

And we're going to credit and conferences control not for 60 506,000. The original estimated amount. We always reverse the original encumbrance for the original estimated amount. Then we're going to record the Xerox machine at its actual amount, but you know what I'm going to say. Now, you can't debit equipment for the 6,500.

The general fund is forbidden to carry fixed assets. None of the five governmental funds are allowed to carry fixed assets. So the general fund now is going to debit expenditures control 6,500. Remember, they treat the purchase of a fixed asset, like an expense. So they're going to debit expenditures control for what they're actually billed 6,500 and credit vouchers payable for the 6,500.

So reverse the original encumbrance for the original, the original estimated amount. And then we book the expenditure and the liability vouchers payable and what we're actually built. And for some reason they don't seem to be paying that invoice. Maybe it's in dispute. When we don't know it hasn't been paid yet, but don't just assume it will be paid.

It could be in dispute. And there's nothing to indicate here that the invoice has been paid by the way, where would the government actually report the Xerox machine? Because the general fund is forbidden to carry the fixed assets. Where would they report it? You know, in the government wide statement of net position.

Remember the government wide statements are done under normal cruel accounting. And we will talk about that more later in this CPA Review FAR course, but that's what you'd actually find the Xerox machine. It would be reported with all the other fixed assets in the government wide statement of net position item nine at year end, they do a physical count and they have a supplies inventory of a thousand dollars.

And. Pine city uses the purchase method to account for supplies. Now, what do they mean by the purchase method? It's actually very simple. If you're using the purchase method, that means that as you go through the fiscal year, every time you purchase supplies, you just debit expenditures, control, credit vouchers, payable, debit expenditures, control, credit vouchers, payable.

That's your routine entry. In other words, all year, you expense it. That's what the purchase method means. Every time you purchase supplies. Debit expenditures control credit vouchers, payable, debit expenditures, control credit vouchers payable. Okay. Then at year end, you take a physical count. You've got a thousand dollars of supplies on hand.

Now you'll book an entry you'll debit inventory of supplies for a thousand and you'll credit the non spendable fund balance a thousand that's the entry year end. You've got a thousand dollars of supplies on hand you'll debit inventory of supplies and credit. The non spendable. Fund balance. And we're starting to get into the different designations of fund balance, which you're going to have to know.

This is called the  the non spendable fund balance because this represents the part of fund balance that's already been spent in this case on supplies. So the non spendable fund balance represents the part of fund balance that's already be already been spent in this case on supplies. Now dwell on this, but the other possibility from the purchase method might be the consumption method.

I think you see the consumption method with supplies in profit making company. Quite often. What's the consumption method you probably know in the consumption method, say profit making accounting. If you use the consumption method for the supply, if you use the consumption method for supplies, it means as you go through the fiscal year, Every time you purchase supplies, you debit supplies, credit accounts, payable, debit supplies, credit accounts payable.

And then at year end, you take a physical account and expense. What you consumed. You see that most often in profit-making accounting, the consumption method, but here in modified a cruel, they using the purchase method.

Now in 10, 11, and 12, we're getting back to transfers of money from one fund to another in item 10, notice there's a temporary, we'll get that word. There's a temporary transfer of $3,000 to the special revenue funds. So the general fund is making a temporary transfer of $3,000 to the special revenue fund.

And I'm sure you know, this, what does temporary mean? You know, it means eventually the special revenue bond has to pay it back. So here we go, because this is a temporary transfer of money from one fund to another. In the general fund, they're going to debit a receivable. They're going to get it back.

Eventually. It's temporary. So the general fund, they're going to debit a receivable called due from special revenue fund, 3000. They're going to debit do from special revenue fund 3000 credit cash, 3000. And just to show you the other side, what would special revenue do? Well, special revenue fund is sending the money.

So they're going to, they're going to debit receivable. They're sending they're excuse me, they're receiving the money. So they're going to debit cash 3000 and credit due from, excuse me and credit. Due to the general fund because they have to pay it back. So let me do that again. This is how you handle a temporary transfer of money from one fund to another.

The fund that sends the money. In this case, the general fund is going to debit receivable called do from special revenue fund, 3000 credit cash, 3000. Then on the other side, special revenue fund would debit cash. They get the money and credit a liability called due to general fund. So it's really very simple.

That's how you handle a temporary transfer of money. From one fund to another item 11. Now the general fund receives a permanent transfer, a permanent transfer of $7,000 from the capital projects fund. So you see what's happening. The general fund is receiving a permanent transfer of 7,000 from the capital projects fund.

So you know that the general fund is going to debit cash 7,000 and you know what? They're going to credit other financing sources. 7,000 because it's a rule, a permanent transfer of money from one fund to another for operating purposes is always called other financing sources or other financing uses.

And as we said before, the fund that receives the money. It's a source, the fund that sends the money. It's a use in this case, the general fund received the money. The money came from the capital projects fund. So the general fund is going to debit cash 7,000 and credit other financing sources. What would it look like on the other side, you know, Capital projects is sending the money.

So it's a use that they would debit or the financing uses control 7,000 and credit cash 7,000. That's what it looks like on both sides, but we really we're really just concerned here with the general fund. So it would be a debit to cash and a credit to other financing sources, 7,000 item 12. Now the general fund sends a permanent transfer of 2000 to the debt service fund.

So now the general fund is sending the money. The general fund is sending a permanent transfer of $2,000 to the debt service fund. So, because the general fund is sending the money, the general fund is going to debit. Other financing uses it's a use for the general fund debit, other financing uses, and sometimes you'll see that called operating transfers out.

You might see that account name operating transfers out, operating transfers out is the same thing as other financing users, you know, eventually it would be closed into other financing use. It would show up in the financial statements. It's all the financing uses, but you might see that account name operating transfers out.

So the general fund is going to debit other financing uses or operating transfers out 2000 credit cash, 2000. And of course, on the other side, the debt service fund would debit cash 2000 and credit other financing sources. They had the fund that received the money. So it's a source. So credit other financing sources or what operating transfers in.

Operating trans present, same thing as other financing source, it would show up in the financial statements as other financing sources, but you might see those account names. All right. So we have now done all the journal entries under a modified a cruel, and that takes care of requirement. A, they said prepare the appropriate journal entries for the general fund.

We've done that, but there's also big. Prepare the closing entries for the general fund. Now we're going to go through the closing entries and I don't want you to think it's busy work. You'll see in your homework, a lot of multiple choice are about the closing entries. This is why I make us do a problem, right.

To the bitter end, right through closing entries. Now, if you've been doing, as I asked and you've been posting the entries that we've, that we've done to the T accounts. I want you to shut the class down and get the balance and all the T accounts before we do the closing entries, shut the class down and take a few minutes, get the balance and all the T accounts.

And then we'll go through the closing entries together.

Hopefully now you have the balance and all the T accounts. And now we're going to get into the closing entries. And I want to give you just a little bit of a game plan here that I think will help you try to remember that in modified accrual in modified accrual, you're always looking to close out three things.

Number one, you have to close the budget. Number two, you have to close actual activity. And number three, you have to close the encumbrances. I think it's good to remember that because you get your organized, Hey, it's modified a cruel, I've got to close out three things. I've got to close the budget. I've got to close the actual activity.

I've got to close the encumbrances. I've got to close the budget. I've got to close the actual activity. I've got to close the encumbrances. That's the game plan. Let's close the budget. Now you'll see that when you close the budget, all you have to do is reverse the entry that you made when you set it up.

So now you debit the budgetary fund balance for 18,000. And that should zero that account out. Now you debit appropriations dash estimated other financing uses for the 2000 should zero. That out you debit appropriations control for the 97,000 would zero that out credit estimated other financing sources, 7,000 to zero, that out and credit estimated revenues control for the 110,000 to zero that out.

And I promise you that's all that is ever going to be. It's just a matter of reversing. The entry that you made when you set it up, but it's gotta be done. You gotta close the budget. Now I know that it may seem like a bit of a waste of time. He said, well, Bob, we opened the budget and then we close it. Why don't we do that?

Well, theoretically now, theoretically, the reason why they booked the budget is supposedly theoretically it's there as a control. So I'll just give you an example. You book the budget, right? And then, you know, As you go through the fiscal year that your expenditures plus your in conferences should never exceed your, what can you fill in that blank?

Got the budget recorded, right? And then, you know, as you go through the fiscal year that your expenditures plus your in conferences should never exceed your, what appropriation your legislative authority to spend money. So that's theoretically why it's there. So now, you know what you go through the fiscal year, that your expenditures, plus your encumbrances.

Should never exceed your appropriation, your legislative authority to spend, but it's got to be closed. So the first thing you do is close out the budget. Now, the second thing you close out is the actual activity. Now, what do I mean by the actual activity? You've got to close out the actual revenues, the actual expenditures, the actual sources and the actual usage.

Got to close out all the actual activity, actual revenues, actual expenditures, actual sources, and actual users. So let's do it. We're going to debit revenues control for the 117,000. That's the balance and revenues control member. Actual revenue was a credit to revenues control. And now we're going to debit revenues control for the 117,000 zero.

That out we're going to debit other financing sources control. For the 7,000 to zero that out, we're going to credit. Other financing uses control for the 2000 and we're going to credit expenditures control for the 81,500. Let me do that again. Debit revenues control for 117,000 zeros that out we're going to credit expenditures control for the 81 five.

Zeroed out, we're going to debit other financing sources control for the 7,000 in credit. Other financing uses control for the 2000. See, that's what I mean. By close out actual, you've got to close out actual revenues, actual expenditures, actual sources, and actual users. You have to close out all the actual activity.

Now you'll notice the entry doesn't balance. This next number is a plug. Really no other way to get it. We simply need a credit of 40,500. It's a plug. Plug it in there. We need a credit. Of 40,500 to balance the entry out. We're going to credit the unassigned fund balance. Notice the balance, the entry out, we credit the on assigned fund balance.

You have to know all these fund balance designations, and we're going to credit the unassigned fund balance, but 40,500, the unassigned fund balance. That's the part of fund balance. That's spendable. It's unrestricted. It's uncommitted again. When you see the unassigned fund balance, that's the part of fund balance.

That's spendable, it's spendable, it's unrestricted it's uncommitted. It's called the unassigned fund balance. Now listen carefully in any other fund, other than the general fund in any other fund, that would be called the assigned fund balance because that fund balance would be assigned. To the purpose of the special revenue fund that fund balance would be assigned to the purpose of the capital projects bond that fund balance would be assigned to the purpose of the permanent bond.

That fund balance would be assigned to the purpose of the debt service fund in any other fund that would be called the assigned fund balance. Listen, unless it was in deficit. If it's in deficit, it's always unassigned. Let me do that again. This fund balance for the general fund is called the unassigned fund balance.

It's the part of fund balance. That's still spendable. It's uncommitted, it's unrestricted, it's called unassigned fund balance. But in any other fund, it would be called the assigned fund balance because that fund balance would be assigned to the purpose of that fund. So it would be assigned to the purpose of.

The special revenue fund or assigned to the purpose of the capital projects, bond or assigned to the purpose of the permanent fund or assigned to the purpose of the debt service fund. And then the other fund, it would be called the assigned fund balance unless it's in deficit, anytime it's in deficit, I don't care what fund it is.

It's always called on assigned, but in the general fund, this would be called the unassigned fund balance. And as I say, it's a plug.

Now, the third thing we close out are the encumbrances. Now, if you look at your T accounts on in conferences right now, there's still a $5,000 debit balance and encumbrances control, and there's a $5,000 credit balance. In budgetary fund balance, reserve and conferences. Now, before we get into how we close this, why is there a balance in those accounts?

I think, you know, why, when there's a balance in those accounts, doesn't tell you that there's still $5,000 of purchase orders out in the world somewhere, but the goods and services haven't come in yet. Right? That's what it tells you. You see a balance in those accounts and by the way, they should always agree.

No, it's, it's 5,000 in both. And anytime there's a balance in those accounts, it's telling you that. There's like $5,000 of purchase orders floating around in the world somewhere. But the goods and services still haven't come in yet. In other words, they still have some potential obligations in modified a cruel.

Not only do we keep track of actual obligations, we keep track of potential obligations. Don't we? So here's how you close out the encumbrances. It takes two entries. First we debit the budgetary fund balance reserved for in conferences and we credit and conferences control 5,000. That zeros, those accounts out.

That's our first entry. We debit by Sri fund balance, reserved for and conferences and we credit and conferences control 5,000. Those accounts was zeroed out, but I still have a problem. There's still $5,000 of purchase orders floating around somewhere. We still have potential obligations. So here's what we do.

We make a second entry in our last entry in our, when we closed out the actual activity, didn't we establish that this general fund has an unassigned fund balance. 40,500. Well, it turns out not all their fund balance is unassigned. They've got purchase orders outstanding. So now we debit the unassigned fund balance for 5,000 and we credit the committed fund balance 5,000.

Again, my second entry, we're going to debit the unassigned fund balance by thousand, and we're going to credit the committed fund balance 5,000. The committed fund balance is the part of fund balance. That's already committed. It's the fund balance that's reserved for contractual commitments. The part of fund balance that's reserved by decision-making.

I'll say it again. The committed fund balance represents that part of fund balance. That's

already committed. It's already, it's already committed because of contractual obligations or decision-making. So it's a part of fund balance. That's contractually committed. Think of it that way. It's called the committed fund balance. All right. Now we have made all the closing entries. And if you look at the T accounts, all that's left our balance sheet, the accounts.

And if you look in the viewer's guide, you'll see the balance sheet for the pine city general fund. And as I say, that's all this left and the T accounts are balance sheet accounts. And if we were to do the balance sheet for the general fund it's in the viewers guide, take a look at it under assets, this cash of 44,000 there's taxes receivable, current of 2000, but they also have estimated uncollectable taxes of 2000.

So the net receivables are zero. They have a thousand dollars in supplies, inventory, and notice that due from special revenue fund member, that was a temporary transfer. It's eventually going to come back to the general fund. So that's going to show up on the general fund balance sheet as due from special revenue fund to receivable of 3000.

So the total assets add up to 48,000, then there's liabilities and fund balance. There's only one liability that voucher is payable. For some reason that 6,500, we have not paid for that Xerox machine yet, as I said, maybe that invoice is in dispute, but notice how we present the fund balance. They have an unassigned fund balance of 35 five.

They have a fund balance. That's committed. That's contractual commitments of 5,000 and a non spendable fund balance of a thousand. Hey, that's the part of fund balance that's already been spent on supplies. If you look at the next page, notice. Pine city's general fund statement of revenues expenditures and changes in fund balance.

So if we were to do the statement of revenues, expenditures and changes in fund balance for the general fund under revenues, you've got real estate taxes of 106,000 miscellaneous revenues. That was the parking meter money of 11,000. So the total revenue is 117,000 total expenditures, 81 five that gave you an excess of revenue over expenditures of 35 five.

Then there was other financing sources of seven other. The financing uses of two that gave us an excess of revenue and sources over expenditures and uses of 40,500. But don't forget, we've got that committed fund balance contractual commitments of five. So the increase in the unassigned fund balance 35 five, then you would simply show.

The unassigned fund balance back on January one. In this case, it was zero because the city just come into existence. And that gives you the unassigned fund balance at December 31, which is 35 five.

Those are fund financial statements. Now we do these. Fun financial statements, and they're supposed to help with three things. These fund financial statements are supposed to help us make political decisions they're supposed to help us establish social policy. Again, these fund financial statements are supposed to help us make political decisions they're supposed to help us establish social policy.

And these fund financial statements are supposed to help us evaluate generational equity. These fund financial statements are supposed to help us evaluate generational equity. And you might see that term in the exam, generational equity. So I want to talk about it. What do we mean by generational equity?

Now, when you see that phrase in the exam, generational equity, in this context, the word equity means equitable fairness. Think of it as generational fairness. And what it basically means is we're not supposed to charge future generations for the cost of services were receiving today. Again, Think of it as generational fairness, simply meaning we're not supposed to charge future generations for the cost of services we're receiving today.

That will be generational inequity. That would be generational unfairness. And if you go back to the general fund balance sheet, take a look at it. Is there generational fairness? There is because notice the unassigned fund balance is in surplus by 35 five. That's really what you're looking for. Deficits.

You may not have ever heard that before, but what a deficit really represents is charging future generations for the cost of services we're getting today. That's what a deficit really represents. But here for the first time in the history of the world, we have an unassigned fund balance that's in surplus.

So in this financial statement, there is generational fairness. There is generational equity, but you have to be aware of that term. And these fund financial statements are supposed to help us evaluate generational fairness, generational equity. Now I want to go back to all these fund balance designations because they're, they're important in the FAR CPA Exam that you know, all of them.

And so far we've covered five, right? There's the budgetary fund balance. That's you know what the budget fund balance represents. Is the impact your budget's going to have on fund balance, right? That's called budgetary fund balance. The impact your budget you're projecting your budget will have on your fund balance.

Then we looked at the non spendable fund balance what's that the non spendable fund balance is the part of fund balance that's already been spent. In our example, on supplies it's already spent called the non spendable fund balance. Then we looked at the committed fund balance. The committed fund balance is the part of fund balance that's for contractual commitments.

And then we looked at the unassigned fund balance, right? The part of fund balance that's spendable part of on balance it's uncommitted part of fund balance. That's available. It's called the unassigned fund balance in the general fund in any other fund, what's it called? The assigned fund balance because that fund balance would be assigned to the purpose of the special revenue fund.

That fund balance would be assigned to the purpose of the capital projects fund and so forth. Any other fund it's called the assigned fund balance unless it's in deficit and it's always called unassigned, but there is one more. I bring this up because there is one more fun balance you might see referenced in the exam.

It's called the restricted fund balance. The restricted fund balance is the part of fund balance. That's restricted by law. The part of fund balance that's restricted by law by the constitution by enabling legislation. That's what the restricted fund balance represents by the fund balance. That's restricted by law could be by the constitution by enabling legislation.

That's called the restricted fund balance. And you may see that mentioned as well. Now, you know, all the fund balance designation. In governmental accounting. I'd like you to try some questions. We've been through a lot. I'd like you to try questions three to 14, please do number three to number 14, get all your answers and then come back.

Welcome back. Let's look at these questions together. In number three, they asked. Which event is supportive of into period equity, that I'm a generational equity equity between periods, fairness, between periods. We don't want to charge future generations for the cost of services we're getting today. So what would be supportive of generational equity into period equity?

How about number one? How about a balanced budget is adopted? Yes, that's supportive of interfered equity because we're not running up deficits. We're not trying to charge future generations for the cost of services we're receiving today. And then number two. Residual equity transfers out equals residual equity transfers in the whole idea that transfers between funds, the transfers out will equal transfers in, has nothing to do with generational equity into period equity, you know, transfers out should always equal transfers in it.

Doesn't that doesn't mean have any effect on it. So the answer is a only the first statement a balanced budget is supportive of interfered equity. Number four park city uses a com in incumbrance accounting. Formerly integrates the budget into the general fund. The County records. Here's the budget information.

When Park's budget is adopted, they want to know what would be the budgetary fund balance. Well, let's just put the entry down together. You know, you're going to debit estimated revenues control for the 30 million. You're going to credit appropriations control for the 27 million. And then there's a transfer.

There's an estimated transfer to the debt service bond of 900,000. It has to be permanent. I'll tell you why. I know that might bother you. But they're not going to necessarily say the word permanent. You have to assume that's permanent for a couple of reasons. First of all, the money's going to the debt service fund.

It's going to be used to service debt. It's never going to come back. It is permanent. The debt service funds like a black hole. Once money goes into the debt service bond, you're never going to see it again, but not only that, if this makes you feel better, if it's temporary, they have to say it. If it's temporary transfer, they will say the word temporary, but it's a permanent transfer.

And of course, permanent transfers have to be budgeted for. Now they said, this is a estimate of transfer to the debt service fund. So the general fund is going to send the money. So to the general fund, it's a use. So when the budget we're going to credit appropriations dash estimated other financing uses for the 900,000 and now we plug our credit to budgetary fund balance.

I've answered C 2,000,001. You've got to know that entry to record the budget. Number five, the estimated revenues control account. If a governmental unit would be debited when you know, answer, see what the budget is recorded. When we record the budget, we debit estimated revenues control. Now in number six, remember I mentioned that the FAR CPA Exam loves two things.

They love the entry to record the budget and they love closing entries. And this multiple choice is about both. It's about the entry. It's about the entry to book the budget. And it's also about closing entries. They're basically asking a number six. How would recording the budget and closing entries affect one account name, the budgetary fund balance, but you had to be careful cause notice in the first sentence it says the budget of a governmental unit for which appropriations exceed estimated revenues.

In other words, if you just make up some numbers, when this governmental units, when this governmental unit adopted their budget, they debited estimated revenues control for say 200,000. And credit appropriations control for 250,000 just making up numbers. But the point is they have legislative authority to spend more than they're going to collect.

Great idea. Right. It's why we're in such a mess. Oh yeah. That's politicians. Oh, we have legislative authority to spend much more than we have. So we'll just borrow the rest. Right. So are you getting in trouble? But that's what they're talking about. There, they would have debited estimated revenues control say for 200,000, but credit appropriations control for two 50.

So in other words, they would debit. In their budget, debit, budgetary fund balance for the 50,000. In other words, budgetary fund balance was in deficit when they recorded the budget. Then at year end, when you close out the budget, you reverse the entry. So you would credit by salary fund balance for the 50,000.

Debit appropriations control two 50 credit estimated revenues for the 200,000. You'd reverse everything. So in this question, what's the effect of the budgetary fund balance it's answers. See, it would be debited at the beginning of the year, cause it's in deficit and credited at the end of the year, when you close it out, kind of the opposite of what you'd normally think, but you have legislative authority to spend more than you're going to collect.

Number seven in the current year, new city issued purchase orders and contracts. Of 850,000 that were chargeable against current year budget, appropriations of a million. So at least they haven't exceeded the legislative authority to spend the journal entry, to record the issuance of the purchase orders and contracts would include what well, you know, just the act of sending out a purchase order report requires an entry.

So in modified a cruel, you would debit in conferences control for the eight 50 and answer B. Credit credit, budgetary fund balance reserved for in conferences for the eight 50. The answer is B number eight. The encumbrances account of a governmental unit is debit. And when, when do we debit encumbrances control?

You know, answer B when a purchase order is approved, just the act of sending out a purchase order requires an entry because we use an encumbrance system number nine, which of the following amounts are included in. The general funds incumbents account, you know, this is really the CPA exam, kind of looking you in the eye, say what's an encumbrance.

Well, before we answer, what is an encumbrance? Do you know? It's a potential obligations? What an encumbrance is. So what am I going to find in the incumbent's account? How about number one? Am I going to find outstanding vouchers payable amounts? No, that's an actual obligation. An encumbrance is a potential obligation.

Am I going to find number two outstanding purchase orders? Of course I will. Those are potential obligations. How about number three? How about the excess of the amount of a purchase order over the actual expenditure on the order and off the actual expenditure has been booked than the original and conference has been reversed.

It's gone all I'm going to find in the unconference account and that list is answer C just number two, outstanding purchase. Number 10. Okay. The encumbrance system. Again, the FAR CPA Exam loves the encumbered system because there's nothing like it in profit making accounting. Elm city issued a purchase order for supplies with an estimated cost of 5,000.

So just if you're getting used to mentally, what was the entry didn't they debit and conferences control 5,000 credit budgetary fund balance reserve and conferences, 5,000. Get good enough at this. You can just kind of do it mentally. When the supplies were received, the accompanying invoice indicated an actual price of.

49 50. So what did they do? You always reverse the original and comments for the original estimated amounts. So now you would debit by jury fund balance reserved for conferences for 5,000. The answer is D credit and conferences control 5,000 and then book the expenditure and the liability vouchers payable at what they're actually built 49 50.

But the answer there is D because you'd have to debit, but surely fund balance reserve for, and is 5,000 and credit and conferences control 5,000. When the bill comes in.

number 11. We're back again to closing entries. Now, remember I said that, I think what helps you is to remember that in modified a cruel in modified a cruel, we're always looking to close out three things. We've got to close the budget. We've got to close the actual activity and we have to close the encumbrances in this multiple choice.

Are they asking us to close the budget? No. The only budget account we know is appropriations. Right? It's only budget account I have is appropriations. In other words, I don't know. Estimated revenues. I don't know budgetary fund balance, so I can't close the budget. Are we being asked to close and conferences?

I don't know the encumbrances. No. What they're asking you to do here? It's thinking about how you close out the actual activity. Notice the FAR CPA Exam loves closing entries. Now, you know what this means, you know, what do I mean when I say close out actual activity, I mean, close, actual revenues, actual expenditures, actual sources and actual usage.

It's got to close out all the actual activities. So let's do it. We're going to debit revenues control 8 million. We're going to credit expenditures control 5 million because we have to close out the actual revenue, the actual expenditures. Do that. Notice there's a source here of 1,000,005. Now, if it's a source, did they send the money or receive it?

They received it during the year. Didn't they debit cash, credit, other financing sources. So to close it out, we're going to debit or the financing sources, 1,000,005. And I think it through, there's also a use. Now, if there's a use, that means they sent the money. That means during the fiscal year, they debit it.

Other financing uses credit cash. So the close it out. I credit other financing uses 2 million. That's what it means to close out actual activity. You have to close out the actual revenue, the actual expenditures, the actual sources and the actual uses. And now the entry doesn't balance. It's always a plug.

I need a credit of 2 million, five to bounce the entry out. And that is the unassigned fund balance. That's what they wanted. And the answer is B number 12. County's balances in the general fund include the following. They give us a list of balanced and they say at the bottom, what is the remaining amount available for use by the County?

That is the question. What is the remaining amount available? Don't you know, you know, as you go through the fiscal year, That your expenditures, plus your encumbrances can never exceed your appropriation. Your expenditures are 164,000. Plus your encumbrances 18. That adds up to what, 182,000. What's your legislative authority to spend four 35, 435,000.

The appropriation minus your expenditures. Plus you're in conferences minus one 82. The answer is C that's. What's still available. Right. Your expenditures, plus you're in conferences should not exceed your legislative authority to spend your appropriation. So since the legislative authority to spend is four 35 so far, they've spent one 64, they have contractual obligations of 18 to 53 still available, but you knew that answer.

See, I have a 13, 13 says what do the following journal entries would a city used to record 250,000 in fire department. Salaries incurred during the day. Now I like this question because we haven't talked about fire department salaries, and yet I hope you answered this with no problem because you know, modified a cruel and if, you know, modified a cruel, some answers just shouldn't make sense.

Would you ever a debit and expense and credit appropriations? Of course not ever, because you're combining their, an actual account with a budget account. Those things that's never done in modified a cruel, there are actual accounts and there are budget accounts and they're never mingled in a journal entry.

So Hey makes no a I'm hoping you so pop. That makes no sense. How about B would you ever debit an expense and credit and an encumbrance? No. Never because you're combining an actual account with a budget account. Would you ever see debit in conferences in credit? A liability? Never. So the only answer that makes any rational sense at all, to those of us who know modified a cruel is D far different Ms.

Salaries, no problem. It's gotta be a debit to some kind of expense account expenditures control for salaries, liability, a payable that makes some sense and number 14 financing for the renovation of. First cities, municipal park was begun and completed during the year. And here are the list of their sources.

They got a grant from the state government. They got proceeds from bonds that transfer from the general fund and they say in the capital projects fund, what would be revenues? What would be other financing sources? Let's start at the bottom. How about the transfer from the general fund now? You know, you know how to handle this member?

It's gotta be permanent. It's gotta be a permanent transfer from the general fund because they have to say the word temporary. If they don't say it's temporary, you gotta assume it's permanent. Now when the capital projects fund got that transfer from the general fund, one entry did capital projects make didn't.

They debit cash for the a hundred thousand and credit other financing sources. It's a permanent transfer of money from one fund to another for operating purposes. So that would be in the capital project fund a debit to cash and credit other financing sources. So that's other financing sources. How about the proceeds from the bonds?

We said this. Earlier in this FAR CPA Review course member, if one of the five governmental funds issues, bonds, they debit cash. They can't credit bonds payable. They're forbidden to carry long-term debt. The capital projects fund would be forbidden to carry longterm debt. So when they issue bonds, they debit cash and credit other financing sources that would be other financing sources.

And then the grant from the state government that would be debit cash, credit revenues control. That would be revenue, grant revenue. And the answer is. See, and since we're talking about a grant in this case, I want to get into something.

Let's talk about a rule that's unique to modify to cruel and it's rule. You have to be aware of in modified a cruel. If a governmental unit receives restricted money, like a grant that governmental unit is not allowed to recognize that grant money is revenue until they spend the money for the intended purpose until they meet the terms of the grant.

We say that again in modified a cruel, if a governmental unit receives restricted money, like a grant that's usually comes up with some sort of grant, a state grant. In modified accrual, that governmental unit is not allowed to recognize that grant money as revenue until they spend the money for the intended purpose until they meet the terms of the grant.

Let me just give you a quick example. Let's say a town gets a $200,000 state grant and the money's restricted to purchase equipment. All right. So it's restricted. So town gets a state grant of 200,000. And the money is restricted to purchase equipment. When the town gets that grant, they're going to debit cash 200,000, but they haven't spent the money yet for the intended purpose.

So they would credit deferred revenue. They can't recognize the revenue until they spend the money for the intended purpose. So in this case, they would debit cash 200,000 and they would credit deferred revenue for the 200,000. Now, if we did a balance sheet at this point, that deferred revenue would be a liability.

Wouldn't it? Why is it a liability? Because theoretically, if they never meet the terms of the grant, they have to give the money back. Now that's never happened in the history of the world. Believe me, they'll spend it, but theoretically, if they never spend the money for the intended purpose, eventually they have to pay it back.

It's a liability. So right now it would be a liability called deferred revenue. And I want to emphasize that this money is not being received in advance of timing requirements. Again, this is a grant that's been received, not in advance of timing requirements. In other words, the money could be used immediately.

So even though the money can be used immediately, it wouldn't be revenue immediately because it's not revenue until they spend the money for the intended purpose. Now let's say the town goes out and buys $200,000 worth of equipment. If they go out and they purchased $200,000 worth of equipment, they would remember the not allowed to carry fixed assets.

So they would debit expenditures control 200,000 credit vouchers payable, 200,000. And now that they've spent the money for the intended purpose, they would debit deferred revenue, 200,000. And credit revenues control 200,000. That's how it works. You can't recognize the revenue until you spend the money for the intended purpose.

And going back to question number 14, that grant from the state government, I had to assume they spent the money for the intended purpose, because it says this renovation was begun and completed. It was completed. So I'm assuming in that multiple choice, we had to assume that the money was spent for the intended purpose.

So the grant revenue could be recognized, but I want to emphasize again. That this is grant money that you've received and it's spendable immediately. It's not, it's not money in advance of timing requirements, but I have to get into this. What if a governmental unit did receive a grant in advance of timing requirements?

That's a little different. If a governmental unit receives a grant in advance of timing requirements, they would debit cash and credit deferred inflow of resources. Let me say that again. If a government, if a governmental unit receives a grant, In advance of timing requirements. In other words, it, you it's it's, it can't be spent until some future time.

They get a grant in advance of timing requirements. The entry would be a debit to cash and a credit to deferred inflow of resources. Now that account you're gonna, you might see that in financial statements, if you see that account deferred inflow of resources, it always has a credit balance, and it would be shown below liability.

In a general fund balance sheet, you would see that at below liabilities called deferred inflow of resources, that would be in the general fund balance sheet. And later when we talk about the government wide statements, you would see that below liabilities in a government wide statement of net position, and you really might see that account deferred inflow of resources.

Now then when the timing requirements are met, then you would debit deferred inflow of resources. And credit revenue. When the timing requirements are met, then you would debit deferred inflow of resources and credit revenue. Bob, you might see that account name deferred inflow of resources always has a credit balance.

When else would this be used? Well, if there was a deferred gain on refinancing debt, if there was a deferred gain on refinancing debt, that would be deferred inflow of resources, a deferred gain on a sale leaseback, a deferred gain on a sale leaseback would be. Deferred inflow of resources proceeds from the sale of future revenue.

Proceeds from the sale of future revenue would again be a debit to cash credit deferred in fluid inflow of resources, an increase, an increase in the fair value of hedged securities. When a government hedges future transactions an increase in the fair value of hedged securities, what would the entry be?

There was an increase in the fair value of hedged securities debit, the investments credit. Deferred inflow of resources. I just mentioned this because you could see that on a general fund balance sheet again, below liabilities or in a government wide statement of net position below liabilities. Now how about a deferred outflow of resources?

Let's say grant expenses are paid in advance of timing requirements. Again, let's say grant expenses are paid in advance of timing requirements. What would you do? You would debit. Deferred outflow, deferred outflow of resources and credit cash. Again, if you paid grant expenses in advance of timing requirements, the entry would be debit deferred outflow of resources and credit cash.

And that account, you might see that in financial statements differ it outflow always has a debit balance. You could see that on a general fund balance sheet below assets or on a government wide statement, the net possession net position below assets. And then when the timing requirements and that, what do you do?

Debit, debit expenditures and credit deferred outflow. When else would you debit deferred outflow? Well, if there's a deferred loss on refinancing debt, if there's a deferred loss on refinancing debt, that would be debited to defer it outflow a deferred loss on a sale, lease back a different loss on a sale.

Leaseback would be a debit to deferred outflow of resources. The. Cost of acquiring rights for future revenue. The cost of acquiring rights of future revenue would be a debit to defer it outflow and a decrease in the fair value of hedged securities, a decrease in the fair value of securities of hedge securities.

When the governmental unit is hedging future transactions. If those, if there's a decrease in the fair value of hedged securities, You're going to debit, defer it, outflow of resources and credit the investment. You're gonna write it down. And one more time, you could see these accounts, you know, below you could see this account deferred outflow of resources below assets on the general fund balance sheet or below assets on the government wide statement of net.

I want to go back to modify to cruel. As I said earlier in this FAR CPA Review course, the best way to learn modified or cruel is to do journal entries. Two

get used to the account names and how they're used. So what I want to get into next is another simulation that's in your viewers guide. I want you to go to Maura city. What we're going to do now is a simulation where we have to go through the journal entries and the account names for a capital projects fund.

And that's going to force us to get into the debt service fund.

In Mora city, they're going to construct a new city hall and we know that's the kind of project we account for a capital projects bond because it accounts for the construction of major capital assets. Like a city hall, they have legislative authority to spend up to 775,000 on the construction. They're going to finance the construction by issuing $700,000 worth of bonds and getting a hundred thousand dollars state grant in items two through nine, we have the activity and let's start with the journal entries in the capital projects fund, as we've been saying.

One of the major differences in modified accrual. And we know the capital projects fund uses modified accrual, all five governmental funds use modified a cruel and in modified a cruel, not only do we have a budget, we actually make a journal entry to record the budget. So that's what we should start.

What would be the entry to record the budget in the capital projects fund? Well, there is something a little different here. Notice how they're going to finance the construction by issuing $700,000 worth of bonds. Now, you know, this. Later in the problem when they actually issue the bonds and we'll get there later in the problem, when they actually issue the bonds, we know they're going to debit cash.

They can't credit bonds payable. They're not allowed to carry long-term debt. So they're going to credit other finances and sources. Aren't they? So here's my point. If you setting up your budget and you're estimating during the fiscal year, there's going to be bond proceeds. When you, anytime you're setting up a budget and you're estimating during the fiscal year, they're going to collect bond proceeds.

That has to be part of your budget as a debit, to estimated other financing sources for the 700,000. So that's how we'll start our budget entry. We're going to debit estimated other financing sources, 700,000. They're also expecting a hundred thousand dollars state grant debit, estimated revenues control for the a hundred thousand.

They have legislative authority to spend up to 775,000 on the construction. You know what that is? It's the appropriation. Legislative authority to spend money. That's the definition of an appropriation. This is getting to be old hat for you now. So we're going to credit appropriations control for the 775,000.

Now the entry doesn't balance does it. We need a $25,000 credit to balance the entry out. You know what that is? That's your budgetary fund balance 25,000. Now let's get into the actual activity in item two, they actually received. The a hundred thousand dollars state grants. What are you going to do in the capital projects fund?

They're going to debit cash a hundred thousand and credit deferred revenue, right? Member in modified a cruel. When the governmental unit receives restricted money like a grant, they're not allowed to recognize that grant money as revenue until they spend the money for the intended purpose until they meet the terms of the grant.

And this is not ahead of any timing requirements. You know, the money's available right away, but they haven't spent the money yet on meeting the terms of the grant. So they'll credit deferred revenue for the hundred thousand item three. Now they actually issue the bonds. They go out and they issue $700,000 worth of bonds at a premium.

They sell the bonds for 745,000. And this is something I really want to get into in this simulation. Because we haven't talked about this yet. How do we handle selling bonds at a discount selling bonds at a premium? And let me start with a discount, even though that's not in this problem, but I'm just, well, let me just change it.

What if instead, and make sure this is clear in your notes, I'm going to change it. What if instead they sold $700,000 with the bonds for 680,000 at a discount? Well, that's pretty easy if they went out and sold $700,000 with the bonds for 680,000. We know in the capital projects fund, they would debit cash for the 680,000.

They can't credit bonds payable. They're not allowed to carry longterm debt. So they would credit other financing sources control for the 680,000. And with a discount that's pretty much all you'd have to do because with a discount, the real issue is did they receive enough money to do what they want to do?

Because if they didn't, there's going to have to be another source of financing. And the problem we say that again, The real issue with the discount is, did you get enough money to do the project? Did you get enough money to do what you want to do? If you did not, they would have to be another source of financing in the problem.

And that's pretty much it. What I'm saying to you is a, discount's not very complicated. You sell bonds at a discount. You would just debit cash for the 680,000 and credit other financing sources six 80, and that's pretty much it. Now in this problem, there's a premium and premiums are more difficult in this problem.

They sold $700,000 worth of bonds. For 745,000. So we're going to start the same way in the capital projects fund, they would debit cash. Of course, what they collected 745,000. They can't credit bonds payable. They're not allowed to carry long-term debt. So they would credit other financing sources for the 745,000.

Now we have to think about something. What are we going to do with that premium? Let me ask you this. If a profit making company had this. $45,000 premium. What would a profit making company do with it? They would amortize it. I want you to listen to me. This is another major difference in modified a rule in modified a cruel there's no amortization taken on bond discount or bond premium.

Let me say that again. Another major difference in modified accrual is that in modified accrual, there's no amortization taken on bond discount or bond premium. You have to be aware of that. Just another difference in modified accrual. But I want to ask you another question. What would a profit making company do with that extra $45,000 cash?

And what would they do with that little windfall? My point is who are we kidding? A profit making company would use that extra $45,000 cash to service the debt. That's why when you buy bonds at a premium, your effective yield is lower because they pay you back with some of your own money. That's what a profit making company would do with that extra money.

They would use it to service the debt. Governments are no different what a government is going to do. Is used that extra $45,000 cash to service the debt. Where is the debt service in the debt service fund? So now we're going to make another entry in the capital projects fund, where we literally transfer this $45,000 premium over the debt over to the debt service fund to service the debt.

So let's make another entry in the debt, in the capital projects fund. What are we going to debit? Isn't this a permanent. Transfer money. It's not coming back. It's a permanent transfer of money from one fundal and other for operating purposes. And since the capital projects fund is sending the money to the capital projects fund, it's a use.

So the capital projects fund is going to debit. Other financing uses control 45,000 and credit cash. 45,000. Hope you see why that entry is being made. The capital project fund is sending that $45,000 cash received for the premium over to the debt service fund to service the debt. Let's go to the debt service fund.

So far, all of the entries we've made are in the capital projects fund, but now let's go to the debt service fund. What would the debt service fund do? Remember? I said, all the debt service bond does is accumulate money. To make interest payments and principle payments on long-term debt of the other four governmental funds.

It's all it does. All the debt service fund does is service debt. That's why, when you're in the exam, you're going to let the name of the fund help you remember its purpose. I know you will. All right. So when the debt service fund, they get the money and they're going to debit cash 45,000. And what do they credit?

What's a permanent transfer for operating purposes. And debt service received the money. It's a source. So they're going to credit other financing sources control 45,000. That's what debt service would do. It's a transfer of money from one fund to another. Now we keep saying that, you know, all the debt service fund does is make interest, payments, and principle payments on long-term debt of the other governmental funds.

Where does the debt service fund get the money to service the debt? Well, there were three primary sources. Three primary sources. Number one, that could be transferred to some other funds. Like the one we just looked at the 45,000. So that could be transferred from other funds that could be special tax levies.

And then don't forget number three, the debt service fund has all this cash laying around. So they make investments and generate a lot of investment income as well. You know, that's what the debt service fund gets the money to service the debt. Or now let's say, you know, six months go by now, you'll see in this simulation, we don't have.

A lot of information about the bonds. So I'm just gonna make a note. Let's just wanna make up a number here. Let's say six months go by and it's time for the first semi-annual interest payment of 21,000. I'm just making up a number to illustrate. You cannot derive that number from anything I've said or anything that's written down there, but let's say it's time, six months go by it's time for the first semi-annual interest payment of 21,000.

What would you see in the debt service fund in the debt service bond? If it's time for the first semi-annual interest payment. The debt service fund would debit expenditures control for the 21,000 and credit matured interest payable. 21,000. That word matured is very important. We'll talk about it in a minute and then they'd get approval to send out the checks.

So they would debit majority interest payable, 21,000 and credit cash. 21,000. Now, again, we don't have a lot of information on the bonds. Let's say these are 10 year bonds. What's going to happen 10 years from now. When the bonds mature. Well, 10 years from now, when the bonds mature, won't. They have to make the last interest payment and pay off the principal if they attend your bonds.

So let's go ahead. 10 years. They've got to make the last interest payment pay off the principal. So you'd see entries like this. You'd see in the debt service fund, you'd see a debit to expenditures control for 721,000 credit matured interest payable. 21,000 credit matured bonds payable, 700,000. That's what happens when the bonds mature debit expenditures control 721,000 credit matured interest payable.

21,000 credit matured bonds payable, 700,000. Again, that word mature is important, and then they get approval to send out the checks. They would debit matured, interest payable, 21,000 debit matured bonds payable, 700,000 and credit cash. 721,000. I want to say word about this word matured. We've now run into another major difference in modified a cruel.

This is important. Remember in modified accrual in that debt service fund. They would never accrue interest like a profit making company. Again, under modified accrual in that debt service fund, they would never accrue interest like a profit-making company. No under modified a cruel that debt service fund will not record interest or principal interest or principle until it's mature, due and payable until it's a payment date.

So try to remember that they don't make a cruelty in modified accrual. They wouldn't accrue interest. Not modified a cruel and modified a cruel that debt service fund will not record interest or principle until it's matured due and payable until it's a payment date. And that's what I'm illustrating there.

So if you see the kind of entries that are made in the debt service fund, cause that's all it does is service debt. It makes interest, payments and principle payments on long-term debt of the four other governmental funds.

Item four. Now they sign a contract with a construction company to build a city hall for 650,000 and more city has agreed to furnish some labor on the project and some materials on the project. Well, You know what we've already learned in this FAR CPA Review course? Just the act of sending out a purchase order, just the act of signing a contract like this creates a potential obligation.

It's not an actual obligation yet, but in modified a cruel, we don't just keep track of actual obligations. We keep track of potential obligations in the incumbent system. So, you know, my point when they signed that contract with a construction company in the capital project spawn, they're going to debit.

Encumbrance is control 650,000 and credit. Budgetary fund balance reserve for in conferences, 650,000. Don't forget the incumbent system, just the act of signing that contract is going to require an entry in the capital project fund. They signed that contract. They're going to debit and conferences control 650,000 and credit budgetary fund balance reserved for encumbrances 650,000.

And always remember on encumbrance is just an estimate of what we think something's going to cost. We don't know the actual amount. Until we're built. Now, they said an item for that more city did agree to furnish some labor on the project. And number five says, now they pay 15,000 of wages to people who worked on the project, probably planning.

So in the capital projects fund they'll debit expenditures control for 15,000 and credit cash, 15,000 was paid. They also said an item for that. They're going to furnish some raw material on the project. And item six says they approved purchase orders for raw material. Estimated the cost. 38,000. You know what to do.

Don't forget the encumbrance system. They send out those purchase orders. Then in the capital projects fund, they're going to debit in conferences, control and credit budgetary fund balance reserve from conferences 38,000. I know Bob, I can do the incumbent system, my sleep now. Good. That's what I want. I know the encumbrance system.

So they send out those purchase orders you can do in your sleep. Yes. Debit and conferences controlled 38,000 credit by general fund balance, reserve and conferences. 38,000. No problem, Bob, what I want to hear. Number seven, the raw materials are delivered and they get a bill for 36,000 and it was approved for payment, you know, without, even without me saying it, you always reverse the original encumbrance for the original estimated amount when a bill comes in.

So when that bill comes in, they're going to debit. Budgetary fund balance reserved for in conferences. And they're going to credit in conferences control, not, not for 36,030, 8,030, 8,000, the original estimated amount. You always reverse the original incumbrance for the original estimated amount. And then you would book the expenditure and the liability at what you're actually built more or less here.

It was less. So they're going to debit expenditures control and credit vouchers payable for what they're actually built 36,000. And they said it was approved for payment. So they'll debit. Bob just payable 36,000 and credit cash. 36,000 item eight, the construction is finished and they get an invoice from the construction company for 609,000.

And that is approved for payment. Well, here again, you're billed, you always reverse the original encumbrance in this case for the original contract amount. So they're going to start here by debiting budgetary fund balance. Reserved for in conferences and they're going to credit and conferences control not six Oh nine, 650,000.

The original contract amount. You always reverse the original in conference in this case. For the original contract amount. So the first entry would, would be to debit budgetary fund balance, reserved for in conferences, credit and conferences control for this for the 650,000, the original contract amount.

Now that they've done that, they're going to record the city hall and its actual amount, but you know, the capital project bond is for bid and carry fixed assets. So they'll debit expenditures control for the 609,000 and credit vouchers payable for the 609,000. What they're actually build. And then they said it was approved for payment.

So they'll debit officers payable 609,000 and credit cash, 609,000. And let me add this. Now, they must have spent that state grant, now that the construction's finished, they must've spent that state grant meeting the terms of the grant. So now they can debit deferred revenue for the a hundred thousand and credit revenues control for the a hundred thousand.

Now they have some actual revenue.

Item nine. Let's do the closing entries. As we've been saying in this FAR CPA Review course it always helps you to step to step back and go, wait a minute. It's modified a cruel and modified a cruel. We're always looking to close out three things. You know what they are. Got gotta close the budget. You've got to close the actual activity and you have to close the encumbrances that always gets you organized.

Hey, it's modified a rule. I've got to close the budget. I've got to close the actual activity and I've got to close the encumbrances. Let's close the budget. As we've said in this FAR CPA Exam prep course, closing, the budget's never going to bother you. It's just a matter of reversing the entry that you made when you set it up.

So that's not bad. As long as you remember, it's gotta be done. So now we're going to debit budgetary fund balance. For the 25,000, if you debit budgetary fund balance 25,000, that would zero that out. We're going to debit appropriations control for the 775,000 to zero that out. We didn't keep track of T accounts here.

I only make you do the T accounts once to really start getting used to it. We're just doing entries here, but yeah, no one I debit appropriations control 775,000. It'll zero it out. I'm going to credit estimated revenues control a hundred thousand. That would zero that out and credit estimated other financing sources.

700,000 and that would zero that out. And I promise you that's all that entry's ever going to amount to. It's just a matter of reversing the entry that you may to set it up in the first place. Now that we've closed the budget, we closed the actual activity and you know what that means closed the actual revenue, the actual expenditures, the actual sources and the actual use has got to close out all the actual activity.

Let's do it. We're going to debit revenues control for the a hundred thousand. That's the state grant we're going to. Credit expenditures control 660,000. Now we don't have a T account here. Where did that? Six 60 come from? Well, that's all the expenditures on the project that was the 609,000. We paid to the construction company.

That was the 36 thousands of raw material that we provided on the project. And the 15,000 of wages we paid on the project. Again, that's six 60. If you had a T account would be obvious. So all of the expenditures on the project. The 609,000. We paid to the construction company, the 36,000 of raw material that we provided on the project and the 15,000 of wages we paid on the project.

And by the way, if you will look at, if you were to look at the government wide statement of net position, you would remember that's what the government reports is fixed assets and the government wide statement of net possession. And if you were to look at the government wide statement of net position, you'd see that city hall on there at six 60.

In other words, the point I'm making is we capitalized. All the expenditures on the project, not just what we pay to the construction company. So keep that in mind, we would capitalize all the expenditures on the project, not just what we paid to the construction company. You'd find that city hall on the government wide statement in that position at 660,000, but he had that's our actual expenditure.

So we're going to credit expenditures control six 60, close out the actual expenditures. We're going to debit other financing sources control for the 745,000. Remember that account was created. When we issued the bonds close out, our actual sources, we're going to credit other financing uses control for the 45,000.

That account was created when we sent the premium to the debt service fund. So, you know, it's what I've done here. I've closed out the actual revenues of a hundred thousand, the actual expenditures of six 60, the actual sources of seven 45, the actual uses of 45,000 and the entry doesn't balance. We need a credit of 140,000 to bounce the entry out.

What would we call that? I need a credit here of a hundred. Let's have a little multiple choice here because I know you're getting good at this. Now I know you want to show off. So I need a credit here of 140,000 to balance the entry out. What would I credit for 140,000? I'll give you some choices. What I credit restricted fund balance one 40.

On assigned fund balance one 40 assigned fund balance, one 40 committed fund balance one 40. How do you feel about that? A little multiple choice more yet, or what I credit for one 40, the restricted fund balance, the unassigned fund balance, the assigned fund balance, the committed fund balance. Do you have a thought on that?

Very good credit. The assigned fund balance. Of one 40, because this fund balance is assigned to the purpose of this fund. Remember if this was the general fund, that would be the unassigned fund balance, but in any other fund, that's the assigned fund balance because this fund balance is assigned to the purpose of this fund credit assigned fund balance for the 140,000.

Now the third thing you close out are the encumbrances we've closed out the budget. We've close out all the actual activity. Third thing we close out of the encumbrances, but if you had T accounts, this would be obvious. There are no outstanding conferences, but even though there are no outstanding conferences we're not done yet.

I'll tell you why there's a little wrinkle here again. There's no outstanding conferences. Don't worry about that, but we're not done because here's what's left. If you had T accounts, here's what you would see once you close out the budget. Once you close out the actual activity, there no one conferences, all that's left is a debit and cash of 140,000 and a credit in the assigned fund balance.

Of 140,000, that's all this left, a debit and cash of 140,000 and a credit, any signed fund balance of 140,000. Here's the point in a capital projects fund. If the project is finished, if it's finished and it's still an assigned fund balance, they would want you to assume they would use that assigned fund balance to service the debt again, in a capital project fund.

If the project is finished, it's got to be finished and the still an assigned fund balance, they would want you to assume they would use that assigned fund balance. To service the debt. So now we're going to make another entry in the capital projects, bond, where we transfer this 140,000 to the debt service fund to service the debt.

So, you know what you're going to do. You're going to debit the financing uses, right? This is a permanent transfer. It's never coming back. It's a permanent transfer for operating purposes. The capital project fund is sending the money. So it's going to be a debit to other financing uses for the 140,000.

And credit cash 140,000, and then they'd make one more entry in the capital projects, bond, where they would debit the assigned fund balance, 140,000 and credit. Other financing uses 140,000. And now that entry closes out the capital products. One, one more time, I'm going to debit. Other financing uses 140,000 and I'm going to credit cash 140,000 that sends the money to the debt service fund to service the debt.

Then I make one more entry where I debit the assigned fund balance for 140,000. Closed it out. And credit other, the financing uses 140,000. That entry closes out the capital projects fund. And of course, then in the debt service fund, they would debit cash 140,000 and credit other financing sources, 140,000.

They'd use the money to service the debt. So try to remember that in a capital project fund, if the project is finished, it's got to be finished and there's still an assigned fund balance. They would want you to assume they would use that assigned fund balance to service the debt.

Remember, we said that a governmental unit, like a town, a governmental unit, like a city uses three types of funds. They use governmental funds. And as you know, very well, there are five of those general fund, special revenue fund capital projects fund permanent fund debt service fund. It's five governmental funds.

They use proprietary funds. There are two of those and they also use fiduciary funds. There are four of those. So governmental unit uses 11 different types of funds, five of a metal funds, two proprietary funds for fiduciary funds. Let's get into the. Proprietary and the fiduciary funds. First thing I want to say, the proprietary and the fiduciary funds carry their own fixed assets.

Again, the proprietary and the fiduciary funds carry their own fixed assets and they depreciate their own fixed assets. So you would see depreciation expense in the proprietary funds. You'd see depreciation expense in the fiduciary funds, the proprietary and the fiduciary funds carry their own long-term debt.

So you'd see accounts like bonds payable, long-term notes payable in the proprietary funds, the fiduciary funds because they carry their own long-term debt. Also the proprietary and the fiduciary funds service their own long-term debt. So you would see an account like interest expense in the proprietary funds, in the fiduciary funds.

So that's the bottom line, the proprietary and the fiduciary funds carry their own fixed assets, depreciate their own fixed assets, carry their own long-term debt, service, their own longterm debt. In other words, the proprietary and the fiduciary fund. Use normal accrual accounting, not modified accrual, not modified accrual.

Also the proprietary and the fiduciary funds use have the same measurement focus, the measurement focus, and you know, the FAR CPA Exam likes this kind of thing. The measurement focus and the proprietary and the fiduciary funds is total economic resources. That's why they carry their own fixed assets for the carry their own longterm debt because their focus is total, total economic resources and income measurement.

These funds want to see if they're making a profit or not? That's their focus, total economic resources and income measurement. All right, now let's talk about the proprietary funds. There are two proprietary funds. The first proprietary fund is called an enterprise fund. Now listen carefully. The government sets up an enterprise fund.

Anytime the government wants to act like a private enterprise. Let the name of the fund. Probably to remember what it does. Government sets up an enterprise bond. Anytime the government wants to act like a private enterprise, any kind of public utility. That's what you normally see in the exam. Municipal gas, municipal electric, municipal water department.

That would be an enterprise fund because the government's going to act just like a private enterprise. Just stop and think, how would you finance the day-to-day operations of a municipal water department? How would you do it? How would you finance the day-to-day activities? Of a municipal water department, you would charge consumers.

You would charge the public, just like a private enterprise. This could be a municipal parking garage. How would you finance the activities? The day-to-day activities of a municipal parking garage? You charge the people who park there. You charge the public, you charge consumers, just like a private enterprise.

That's when the government sets up an enterprise fund. When the government's acting just like a private enterprise, then the second proprietary fund is called an internal service fund. The government sets up an internal service fund. When one agency of the government is servicing other agencies of the government.

Again, internal service fund it's when one agency, the government is servicing another agency of the government. So this would be something like a central printing office for all governmental agencies, a central motor pool for all governmental vehicles, a central data processing department for all governmental agencies.

That's why you have an internal service fund, you know, just stop and think. How would you find it? The day-to-day activities of a central printing office by charging whom other government agencies. That's why there's two. That's why there's two proprietary funds. Enterprise funds charge the public charge, consumers for services, just like a private enterprise internal service funds charge other government agencies for services.

So that's why this do with them.

Let's talk about the fiduciary funds. Now, when you get into the fiduciary funds, now what you're into are the trust funds and

why does government need trust fund? Well, the government needs a trust bond. Anytime the government is holding assets in trust. Let the name help you companies a trust bond. Anytime the government's holding assets in trust, the first fiduciary fund is called the pension trust. The pension trust is for the pension system, the retirement system for city employees.

If you think about it, For the pension system, the retirement system for city employees, that has to be a trust fund because the government is holding that money and trust the government doesn't own that money. The employees do. Government holds that money in trust. That's called the pension trust. Next trust fund is called a private purpose.

Trust the government sets up a private purpose trust when the government's holding money in trust that will benefit a private individual or a private organization. It gets called a private purpose trust. Government sets up a private purpose trust. When the government holding money in trust, that'll benefit a private individual or private organization.

For example, let's say somebody dies and leaves, you know, $10 million to the city and they want all the, they want all the interest in dividends to go to a certain nursing home. And if the nursing home ever goes out of business, the city keeps the 10 million and these kinds of things happen when somebody dies, leaves $10 million to the city.

And they want all the interest in dividends to go to a certain nursing home. And if the nursing home ever goes out of business, the city keeps the 10 million. That would be a private purpose trust because the, the governmental unit is holding money in trust that benefits a private organization, the nursing home or private individual third trust fund is called the investment trust.

Let's say that. The government runs a temporary surplus. It would be very temporary, but if the government runs a temporary surplus, the government has to invest that money in, you know, government backed bonds. And that would happen that those bonds would have to be held in a trust fund because the government really holds those investments in trust.

The government does not own that money. The taxpayers do again, let's say a government runs a temporary surplus. They would invest that surplus in government backed bonds is what they would do. And. Those investments have to be kept in the trust fund because the government is holding that money and trust the government doesn't own that money.

The taxpayers do. That's why you have an investment trust and there is one more fiduciary fund. You have to be aware of it. It's called an agency fund called an agency fund and the government sets up an agency fund. Anytime the government is going to act as an agent. You know what the name always help you to remember its purpose.

Government sets up an agency fund. Anytime the government is acting as an agent for somebody else. And I want to give you an example, and it's an example. You see a lot in the exam, let's say, let's say a municipality, you know, is going to collect school taxes. You know, let's say you know, let's say a municipality is going to collect school taxes for, you know, 50 different school districts in their area.

So we have the municipality they've agreed to collect school taxes, you know, for 50 different school district. In their area. Well, that would be an agency fund because that municipality is going to act as an agent for all the school districts. Now, I don't want to show you a lot of entries, but I want to show you one entry, but just let's stay with that example.

Let's say, I mean, it's a pallet. He's going to collect school taxes for 50 different school districts and they go out, they set up an agency fund, they collect all the school taxes. What's the entry in the agency. They would debit cash and credit due to district one, due to district two, due to district three, there'd be, there'd be 50 credits.

I'm making a point.

In an agency fund, you're never going to see revenues ever, or expenditures or any kind of fund balance or net asset position. Remember this in an agency fund, there were never any revenues or expenditures or a fund balance or a net asset position of any kind. All you ever seen. An agency fund is cash and a liability due to somebody.

In other words, all an agency fund is, is a temporary holding account for money. It's it's always cash and do to somebody there's never any revenues expenditures, a fund balance, or a net asset position. It's impossible. You know, the example of exceptions, it's impossible. Can't have revenues and agency fund can't have revenues.

Can't have expenditures can have a fund balance. Can't have a net asset position. All you ever seen an agency fund is cash and then a credit due to somebody, you know, they could use an agency fund for federal withholding for city employees, debit cash credit through the federal government. Life insurance, health insurance, premiums, and agency fund for all city employees, they would debit cash credit due to insurance company.

That's all you ever seen? An agency fund is cash, and then a credit, a liability due to somebody I'd like you to try some more questions. I'd like you to shut the class down, do questions 15 to 23, 15 to 23, and then come back.

Welcome back. Let's do these questions together. The number 15, six city use the following funds for financial reporting purposes, and they want to know how many of these funds use normal accrual accounting. I hope you picked them right out the. Internal service fund is proprietary fund normal accrual accounting.

The enterprise fund, the airport enterprise funds proprietary fund normal cruel accounting. The pension trust. It's a fiduciary fund, normal accrual accounting. And the answer is B three funds use normal cruel accounting. The general fund, the capital projects fund the special revenue fund debt service.

The governmental funds. They all use modified a cruel 16. The modified accrual basis of accounting would be used for which of the following funds. I know you could do it. Blindfold capital projects, governmental fund, not an enterprise fund that's proprietary fund proprietary funds use normal cruel accounting, pension trustees as normal cruel accounting.

You know that the answer's a 17, the debt service fund, our governmental unit is used to account for the accumulation of resources. Four and the payment of principal and interest in connection with what a private purpose trust fund. No, a proprietary fund. No, these funds carry their own long-term debt and service their own long-term debt.

Now the debt service bond is for the governmental funds, right? But the governmental funds not proprietary funds, not fiduciary funds. Double no answer. A 18. Cedar city issued a million dollars of 6% revenue bonds at par April 1st to build a new water line for its water. Enterprise fund interest is payable every six months.

What amount of interest expense will be reported for the year on a December 31? I have a question for you. Let's forget. This has governmental for a second. If this were profit making company, if this were profit, forget governmental, forget all that. If this were profit making company, what would be the interest expense for the year?

Wouldn't you take 6% of a million, that 60,000 of interest for a full year. We don't want a full year. We want April through December, which is nine twelfths of a full year, which would be 45,000. If this were profit making company, the answer would be, say 45,000. And that's what it is for an enterprise fund to answer C because it's just like a private enterprise.

It's just like a private enterprise. Let the name of the fund to help you remember that. 19, the following information. For the year ended June 30th pertains to a proprietary fund established by Glenn village in connection with the public parking facilities. They want to know for the year ended June 30th, this proprietary fund would report net income of what?

Well you have their receipts. 600,000. What are their expenses? They've got expenditures for parking. They've got expenditures for salaries and other cash expenses. 96. And they also have parking meters and they have depreciation of the parking meters member. It's a proprietary fund. It's an enterprise funds prietary fund carries its own fixed assets, depreciates its own fixed assets, normal rule accounting.

So you're going to pick up the salaries and other cash expenses and the depreciation expense of 94. The total expenses were 190,000, so 600,000 minus one 90 and expenses. The answer is D just like a profit making company. It's just like a private enterprise and enterprise fund.

Number 20, they say through an internal service fund, new County operates a centralized data processing center to provide services to. News other governmental units, but we have here as an internal service bond. We have one agency, the government servicing other agencies of the government, this internal service fund build.

Think of that word build. They build the new, they build news parks, recreation fund 150,000 for data processing services. What account would news internal service fund credit to record this billing? Well, I'll tell you what's important about this question. The most important thing. To notice about this question is that this is not a transfer between funds.

It's a transaction between funds and you might want to write this down. So you remember it. This is called a quasar external transaction. She might want to write down. So QET again, it's not a transfer between funds. It's a transaction between funds. We have one fund billing, another fund for services. It's a transaction between fund.

And it's going to give you a quick note here on how you handle all cuase I external transactions. They're really easy. As long as you can pick up in the exam. Hey, this is not a transfer between funds. This is a transaction between funds. It's a QET, it's a Quayside external transaction. Here's how you handle all cuase I external transactions.

Just remember the fund that sells the goods or services recognizes revenues control the fund that sells the goods or services. Credit's revenue is control the fund that buys the goods or services, debit expenditures control. It's really that simple. That's how you handle all quasar external transactions.

Just remember the fund that sells the goods or services credits, revenues control the fund that buys the goods or services debits expenditures control. So in this case, the internal service bonds sold the service. So they would credit revenues control, answer D same thing with number 21, they say. City's electric utility, which has operated as an enterprise fund.

That makes sense. It's just like a private enterprise, any kind of public utility. That's going to be an enterprise fund, a city's electric utility, which has operated as an enterprise fund rendered billings for electricity supply to the general fund. We have one fund billing, another fund for services.

Again, you might want to write down it's QE TIG. Oh, it's QE T it's not a transfer between funds. It's a transaction between funds. It's a quasar external transaction. Which of the following accounts would be debit by the general fund? Well, since the general fund bought the service, the general fund would debit expenditures control, answer B 22 gets us into residual equity transfers.

Now, as I've said in this FAR CPA Exam prep course, the FAR CPA Exam loves transfers of money from one fund to another. And so far in this FAR CPA Review course we've looked at two types of transfers First we looked at a Temporary transfer of money from one fund to another That's not hard right If there's a temporary transfer of money from one fund one other the fund that sends the money debit or receivable called do Do from the fund that receives the money credits a payable called do to really very simple That's how you handle a temporary transfer of money from one fund to another The fund that sends the money debit are receivable called do from fund that receives the money credits a payable called do too Then we looked at a permanent transfer from one fund to another for operating purposes If you see a permanent transfer of money from one fund one other for operating purposes the fund that sends the money debits other financing uses the fund that receives the money credits other financing sources We know that Well this is a different one This is called a residual equity transfer just in case they mentioned it I'll tell you what it is A residual equity transfer is a permanent transfer of money That is permanent It's a permanent transfer of money from one fund to another but not for operating purposes Say that again A residual equity transfer is a permanent transfer of money It is permanent from one fund or another but not for operating purposes Notice this is going from the general fund to On internal service fund what it probably is not for operating purposes it's capital you know it's seed money In most cases that's what it would be capital to get the internal service fund started Let me just show you the entry on both sides What the general fund would do If the general fund sends a they say here Jim city's internal service bond received a residual equity transfer of 50,000 from the general fund This $50,000 transfer would be reported in the in the internal service fund as a credit to what was what looks like on both sides When the general fund sends a $50,000 residual equity transfer to the internal service fund the governmental fund because it's a permanent transfer would debit other financing uses it's a permanent transfer for operating purposes So the general fund would debit Other financing uses dash residual equity transfer 50,000 and credit cash 50,000 That's how the general fund would handle it It's permanent It's never coming back So the general fund would debit other financing uses dash residual equity transfer 50,000 credit cash 50,000 and then the proprietary fund In this case the internal service fund would debit cash and answer be credit transfers in that's How you handle a residual residual equity transfer Number 23 jape city a million dollars of general obligation bonds at one Oh one to build A new city hall So this would be a capital projects fund it accounts for the construction of major capital assets As part of the bond issue The city also paid 500 and underwriters fees in 2000 and debt Other debt issue costs so that they got some bond issue costs a year of 2,500 What amount would jape city report is other financing sources Well we've said it several times in this FAR CPA Review course If one of the governmental funds like a capital project fund issues bonds they go out and issue a million dollars worth of bonds at one Oh one The capital project fund would debit cash for 1,000,010 thousand and answer a credit of the financing sources Remember they can't credit bonds payable They're not allowed to carry long-term debt They're forbidden to so capital projects would debit cash for a hundred 1% of a million 1,000,010 thousand credit other financing sources They can't credit bonds payable So they credit other financing sources 1,000,010 thousand So the answer is a and then the bond issue costs would be handled by the debt service fund services The debt And in the debt service fund the bond issue costs will be a debit to expenditures control 2,500 and credit cash but it wouldn't fact it wouldn't affect other financing sources Now it's important to remember that when you're talking about state local governmental accounting What you're talking about is the Gasby the governmental accounting standards but not the FASBI You're talking about the Gasby the governmental accounting standards board the governmental accounting standards board The Gasby establishes generally accepted accounting principles for state local governmental units And what we're going to get into next is Gasby 34 It's a very important Gatsby Gatsby 34 established the reporting model for state and local governmental unit And what I'm talking about is the comprehensive annual financial report the CAFR So just remember Gasby 34 established the reporting model for state local governmental units It's what they call the CAFR the comprehensive annual financial report Now there are six parts to the CAFR and I want to go through each one This is very important and very heavily tested You have to be aware of these six parts There are six parts to the CAFR part One is the management discussion and analysis the MD and a the management discussion and analysis always precedes the financial statements always the management discussion and analysis The MDNI always precedes the financial statements and what it does is compare the current year to the prior year and explains any major changes That's what it does The MD and a the management discussion analysis It's all it always precedes the financial statements It compares the current year for the prior year explains any major changes and one small thing the management discussion and analysis even though it's it always precedes the financial statements It's part If they ask it's part of the RSI it's part of the required supplementary information Again even though it always preceded the financial statements if they ask the management discussion and analysis is always it's part of your required supplementary information it's part of the RSI which will Say more about in a little bit Part two of CAFR is the heart and soul of the whole thing Part two is the basic financial statements This is the heart and soul of Gatsby 34 heart and soul of the whole thing The basic financial statements Now remember the basic financial statements include first The government wide statements Again your basic financial statements first include the government wide statements the government wide statement of net position and the government wide statement of activities And then your basic financial statements also include the fund financial statements You know there are five governmental funds general funds special revenue fund capital projects fund permanent fund debt service bond There are five governmental funds and those statements are done under Modified a cruel Then there are two proprietary funds enterprise internal service fund and their statements were done under normal rule accounting And then there are four fiduciary funds the pension trust the private purpose trust the investment trust and the agency fund There are four fiduciary funds and those statements are done under normal accrual accounting focus in on the government wide statements Now if you look in your viewers guide as I mentioned there were two government wide statements You have an example of both and I just want to point out some important things about them The first government wide statement That is an example in your viewers guide First one is a government wide statement of net position and it's basically a balance sheet but it's called a government wide statement of net possession And when you look at the government wide statements and you just start by looking at the government wide statement of net position right away the first thing you notice is in the government wide statements they separate governmental activities from business type The first thing you should notice the government wide statements separate governmental activities From business type activities Give me an example of a fund that's governmental activities Clearly what comes to mind will be an example of a fund that's clearly governmental activities general fund special revenue fund capital projects fund What would be a fund that would be business type activities proprietary funds Right Enterprise fund internal survey of the enterprise pond that comes to mind right away Right The pre the proprietary fund and enterprise fund She's like a private enterprise All right So that's what the government wide statements do It separates governmental activities from business type And if you look at the statement you'll notice a couple of things You'll notice that this is Where the government reports it's fixed assets Notice they have fixed assets with accumulated depreciation So this is where the government reports it all It's fixed assets with accumulated depreciation And I want to give you a note here in the fixed assets you would also find infrastructure Now what's infrastructure infrastructure would be roads you know bridges sewer systems Now here's what the FAR CPA Exam I'd ask you Should you depreciate infrastructure again infrastructure would be things like roads bridges sewer systems and the FAR CPA Exam I'd ask you Should you depreciate infrastructure The answer is no you don't You're not required to depreciate infrastructure If you do three things number one you keep an up-to-date inventory of your infrastructure That's number one you must keep an up-to-date inventory of your infrastructure Point Number two you have to assess its condition at least every three years Number two you have to assess its condition at least every three years And number three you have to disclose the expenditures that will be required to maintain it As long as you do those three things If you keep an update inventory of your infrastructure if you assess its condition at least every three years and disclose the expenditures that will be required to maintain it why don't you do those three things You don't have to depreciate infrastructure and you have to know this that's called the modified approach Of depreciation for infrastructure That's what that's called It's called the modified approach of depreciation for infrastructure which means depreciation doesn't have to be taken notice in the government wide statement of net position Here's where the government reports its longterm debt you know including bonds payable long-term notes payable Here's what the government reports it's longterm debt Now as I've been saying the whole point of the government wide statements is to separate governmental activities Like the general fund from business type activities enterprise pond where would I find the fiduciary funds Well remember the fiduciary funds are excluded from the government wide statements Got to know that Remember the fiduciary funds are really trust funds for the most part the government is holding assets in trust So when you really look at it fiduciary funds not governmental activity they're our business type activities It's just the government holding money in trust So the fiduciary funds are excluded from the government wide statements Notice something else Notice the column for component units Now what are component units Why don't you just write this in Just to remember it would be like a school district you know a school board a rescue squad something like that component units Now you have to be aware of something with component units again a school district a school board a rescue squad Now listen very carefully If a component unit is organized as a separate legal entity if it's organized as a separate legal entity its governing body is not substantially the same as the governing body of the primary government I'll say it again If a component unit is organized as a separate legal entity It's governing body The component units governing body is not substantially the same as the governing body of the primary government Well then it would be shown as we have it here as a discreet presentation No it's a separate column Then it's shown as a discrete presentation in a separate column Now on the other let's just flip it around If a component unit is not organized it's not organized as a separate legal entity Its governing body is substantially the same As the governing body of the primary government really services the primary government then the component unit would just be blended That's the word just blended into governmental activities Hope you see that that's really the choice there with component units If the separate legal entity its governing body is not substantially the same as the governing body the primary government it would be discreet presentation a separate call as it is in our example But if it's not a separate legal entity The governing body of the component unit is substantially the same as the governing body of the primary government Then you would just blend it into governmental activities Now now the point we've been saying that the whole point of the government wide statements is to separate governmental activities from business type Where would I find the internal service fund Now this drives people crazy You would think logically well the internal service fund Is a proprietary fund It's gotta be business type No they took the position that what is an internal service fund It's one agency the government servicing other agencies of the government So remember in the government wide statements the internal service fund is always governmental activities They catch a lot of people on that Remember that even though it's a proprietary fund in the government wide statements on internal service fund is always governmental activities Now if you Notice in the government wide statement in that position you see the interfund transactions you see that inter fund balance I want to talk about this That would be something like a do from on the general fund balance sheet and a do to on the enterprise fund balance That's what the that interfund balance would be It would be like a do from on the general fund balance sheet and a do to on the enterprise fund balance sheet Now here's here's the point I want to make that if there's a due to do from within governmental activities that gets eliminated from the government wide state And again if anytime there's a due to do from within governmental activities that gets eliminated from the government wide statements they don't want you to gross up your assets Likewise if there's a do to do from within business type activities that gets eliminated from the government wide statements But if there's a do to do from between governmental and business type activities it stays in the state That's what you're seeing there It's what they call a partial elimination of interfund transactions Not not a total elimination of interfund transaction I'm just go through that again Anytime there's a do to do from within governmental activities that gets eliminated from the government wide state If there's a do to do from within business type activities all within business type activities gets eliminated from the government wide statement spot do to do from between okay Governmental and business type activities We lead it we leave it in the statement So that's what's required in the government wide statements a partial elimination of interfund transactions not a total elimination of indifferent transactions And then one more thing I want you to notice about the government wide statement of net position Notice there are three categories of net Look if you look at the bottom there were three categories of net position There's the net investment in capital assets That's the first category the net investment in capital assets What's that is what that represents are your capital assets your fixed assets less accumulated depreciation and less any corresponding debt any mortgages that's called net investment in capital assets Then there's restricted and unrestricted but you have three categories of Now also in your viewers guide you'll see an example of a government wide statement of activities basically an income statement Now you already know a lot about this notice in a government wide statement of activities The whole thrust of the statement is to separate Governmental activities from business type activities And where am I going to find the fiduciary funds member The fiduciary funds are excluded from the government wide statements Notice the component units you know what that is You know it's a school board it's a school district a rescue squad And if it's organized as a separate legal entity the governing body of the component unit is not substantially the same as the governing body the primary government it would be a discrete presentation as we have here In a separate column where would I find internal service fund even though it's a proprietary fund and the government wide statements it's governmental activities But the main thing you want to notice in the government wide statement of activities that is that first the whole thrust of the statement is to separate governmental activities from business type activities and then report net revenues or net expenses by program That's what you can see there Yes we separate governmental activities from business type activities and our first Mission on that statement is to report net revenues or net expenses by program And once you've done that Once you've reported net revenues or net expenses by program then notice general revenues have separated Then general revenues come in and then extraordinary items There was a gains or losses that are both unusual and infrequent the criteria that you know well extraordinary items Then there are special items gains or losses that are unusual but not infrequent and frequent but not unusual It's one of the criteria So once you've reported net revenues or net expenses by program Then at the bottom you bring in general revenues they're separated and then extraordinary items and special items But once again we have a government wide statement the government wide statement of activities separating governmental activities from business type activities reporting net revenues or net expenses by program There are five governmental funds There are five governmental funds and their statements are going to be done under modified a cruel They have to do a balance sheet and we did one earlier in this CPA Exam FAR course Maybe we did a balance sheet for pine city It's in your viewers guide We did a balance sheet for pine city under modified a cruel but they have to do a balance sheet The five governmental funds have to report a balance sheet and a statement of revenues expenditures and changes in fund balance And we did one of those as well So if you look in your viewers guide back in pine city you'll see an example of a balance sheet and a statement of revenues expenditures and changes in fund balance for the general fund But In the fund financial statements the five governmental funds general fund special revenue fund capital projects fund permanent fund debt service fund have to do a balance sheet and a statement of revenues expenditures and changes in fund balance under modified accrual Now the two proprietary funds enterprise internal service they have to show a statement of net position basically a balance sheet but it's called a statement of net position and a statement of revenues expenses and changes in fund net position Again they have to show a statement of net position basically a balance sheet And remember these statements done on a normal cruel accounting These are proprietary funds enterprise internal service These statements will be done under normal cruel accounts And I have to show a statement of net position a balance sheet basically and a statement of revenues expenses and changes in fund net position and listen carefully The proprietary funds are the only funds in governmental that have to do a statement of cash flows Now if you look in your view as guide I want to show you a couple of things here in your viewers guide You'll see an example of a statement of cash flows under the FASBI format And I just put this in just to refresh your memory because it's the format you know so well notice in a statement of cash flows under the FASBE format we have cash flows from operating activities Cash flows from investing activities cash flows from financing activities and basically cash flows from operating activities is cash received From customers minus cash expenses And then you have cash provided by cash flows from investing activity What goes in there if you buy or sell property plant equipment if you buy or sell investments and then finally cash flows from from financing activities If you borrow or repay principle if you pay dividends if you issue shares or you buy or sell treasury stock Just a review of what you already know but if you go to the next page here's how you do a statement of cash flows under the Gasby format And one more time the proprietary funds when they do their statement of cash flows and they're the only funds in government that do a statement of cash flows But when the proprietary funds do a statement of cash flows it's this Gasby format Now notice in the Gasby format you've got cash flows from operating activities So that's you know cash revenues less cash expenses That's pretty clear That's cash flows from operating activities cash revenues less cash expenses And then this cash flows from investing activity So if you buy or sell investments that make sense and notice interest cash received the interest in dividends cash received interest in dividends I've got a question for you Where would I find cash received for interest in dividends In a statement of cash flows under the FASBI format it would be on the income statement It would be operating notice here It's investing got to notice the differences here cash received for interest and dividends This is where the FASBI format beyond the income statement will be operating here It's investing And then what the Gasby format does is divide financing activity into two This cash flows from non-capital financing and cash flows from capital and related financing activities Let's look at Cash flows from non-capital financing activity What's what goes in here If you borrow or repay principle for purposes other than to acquire construct or improve capital assets that's cash flows non-capital financing activities Notice cash interest paid Once you once you highlight that cash interest paid where would I find cash interest paid in a statement of cash flows in the FASBI format it will be on the income statement You'll be operating They'll just hear it's financing It's different Isn't it And then finally this cash flows from capital and related financing activities Notice the first one buy or sell property plant equipment buy or sell property plant equipment Where would I find buy or sell property plant and equipment in a statement of cash flows under the FASBI format It's investing here It's financing Notice these differences If you buy yourself PP and E That's cash flows from investing activity in the FASBI format here it's financing And again notice cash interest paid That would be on the income statement the operating activity in the FASBI format here it's financing Make sure you know these differences Could the CPA exam have a simulation where they want you to do a statement of cash flows for a proprietary fund Absolutely Certainly they have multiple choice on this And they could have a simulation where they want you to do a statement of cash flows for the proprietary funds And when a proprietary fund does a statement of cash flows And they're the only fund in governmental that does a statement of cash flows They follow the Gasby format It's got four categories cash flows from operating activity cash flows from investing activity cash flows from non-capital financing activities and cash flows from capital and related financing activities Be careful All right Now the fiduciary funds the fiduciary funds happening We're still in we're still in case you've lost track We're still in part two of CAFR the basic financial statements the fiduciary funds have to do a statement of fiduciary net position basically a balance sheet but they have to do a statement of fiduciary net position and a statement of changes in fiduciary net position And that's part two again the fiduciary funds ha and remember their statements would be done just like the proprietary funds on the normal cruel accounting The fiduciary fund statements will be done under normal cruel accounting and they have to show a statement of fiduciary net position and a statement of changes in fiduciary net position And that's part two Part three of CAFR would be notes to the financial statements Here's what you would disclose For example how many employees have vested rights in the pension plan Something like that So part three would be notes to the financial statements Part four in CFR would be your RSI You are required supplementary information Now what is your RSI This is part four the required supplementary information other than MTNA it's your required supplementary information other than M DNA Remember management discussion and analysis is part of your RSI but that's always preceding the financial statements So now we're talking about your RSI other than management discussion and analysis Well you'd have to compare The original to the final budget and your required supplementary information other than MD and a you're comparing the original to the final budget You're disclosing fixed asset accounting methods In other words here's what you would disclose You're using the modified approach of depreciation for infrastructure For example you'd have to disclose now this is where you're using where you're disclosing that you're using the modified approach of depreciation for infrastructure Also you would have a 10 year schedule For pension trust funds things like that Part five of CAFR would be combining statements for non-major funds and non-major components Again part five would be combining statements for non-major funds and non-major components The point is if there are non-major funds and non-major components they can be aggregated and reported in a separate column by the way not just in the not just in the CAFR but also in the fund financial statements both But if they are a non-major funds non-major components they can be aggregated report in a separate column in the fund financial statements And also as part of the CAFR now a couple of points internal service funds and fiduciary funds Are exempt from this analysis In other words there's no such thing as a major and a non-major internal service fund No such thing no such thing as a major and a non-meat major fiduciary thought they're exempt from this analysis But I got into this because you have to know this what is a major fund because now we're drawing a distinction between major funds and major components and non-major funds and non-major components So what's a major fund Well the general fund is always made Yeah General fund it should you should know what a major fund is The general fund is always major Also any funders major whose assets liabilities revenues expenditures are equal to or greater than 10% of the total funds in the same category either governmental or enterprise Again what's a major fund general fund is always major Also any fund is major whose assets liabilities revenues expenses are equal to or greater than 10% Of the total funds in the same category either governmental or enterprise and and equal to or greater than 5% of the total for all funds That's what a major fund is And then also one more point the governmental unit the the primary government can deem any fund They want it to be major In other words even regardless of the criteria the primary government can say we consider This special revenue fund to be major they can just deem any fund They want to be major But the point is if there are non-major funds non-major components they can be aggregated and reported in a separate column in the government wide statements and also in the fund financial statements And then finally part six in CAFR would be all the individual fund statements and schedules for all the primary government's funds Part six Would be the individual fund statements and schedules for all the primary government funds Now there's days we find all the detail they could have 75 capital projects funds going Now you find all those statements They could have 15 special revenue funds going so far at six or all the individual fund statements and schedules for all the primary government funds They've got 150 capital projects funds going Here's where you find all the detail to your heart's content Please do some more questions I'd like you to do 24 to 34 and then come back welcome back Let's do these questions together And number 24 they say Marta city school district we're talking about a component unit is a legally separate entity You know that's important And two of its seven board members are also city council members Well if it's two of seven would you say that the governing body of this component unit is substantially the same as the governing body of the primary government No So you know that if it's a separate legal entity and the government governing body of this component unit is not substantially the same as the governing body of the primary government will then it should be a discreet presentation a separate column In the government wide statements in the fund financial statements it's a discreet presentation Answer B 25 Chase city uses an internal service fund for a central motor pool The assets and liabilities account balances for this fund that are not eliminated normally would be reported in the government wide statements as why Well we talked about this please Don't miss this even though it's a proprietary font and you would think logically In the government wide statements it would be business type activities No the government wide statements internal service fund is always governmental activities Answer a because it's one agency the government servicing other agencies the government always governmental activities Number 26 Dale town's public school system Again we're talking about a component unit Is administered by a separately elected board of education By the way that's not the same thing As the governing body the board of education decides things like curriculum That's not the governing body The board of education is not organized as a separate legal entity does not have the power to levy taxes issue bonds that never would Dale's town council approves the budget and they want to know how we handle this and the government wide statements Well if it's Not a legally separate entity just blend it blended into the governmental activities And the answer is B 27 Barry townships eligible infrastructure assets are exempt from depreciation If the modified approach is used that's true Which of the following requirements Which of the following are requirements of the modified approach How about one The entity performs condition assessments Yes At least every three years That's a requirement to the entity annually estimates the amount to preserve Yeah You have to disclose the amount to preserve to maintain number three the entity assesses asset conditions in comparison to condition levels established by the national association of public works engineers or a comparable organization That sounds like it ought to be true but it's not it's not a requirement You know the requirements they have to keep an up-to-date inventory of infrastructure assess its condition at least every three years and disclose the expenditures needed to maintain it So just the first two are required The answers B 28 Dogwood city's water enterprise fund received interest of 10,000 on long-term investments How would this I'll be reported in a statement of cash flows Now you know an enterprise fund is a proprietary fund and you know that the proprietary funds are the only funds in governmental that do a statement of cash flows So where would I find this 10,000 of cash received the interest I hope you remember it It's investing activities answer D if it were the FASBI format it would be on the income statement It would be operating but in the Gasby format it's investing activities Got to remember those differences answer D number 29 which of the following is a required financial statement for an investment trust fund Well it's an investment trust fund is a fiduciary fund and you know that it's answer D they have to do a statement of changes in fiduciary net position So they have to do two statements a statement of fiduciary net position and a statement of changes in fiduciary net position 30 It is inappropriate to record depreciation expense in the government wide statements related to the assets of which type of fund How about enterprise fund Well of course that's business type activities Member of the government wide statements report the fixed assets with accumulated depreciation general fund special revenue fund the governmental funds And even though they're not allowed to carry fixed assets in the government wide statements Those fixed assets would report be reported with accumulated depreciation So it's not no your date but agency fund agency fund can not have fixed assets It's impossible because an agency fund cannot have a fund balance or any kind of net asset position an agency fund never has any assets any liabilities any revenues and he expenses any net asset position of any kind any fund balance of any kind It's not possible So an agency fund can't carry fixed assets And that's why it's a 31 They say during the current year Knox County levy property taxes of 2 million they expect 1% to be uncollectable And they give you a lot of information and they say what amount of property tax revenue would Knox County report for their entity wide statement of activities Now this to me is a very important question and I want you to listen very carefully I think this is a big trouble spot for a lot of candidates when you're in that exam Listen to me when you're in that exam and they start talking about financial statements always take a breath and go wait a minute Are we talking about The government wide statements which are normally accrual accounting or the fund financial statements which are modified a cruel Remember that big distinction Anytime they start talking about statements take a deep breath Wait a minute Are we talking about the government wide statements which are normal cruel accounting or the fund financial statements which are modified a cruel All right now here they're talking about what amount of property tax revenue would Knox County report in their entity wide statement activities That's a government wide statement Let me show you the entry and the government wide statements done under normal cruel accounting so that when they levy those real estate taxes they're going to debit taxes receivable current for the 2 million since they expect 1% to be uncollectable they're going to credit estimated uncollectable taxes for 1% 20,000 and credit revenues control 1,000,980 And the answer is C they'll accrue all of it And all that information about 60 days means nothing because the government wide statements A normal accrual accounting Remember the fund financial statements are modified rule and you have to get into that whole 60 day thing I hope you understood that distinction anytime they start them on statements Wait a minute Is that the government wide statements that's normal cruel accounting or is that the fund financial statements which are modified rule Be very careful Hey this is normal cruel accounting So I'll just debit tax receivable current for the full levy for the full levy 2 million credit estimated uncollectable taxes for 1% 20,000 and credit revenues control for the 1,000,009 80 All that 60 day information doesn't mean anything Okay 32 March 1st wag city issued a million dollars of 10 year 6% bonds at par with no bond issue costs The bonds pay interest September one and March one What amount of interest expense and interest payable would wag report in its government wide government wide statement normal cruel accounting at the close of fiscal year December 31 Well what's the total interest expense Well take 6% take 6% of a million That's 60,000 of interest for full year or 5,000 a month I hope you're with me on that If you take 6% of a million That's $60,000 for a full year's interest or 5,000 a month All right So what's their interest expense for the year Well if 5,000 a month it would be March April may June July August September October November December 10 months times 5,000 50,000 and what's interest payable while it was paid on September one So what's Payable would be all the interest accrued for September October November December four months at 5,000 20,000 And the answer is a there's an interest expense of 50,010 months at 5,000 a month And interest payable 20,000 September October November December times 5,033 on January 2nd the city of Walton Issued 500,000 of 10 years 7% bonds interest is paid annually beginning January 2nd of the following year one amount of interest expense is Walton required to report in its statement of revenues expenditures and changes in fund balance and its governmental funds at the close of its fiscal year September 30th Well once again I hope you're in the FAR CPA Exam Take a breath We'll see a statement of revenues expenditures and changes in fund balance That's a fund financial statement In the fund financial statements they use modified accrual and in modified accrual we don't recognize interest or principle until it's mature due and payable So the answer is a not until there's a payment date which is next January 2nd I hope you see the difference This is a fun financial statement So it's modified to cruel and in modified or cruel we don't recognize interest or principle I tell it's a payment date They don't make a cruelty like like a profit making company It's not the major difference in modified rule So they'd be nothing to crude And the answer is a it's a very important distinction Number 34 the following are boa city's long-term assets Fixed assets used in an enterprise fund infrastructure assets roads bridges sewer systems and then all other general fixed assets What aggregate amount would boa report In the government in the governmental activities column of the government wide statements what's governmental activities will not the enterprise fund assets that's business type but the infrastructure assets 9 million and the other general fund fixed assets other general fixed assets 1,000,008 those would be governmental activities Fixed assets answer See the 9 million plus the million eight Now you know that In B 34 we've got the government wide statements under normal cruel accounting but the fund financial statements are done under modified accrual And you know what's inevitable They want a reconciliation Gatsby 34 requires two reconciliations where you reconcile from modified accrual to accrual accounting And you have to know how to do these If you look in the viewers guide you'll see the first example the first one that's required You have to reconcile All your governmental fund balances to the net position in governmental activities in the government wide statement of net position So again in the first one you have to reconcile all your governmental fund balance is under modified rule to the net position in governmental activities in the government wide statement of net position All right So if you look at this first example Notice all the governmental funds all the governmental fund balance sheets we're talking about general fund special revenue fund capital projects fund permanent fund debt service fund All the governmental fund balance sheets are showing total fund balances of 24 million And that and that's all done under modified or cruel There are three reconciling items and we have to decide what would be the net position in governmental activity In the government wide statement in that position on a normal cruel accounting we know it's 22 million but how do you get there Well we have three differences We have to think about we have it's either plus or minus How about the first one long-term debt issued for the capital projects fund are just thinking through with me when the capital projects fund goes out and uses long-term debt What's the entry wouldn't They have debit and cash For that 13 million they can't credit bonds payable right And modified a cruel they're not allowed to carry long-term debt So they would cry They would have credited other financing sources right And modified a cruel that's how that would have been handled by the capital products month They would have debit and cash 13 million credit other financing sources 13 million And then at year end when you close out your actual revenue your actual expenditures your actual sources your actual uses right at year end when you closed out those actual sources that would have caused an increase to the fund balance but in the government wide statements That should not increase net position It should increase the debt So back it out that's a subtraction It's weird Isn't it You're going from modified a cruel to a cruel Let me just do that again When the capital projects fund issued that debt they would have debited cash They can't credit bonds payable They would have credited other financing sources And then at year end When you close out your actual revenues your actual expenditures your actual sources your actual users when you closed out those actual sources that would have caused an increase to the fund balance but in the government wide statements that should not that should not increase the net position It should increase the debt So back it out subtract it It's a little different way of thinking Isn't it You're going from modified a cruel to a cruel How about number two Fixed assets acquired by the general fund will think what happens when the general fund bought fixed assets They can't debit machinery They can't debit equipment They're not allowed to not allowed to carry fixed assets So they would have debited expenditures control for the 9 million and credit vouchers payable And then what happens at year end when you close out your actual revenues close out your actual expenditures when you close out your actual expenditures that would have caused a decrease to the fund balance in modified a rule but in the government wide statements that should not lower the net position it should increase fixed assets So add it back I'll do that again General fund bought fixed assets They can't debit machinery They can't debit equipment They would have debited expenditures control credit vouchers payable Then at year end when you close out your actual revenues close out your actual expenditures that would have caused a decrease to the fund balance and modified a cruel but in the in the government wide statements that should not decrease the net position should increase fixed assets Add it back And let me just say that if that starts to dry you go Bob this is just going to drive me crazy You could memorize it In other words Debt is always subtracted Fixed assets are always add it I meant that's not bad If you can just go Bob I'm just getting frustrated and I see your lips moving but I just don't really understand That is always subtractive Fixed assets are always added And then the last one internal service fund balance is that 2 million Is it already in the 24 million No it's already already in the 24 million because it's not a governmental fund now of all it's in the 24 million at the top or the five gold medal funds General fund special revenue fund capital projects fund permanent fund debt service fund That's all That's in the 24 million the five gold medal funds Remember the internal service fund is a proprietary fund Wouldn't be there but in the government wide statements it's always governmental activity So add it in So that's how you get to the 22 million Now the other one that's required The second reconciliation you have to reconcile the net change in governmental fund balances to the net change in the net net position for governmental activities in the government wide statement of net position So again now you have to in the second one reconcile the net change in governmental fund balances under modified accrual to the net change in the governmental net position in the government wide statement of net position All right So once again at the top you see that during the year there was a net increase in all the fund balances of 12 million Okay 500,000 That's modified accrual and there are six reconciling items here We have to reconcile to what what was the increase or decrease in the net position in governmental activities and the government wide statement of net position under normal cruel accounting Once again you're going from modified accrual to normal cruel accounting In other words the way I look at it you're going from insanity to sanity That's really what you're doing in insanity Back to sanity No modified or cruel is nuts Let's agree on that I mean it is nuts Yeah We have to know it because we're taking the CPA exam Well you are but you see my point You've got to know it because you're taking the CPA exam and that's all there is to it but it doesn't you know modify to rule it should be thrown in the in my opinion in the trash heap of history but we have to know for the FAR CPA Exam All right So let's reconcile We know that during the year there was a net increase in all the fund balances under modified rule of 12,500,000 Let's reconcile How about the bond proceeds Let's go over it again When a governmental fund issued issued bond collected bond proceeds they debit cash for that 3 million They can't credit bonds payable because they're not allowed to carry long-term debt So they would have credited other financing sources Right And then at year end when you close out your actual revenues your actual expenditures your actual sources are actual users That's what happens when they close out those actual sources that would have caused an increase to the fund balance And modified a cruel but in the government wide statements that should not increase net position It should increase the debt So back it out But like I say you can see you can memorize it too Debt is always subtracted How about number two the current repayment of bond principle Now we did look at the debt service fund in this FAR CPA Review course but what happens in the debt service fund When they make a principal payment remember the debt service fund they use modified a cruel So when they make a principal payment don't they debit Expenditures control and credit matured bonds payable So what happens at year end when you close out your actual revenues your actual expenditures when they close out those actual expenditures that would have caused the decrease to the fund balance and modified a cruel but in the government wide statement it wouldn't cause a decrease to net position It would decrease the debt instead So add it back one more time In the debt service fund and modified a cruel they make a principal payment they would debit expenditures control and credit matured bonds payable at year end When you close out your actual revenue your actual expenditures that would have caused a decrease to fund balance but in the government wide statements that should not decrease net position to decrease the debt added back How about the excess of revenue earned over available and measurable What's what's at the top What's in the 12,000,005 available in measurable It's modified a rule But in the government wide statements it's normal cruel accounting So if you earned more than available and measurable than add it in add in the 600,000 because again what's at the top modified a cruel is available and measurable And if it turns out you earned more than what was available and measurable add it in How about the current fixed asset acquisition Add it right You memorize it just add it but you understand the logic If one of the governmental funds Buys fixed assets They debit expenditures control They can't debit machinery They can't debit equipment They debit expenditures control of credit vouchers payable Then the ERN when you close out your actual revenues close out your actual expenditures would have caused a decrease to the fund balance in modified a rule But in the government wide statements that would not decrease net position it would increase fixed assets at a back Like I say you can memorize it Number five depreciation expense Is that depreciation expense reflected at the top No In modified a cruel they don't carry fixed assets They don't depreciate fixed assets but in the government wide statements they use normal cruel accounting The depreciation would be taken Back out 200,000 and then finally the internal service plan net revenues I hope you don't miss this one Is that 800,000 at the top No it's not a governmental fund member All that's at the top are the governmental funds general fund special revenue fund capital projects fund permanent fund debt service fund But in the government wide statements internal service fund is governmental activities So add it in and that's how you get to the 11,000,008 50 You've got to know how to do these reconciliations now This can also of course be tested in multiple choice Try the last two multiple choice 35 and 36 And then come back Welcome back Look at number 35 35 says Knock city reported a 25,000 on the net increase in all the fund balances for total governmental funds Now that's done under modified accrual right They just looked at their five governmental fund balance sheets general fund special revenue fund capital projects fund permanent fund debt service fund They look they look at all their governmental fund balance sheets Add it up the fund balances Add up to 25,000 onto modified a cruel We have three reconciling items and they want to know what would be the net change in the net position For governmental activities in the government wide statement of net position on a normal cruel accounting How about the first one the motor pool internal service fund You're never going to miss that right That nine thousands not already in the 25,000 cause it's not a governmental fund it's proprietary fund but in the government wide statements it's always governmental activities Add it in How about the enterprise fund No that's business type activities Be careful of that trick number We're trying to work out To the net position in governmental activities in the government wide statement net position right We're trying to work out the net position in governmental activities in the government wide statement in that position not business type activities and the enterprise fund enterprise fund his business type activities Wouldn't worry about it How about the employee pension fund Well that's a fiduciary fund and the fiduciary funds as you know are already are always excluded from the government wide statement Don't worry about it The answer is B 36 tree city reported a $1,500 increased in all the fund balances We've got metal funds That's modified a cruel Again all they did was look at their fund balance sheets for their five governmental funds general fund special revenue fund capital project fund permanent fund debt service fund Last year they looked at the fund balances this year and there's been a net change Of $1,500 increase under modified a cruel and they want to know what would they report as the net change in the net position for governmental activities and the government wide statement of net position Well how about the general capital assets of 9,000 fixed assets are always added right You've memorized it now Anyway Right Debt is always subtracted Fixed assets are always added And how about the depreciation expense Is the depreciation expense reflected already in the 1500 No Cause in modified a cruel they're not allowed to carry fixed assets They're not allowed to depreciate fixed assets but in the government wide statements depreciation would be taken So back it out And the answer is 7,500 It's the 1500 plus 9,000 minus 3000 Answer C Let's do one more reconciliation and your viewers guide There's a third reconciliation where you have to reconcile the net change in the governmental fund balances under modified or cruel to the net change in the net position for governmental activities in the government wide statement of net position Now if you look at this during the year there was a net increase in all the fund balances on the modified accrual of 2,000,006 There are nine reconciling items All you have to decide is add or subtract and see if he can work out What was the net change in the net position for governmental activities in the government wide statement of net position I'd like you to shut the class down and get the answer Welcome back I know you did well on this during the year there was a net increase in all the fund balances on the modified rule of 2,000,006 Why don't we together reconcile to the net increase in net position for governmental activities in the government wide statement of net position Why don't we just do that Cause we know this so well now how about the first one depreciation expense on governmental fixed assets Well of course that's not reflected the 2,000,006 because in modified accrual you're forbidden to take depreciation You have a burden to carry fixed assets but in the government wide statements it's normal cruel accounting Take the depreciation back out the 200,000 you would subtract Same thing with the next item amortization of a discount We know in modified accrual at the top There's no amortization taken ever on bond that discount or bond premium but in the government wide statements it's normal cruel accounting The depression the amortization on the discount would be taken subtract that 50,000 the current general fund fixes facet acquisition Well yeah you've memorized Anyway fixed assets are always added Bob I liked that I liked that I don't have to think it through add it 800,000 number four the internal service fund net revenues of a million Is that million already reflected at the top No it's not a governmental fund but in the government wide statements internal service fund is always governmental activities added in How about the enterprise fund net revenues You're not going to fall for that that's business type activities That's business type activities We're trying to work out the net change in the net position for governmental activity Enterprise fund is business type activities Don't worry about it Not consider it How about number six Current bond proceeds the capital projects fund Well you know debt is always subtracted back it out How about current debt service repayment of principle a hundred thousand Are you getting used to this What happens when the debt service one pays principal Debit expenders control credit matured bonds payable then an ERN When you close out the actual revenues actual expenditures and you close off those actual expenditures that would cause a decrease to the fund balance in modified a cruel but in the government wide statements that should not decrease the net position It's a decrease the debt So add it back add that back How about number eight excess of revenue earned or available and measurable or what's at the top The 2,000,006 is modified a cruel available and measurable but the government wide statements are done under normal accrual accounting So if they've earned more than what's available and measurable add it in add that 75,000 in and then the last one number nine fiduciary fund net revenues add to subtract Neither ignore that because the fiduciary funds are just excluded always excluded from the government wide statements anyway and the answer is 3,000,008 25 And that's the last problem we're going to do together And I want to wish you a lot of luck in the FAR CPA Exam from all of us at the Bisk CPA review course we want to wish you the best of luck on the FAR CPA Exam Keep studying . Welcome to Bisk CPA review comprehensive review materials for the CPA exam To let you customize your own review programs to meet your individual learning style and ensure your success Worried about finding the time to study our customizable learning system allows you to study anytime anywhere 24 seven to fit your busy lifestyle and ensure your success on the FAR CPA Exam Looking for a particular way to prepare structured Professor led online reviews to independent self-study programs on CD-ROM video audio and text Our interrelated products are designed to meet your individual learning style Wondering how you're going to master the FAR CPA Exam content Our unique learning management system ensures that you will master the material And features such as exam preparation tips streaming video lectures and a computerized personal trainer actually reduce your study time concerned about the computer-based exam format The online classic and software versions of Bisk CPA review accurately mirror the real life experience of a computer-based exam including multiple choice simulation and written communication questions It's all about passing Each of our products has been specifically designed to ensure your success On the CPA exam with best CPA review you will have the confidence and knowledge to pass it Hello and welcome to the Bisk CPA review course and our coverage of the financial accounting and reporting section of the CPA exam My name is Bob Monette I'll be your instructor for this FAR CPA Review course in this FAR CPA Review course. We're going to be talking about international Financial reporting standards or I firs as I'm sure you know I firs is now tested in the CPA exam and I firs is really an enormous topic So what we're here to discuss is the best way for a student to prepare themselves for questions in the FAR CPA Exam and my feeling about How to handle this is to concentrate on the major differences between us generally accepted accounting principles and international financial reporting standards You want to focus on the major differences between us GAAP and IFRS because I think that for the most part that's what the FAR CPA Exam will focus in on I think it's the best way to study this And before we dive into the topic let me Just mentioned that it's important that you treat this like any other class take good notes be an active participant You know later when we do problems and I assign some it's important to shut the class down do the problems get your answers before you come back and we discuss the problems together You do those simple things I think that you'll get much more out of this CPA Exam FAR course and that's what we both want So make sure you handle it that way Now one major difference between Us GAAP and theoretically  is that usGAAPp is considered more of a rules-based approach It's a rules-based approach Us GAAP sets down bright line rules that we have to follow Where I firs it is argued is more of a principles-based approach lays down general principles regarding recognition measurement reporting general principles and allows more judgment and applying the principles So that's one major difference that us GAAP is a rules-based approach bright line rules more of a principles-based approach and allows more judgment in applying the principles I want to really get started by talking about the financial statements that are required under let's go over the financial statements Under a corporation is required to do a statement of financial position What we generally call a balance sheet but under IFR is it's always called a statement of financial position And we'll be saying more about differences in the statement of financial position As we move along under IFR as a corporation has to do a statement of comprehensive income as you will begin to see very much Emphasizes comprehensive income And we know comprehensive income is comprehensive Income is defined as anything that affects stockholder's equity It's very broad Anything that affects stockholders' equity as long as it doesn't come from the owners like issuing shares or go to the owners like a dividend that's comprehensive income And as I say I for is very much focuses on comprehensive income So under A corporation has to do a statement of comprehensive income Now you may remember that under us GAAP When we report total comprehensive income we can use a one statement approach We can use a two statement approach and remember that what that difference means If we do a one statement approach that means we're doing a combined A combined statement of income and comprehensive income We do our income statement the way we've always done it And then after we report net income after net income we show the items of other comprehensive income the items of OCI for the period And then that lets us show a bottom line total comprehensive income That's the one statement approach where you do a combined statement of income and comprehensive income or under us GAAP You can use a two statement approach Where under the two statement approach we have an income statement the way we've always done it and a separate statement of comprehensive income And when we do a separate statement of comprehensive income we start with a net income on our income statement Remember for most companies that's the biggest part of conference of income So anytime you do a separate statement of comprehensive income you're going to start with the net income right off the income statement and then add all the items of OCI for the period And that lets you report total comprehensive income Well I mentioned this because Under a corporation is required to have a statement of comprehensive income and under they will allow either the one statement approach or the two statement approach under heifers They do allow either the one statement approach or the two statement approach Now another thing I should mention a couple of big differences since we're focusing on the differences between us GAAP And I froze I should mention that when you are doing your statement of income the statement of comprehensive income And as I say they allow the one statement approach or the two statement approach When you are doing your statement of comprehensive income please remember under efforts they do not have extraordinary items Keep that in mind There's a major difference between Iver's and us GAAP that on the statement of income which would be part of your statement of comprehensive income There are no extraordinary items under heifers You have net income from continuing operations is discontinued operations But there are no extraordinary items in another little difference or a major difference depending on your point of view under They do not allow the completed contract approach of recognizing revenue for long-term contracts The completed contract method is not allowed so there's some major differences there All right Number three under IFR as a corporation has to report a statement of changes in equity A statement of changes in equity where you have a statement showing the change in all stockholders' equity items you show during the accounting period What was the change in common stock The change in additional paid-in capital the change in retained earnings the change in accumulated OCI accumulated other comprehensive income items There were gains and losses of course that are not on the income statement They go directly to stockholders' equity as an item of OCI So in stockholders' equity we have accumulated OCI where these gains and losses that are not on the income statement accumulate And so we show on our statement of changes in equity the change during the accounting period to accumulated other comprehensive income items So you do that statement and there must be in that statement there must be a column fuck comprehensive income So in that statement you'll show how net income is part of comprehensive income and goes to retained earnings The items of OCI for the period would be considered part of comprehensive income and go to accumulated OCI But that's that statement is required showing a statement of changes in all equity accounts And in that statement you would also have a column for comprehensive income So we know they have to do a statement of comprehensive income They have to do a statement of changes in equity Number four they have to do a statement of cash flows Now under when a corporation does their statement of cash flows they can use either the direct method or the indirect method I first allows either the direct method or the indirect method but a couple of small things I want to mention Here's a D is a difference in When you do your statement of cash flows under efforts what do you do with it Interest received interest income dividend income Well you know under us GAAP interest income dividend income is on the income statement It's part of cash flows from operating activities will under efforts interest income dividend income can either be in operating activities or investing activities either one as long as it's done consistently So let me say that again U S GAAP interest income no cash received for interest cash received for dividends That would be on the income statement It would be an operating item but under interest income dividend income you know cash received for interest cash received Dividends will either be an operating or investing activities Either one they'll allow you to use either one but it has to be applied consistently Same thing with Interest paid dividends paid Now we know dividends paid is always under us GAAP or efforts financing activities We know dividends paid always under us GAAP financing activities Well under under the cash you pay for interest The cash you pay for dividends can either be in operating or financing either one as long as you do it consistently So a little picky differences in IFAs So the cash you pay for interest the cashew pay for dividends can either be on operating or it can be in financing as long as it is done consistently Another difference in the statement of cash flows under You may you may remember that when we do a statement of cash flows under us GAAP we have to worry about those non-cash investing and financing activities I know you remember those Remember those non-cash investing and financing activities you know preferred stock converted to common stock There's no effect on cash It's a non-cash investing and financing activity bonds converted to stock It's a non-cash investing and financing activity If there's a straight exchange of debt for property you know a company issues a note for an asset what is that It's a non-cash investing and financing activity and also a straight exchange of stock for property A company issue stock for an asset that is a non-cash Investing and financing activity Well under us GAAP these non-cash investing and financing activities are a supplemental disclosure in the statement of cash flows I know you remember that the non-cash investing and financing activities are a supplemental disclosure in the statement of cash flows under us GAAP under They're not a supplemental disclosure in the statement of cash flows They're in notes to the financial statements another picky difference under the non-cash investing and financing activities on not a supplemental disclosure and the statement of cash flows they would be disclosed in notes to the financial statements instead All right so we have a statement of financial position a statement of comprehensive income a statement of changes in equity and a statement of cash flows And then finally number five would be notes Another thing that I want to talk about because the FAR CPA Exam seems to emphasize this and that is what do we consider the data Transition The efforts when a corporation does make a transition to They go from us GAAP to heifers they transition What is the date of transition Well it is a technical point and I think the best way to bring it out is to go to a question If you go in your viewers guide let's look at question number one question number one says on August 1st year two Lex company decided to adopt So that's August one year two Lex is going to convert to Ivers The company's first reporting periods for the year ended December 31st year to Lex will present year one statements for comparative purposes What is Lexus date of transition It's a technical question What is technically the date of transition Well here is the answer The date of transition is the beginning of the earliest period It's the beginning of the earliest period for which a company presents comparative Information under IFR I'll say it again Date of transition is the beginning of the earliest period for which the company presents comparative information under So since they're going to present year one statements for comparative purposes but data transition to heifers would be answer a January 1st of year one the beginning of the year earliest period for which the company presents comparative information under efforts And in this case that would be since they're gonna show here one for comparative purposes It will be January one year one That would be the date of transition answer a and this is something you want to remember under us GAAP There's no particular requirement regarding comparative information under us GAAP There is no particular requirement regarding comparative information but under a company is required to present the prior statements for comparative purposes Notice that on the U S GAAP no particular requirement regarding comparative information but under efforts a company is required To present the prior year's financial statements for comparative purposes So since they decided to Tran transition the heifers in year two they'd be required to present year one statements for comparative purposes under IFR So the date of transition is the beginning of the earliest period of which they present comparative information for under And that would be answer a January 1st year one Now another point I'll use Lex company as an example when Lex company Transitions to efforts What are the financial statements that are required Well we know the date of transition is January 1st year one Lex would be required under heifers to report three statements of financial statements of financial position Three of them one on the date of transition January one year one another one dated December 31st year one the end of the first year And a third statement dated December 31 year two Let me say that again When a corporation transitions to efforts as Lexus doing they'd be required to report three statements of financial position One on the date of transition We know that's January 1st year one another statement of financial position at the end of the first year December 31 year one And then a third statement dated December 31 year two Lex would have to show two statements of comprehensive income two statements comprehensive income one for year one One for year two to statements of changes in equity to statements of changes in equity One for year one one for year two and two statements of cash flows One for year one one for year two Those are the statements that are required when you transition to Let's look at question number two they say how would first time how would a first-time adopter of Recognize the adjustments required to present its opening IFR statement of financial position So we have a first time adopter of Vipers How do we recognize the adjustments required to present the opening first statement that that very first one in Lexus case January 1st year one while he answers date look at answer date It says all of the adjustments Would be recognized directly in retained earnings or if appropriate in another category of equity The answer is D And just to give you a quick example of why both retained earnings and stockholders' equity is implicated here If you're going to see later when we talk about intangibles if you adopt heifers and you elect to use the revaluation model for intangibles You're going to revalue under the revaluation model for intangibles you will revalue the intangibles to fair value and any gain or loss would go directly to retain earnings But if you elect the revaluation model for property plant equipment you would adjust property plant equipment to fair value but the gain of loss would go directly to stockholders' equity as an item of OCI So that's why they're both implicated That's why the answer is D Number three which of the following is the minimum reporting requirement for a company that is preparing its first financial statements Date of transition Do you have to go beyond a you have to show three Statements of financial position right Three of them one on the date of transition another one dated the end of the first year and another one dated the end of the year Second year three a financial position You don't have to go beyond answer a number four The following statements is not required under efforts not required Well notes The financial statements are required I statement of cash flows is required and Ivers Answer D statement of comprehensive income you know as required by the answer C there's no statement of retained earnings answer state that's the answer IFAs does not require a statement of retained earnings They require a statement of changes in equity all stockholders equity accounts and include included in that statement comprehensive income as well Number five in the year of transition to heifers which of the following is not one Of the required statements of financial position So if it is the year of transition the date of transition which of the following would not be one of the required statements of financial position Well just think about Lex would we have to do a statement of financial position January January one year one The date of transition Yes December 31 year one Yes December 31 year two Yes but not answer B There's no statement of financial position position January 1st year too right No it's it's a statement of financial position on the date of transition January 1st year one the end of the first year of the end of the second year But there's no statement of financial position January 1st year two How about statement of cash flows That would be one for year one one for year two How about statement of changes in equity one for year one one for year two How about statement of tech of cash flows one for year one one for year two number six under which of the following is not an allowed method of accounting The long-term contracts you know it's completed contract that's One of the differences in lifers Ivers does not allow the completed contract map under You have to use the percentage of completion method to recognize revenue from a long-term project or They'll let you recognize revenue as you know equal to the costs that have been incurred up to a certain point They'll let you do that But basically it's percentage of completion under IFAs They don't allow completed contract and you need to be aware of that I want to get more into now the changes or the differences that you would see under in the statement of financial position And I want to start with inventory Let's start with inventory Now we know under us GAAP the primary basis of accounting for inventory is historical costs We know that under us GAAP the primary basis of accounting for inventory historical costs Well that's also true under heifers The primary basis of accounting for inventory is also historical costs And what has is what is historical cost Well under IFR is just like just like us GAAP It would be all the costs you incurred To bring that inventory into a condition and location for sale So things like purchasing costs handling costs warehousing costs freight in transportation in as part of the cost of merchandise warehousing costs All these costs would be capitalized to inventory And that's true under as well as us GAAP because under both us GAAP and defers the primary basis of accounting for inventory is historical costs But never forget that Ultimately whether it's us GAAP or efforts inventory must be carried on a balance sheet at its original cost or its market value Whatever's lower under us GAAP and inventory must be accounted for using lower of cost to market And how you apply lower of cost of market to inventory is different Between us GAAP and so let's go to a problem cause I want to show you this It's very important I that you know the difference between applying lower of cost of market to inventory under us GAAP and applying lower of cost to market inventory under I feel there's no question The example always emphasize this So let's go to question number seven aims company determined the following values for its inventory At December 31 notice we know the historical cost We know the replacement costs the sales value the cost to complete and sell the normal profit margin And also the fair value they ask under Ivers What amount would aims report for inventory at December 31 Well before we do first let me refresh your memory on us GAAP How would us GAAP solve this problem I know this will certainly ring a bell even if you haven't haven't thought about it in a while But if you've prepared a little bit on inventory you know it's a little complicated under us GAAP If you're going to apply lower of cost to market to inventory the first thing you have to work out is the ceiling because there's an absolute ceiling and market Can't be above the ceiling The ceiling is called net realizable value So how do we define net realizable value Let's figure that out The net realizable value would be the selling price 190,000 the sales value minus the normal cost to complete and sell minus the normal disposal costs 10,000 So the ceiling net realizable value would be 180,000 OPC How I got that that's simply defined as the selling price 190,000 minus all the costs to complete and sell all the disposal costs of 10,000 So net realizable value will be 180,000 market can never be higher than that Then you have to figure out the floor The floor is defined as that ceiling net realizable value 180,000 minus a normal gross profit on sale So we're going to back out the gross profit on sale 8,000 That's the normal gross profit on sale So the floor would be 172,000 And what I mean by floor is we know market can never be below that amount It's an absolute floor and there's no fancy name for it It's just called the floor the bottom but market can't be below that All right So first we calculate the ceiling net realizable value That is 180,000 Then we get the floor That's 172,000 Now our next step what is market Well we look at three numbers number to figure out market You've got to look at three numbers Look at replacement costs 160,000 the ceiling Net realizable value 180,000 and the floor 172,000 You look at those three numbers Look at replacement costs 160,000 The ceiling net realizable value 180,000 and the floor 172,000 Whatever number is in the middle is your market under us GAAP You look at those three numbers now whatever number is in the middle is your market The middle number here is 172,000 the floor That's your market All right Then your last step is to say all right it's the lower of cost 200,000 or market which I now I now know is 172,000 I'll use 172,000 notice that's answers See if this were us GAAP the answer would be say 172,000 the lower of cost which is historical cost A hundred is 200,000 market I now know is one 72 because it's lower I use market I'd have In other words I'd have to write the inventory down to 172,000 What's the entry let's start What's the entry My job here is to write the inventory down From it's cost 200,000 down to market which I now know is 172,000 So I would debit loss inventory loss 28,000 and take that loss to my income statement And I would credit inventory 28,000 I would literally write my inventory down from 200,000 down to one 72 because market is lower What if it recovers What if it recovers It's not recorded right It's important And us GAAP our recovery would not be recorded now Let's apply efforts Here we go If you apply lower of cost of market to inventory under and RV the net realizable value is defined exactly the same way you take the selling price 190,000 minus the normal disposal costs back out the normal cost to complete and sell 10,000 notice net realizable value is also 180,000 It's defined exactly the same way And under I firs inventory is carried on the balance sheet at the lower of Cost or NRV it's actually easier You don't have to worry about the floor and replacement costs No Under efforts Inventory is carried on a balance sheet at the lower of cost or net realizable value So take the cost 200,000 market is 180,000 and RV I'll use 180,000 because it's lower So what's my entry You know I'm going to debit inventory loss 20,000 That loss is going to go to my income statement and I'm going to credit inventory 20,000 I write my inventory down from 200,000 down to one 80 So that's why the answer is B the answer number seven is B because it's efforts What if it recovers I know I keep asking that let's say the next year they say inventory is recovered by 16,000 Listen carefully Another major difference in I first I first would record a recovery Us GAAP would not under If they said that the following year inventory is recovered in value by 16,000 I would debit inventory 16,000 debit inventory 16,000 write it up and credit income 16,000 I'd have 16,000 of income go to my income statement if it recovers because I for his records recoveries in market Us GAAP does not It's another major difference Let's look at number eight Number eight says accompany determined the following values for its inventory At the end of the fiscal year we know the historical costs We know the replacement costs We know the NRV it's given to us We know the NRV less than normal profit margin That's the floor under us GAAP And we know the fair value Then they say Oh underwriters we're none of us GAAP here We're under IFR for is under lifers What about with the company report for inventory on the balance sheet Well Ivers is actually the leisure than us GAAP under heifers It's the lower of cost which is a hundred thousand or market which is NRV 90 I'll use 90 it's lower And the answer is C You got to love heifers in this sense it's the lower of cost or net realizable value under net realizable value is always market And then remember I for as does record our recovery in Mark where us GAAP would not number nine which of the following is a true statement regarding the accounting and reporting requirements related to inventory for both and us GAAP So what's true of both accounting for inventory What's true about accounting for inventory under both I for as an us GAAP ACE as both and us GAAP are based on the principle that the primary basis of accounting for inventory is fair value Now the primary basis is historical cost under both not fair value bait under both IFRS and us GAAP The cost of inventory includes all the direct expenditures To ready the inventory for sale including selling expenses now not selling I for annual GAAP Wouldn't include selling expenses in the cost of inventory C says both Iverson us GAAP inventory is carried at the lower of cost market And then he write downs of inventory to create a new cost basis that subsequently cannot be reversed Now it could be reversed under ISIS but not Under U S GAAP So that's not true of both but answer D is a true statement under life was prohibited that you can't argue with that That's another thing you need to know that under there is no last in first out you know under under refers you can use first in first out weighted average the retail method but you can't use life of not In our efforts as you know when we're talking about intangible assets we're talking about copyrights and patents trademarks Goodwill secret formulas Lease hold improvements franchises These are your basic intangibles Now in terms of accounting for intangibles there are a couple of issues First of all let's talk about us GAAP If we're talking about us GAAP what costs would we capitalize for Copyright a patent a trademark will remember us GAAP We look for three things We capitalize purchase price So if I purchase your trademark for a million dollars I capitalize the million You do capitalize purchase price Also number two you would capitalize legal and other fees to register the copyright the patent the trademark whatever it is and then never forget Number three you would also when you ask GAAP capitalize legal fees in successful defense of a copyright a patent or trademark though these are the costs we capitalize To intangible accounts Well I for is no different in this regard would capitalize purchase price legal and other fees to register the copyright the patent the trademark and legal fees in successful defense of a copyright a patent or trademark or whatever it might be So us GAAP are the same in that regard now in terms of how we account for an intangible after acquisition There is a difference Starting with us GAAP Remember us GAAP divides and tangibles into two broad categories First there are intangibles with a finite useful life like a patent like a leasehold improvement and under us GAAP If you have an intangible with a finite useful life you amortize that intangible over your best estimate of its useful life That's us GAAP You have an intangible with a finite use for life A copyright a patent a leasehold improvement You'd amortize that intangible over your best estimate of it's useful Now there are also intangibles that have an indefinite useful life Goodwill is the big one Goodwill a trademark In most cases there are intangibles with an indefinite useful life and not a U S GAAP If a company has an intangible with an indefinite use for life it's not Amarin it's not amortized It's tested for impairment at least annually And what if it recovers remember if there's been an impairment loss and it recovers us GAAP would not recover record a recovery in market Now let's talk about now under with intangibles you have a choice with intangibles You can either use what is called the cost model Or the revaluation model under for intangibles There's a choice The company can either use the cost model or the revaluation model Now the cost model is very similar to us GAAP Under the cost model you would divide intangibles into two categories If it's an intangible with a finite use for life you'd amortize that intangible over the best estimate of its useful life If it's an intangible with an indefinite use of life you wouldn't advertise it You tested for impairment at least annually And if you write an intangible down because there's been an impairment loss and it recovers remember I firs would record a recovery in market but listen to me carefully not Goodwill both us GAAP and efforts If they've written Goodwill down to market because of an impairment loss and Goodwill recovers Both us GAAP and diapers will not record a recovery in market for Goodwill there us GAAP and agree But under heifers for intangibles you can choose again what is called the cost model or for intangibles you can use what is called the revaluation model Now in the revaluation model it can only be used if the intangible has an active market You can only use the revaluation model if it isn't intangible with an active market but under the revaluation model it doesn't matter whether the intangible has a finite or an indefinite life Again under the revaluation model it does not matter whether the intangible has a finite or an indefinite life The intangible would first of all be recorded at the cost of acquisition No the purchase plight price plus legal and other fees to register plus legal fees and successful defense So you'd start by recording the intangible at its cost And then periodically you would revalue the intangible to its fair value The gains and losses would go to the income statement That's the revaluation model whether it's an intangible with a finite use useful life or an indefinite useful life periodically you would adjust the intangible to it Fair value And the gains and losses would go to the income statement That is the revaluation model So just remember under heifers you make a choice with intangibles either the cost model which is very similar to the U S GAAP or the revaluation model Let's do a couple of questions Number 10 Number 10 says under efforts an entity that acquires an intangible asset may use the revaluation model for subsequent measurement Only You can only use the revaluation model only if what answer B there's an active market has to be an active market for that intangible number 11 Number 11 an entity purchases a trademark following costs are connected with the purchase of the trademark according to and applying Ivers And assuming that the trademark meets all of the initial asset recognition criteria how at what amount would you capitalize the trademark Well member in this regard in terms of what you capitalize from an intangible us GAAP and heifers are really the same We're going to pick up the purchase price that one-time purchase price of a hundred thousand onto us GAAP And I presume you would pick that up the VAT taxes the value added taxes pick that up you know purchase price the cost of acquisition So you're going to pick up that one Oh five The training sales personnel to use the trademark that's expensed research expense legal fees to register Pick that up That's capitalized that 10,500 salaries of administrative personnel would be expensed So what you capitalize for the trademark under and us GAAP would be a hundred plus five plus ten five answer B in that regard us GAAP and are identical in terms of what you capitalize for a copyright a patent trademark whatever it might be Let's talk about investments for a minute Now first of all you know under us GAAP there are three categories of investments First there's held to maturity securities under us GAAP held to maturity Securities are accounted for under amortized cost Then there are trading securities trading securities are accounted for at fair value right with trading securities under us GAAP We write them up to fair value down to fair value and the unrealized holding gains and losses go to the income statement they're included in earnings Then there are available for sale securities Available for sale Securities are accounted for at fair value Periodically you know at year end we would adjust the available sales securities to their fair value but the gain of loss would not go to the income statement It would go directly to stockholders' equity as an item of OCI an item of other comprehensive income That's us GAAP Now under Ivers under IFR is for held to maturity securities You have a choice under You can either For held to maturity securities use amortized costs just like us GAAP You can either use amortized costs or fair value is what they call fair value through profit loss FV TPL fair value through profit loss In other words that means adjust to held to maturity to fair value gains and losses Go to the income statement They go through profit and loss Just remember it's called FP TPL fair value through profit loss So one more time under For held to maturity securities you make a choice You can either account for held to maturity securities under amortized cost just like us GAAP or FTE DPL fair value through profit and loss for trading securities It's identical to U S GAAP both us GAAP and account for trading securities You ain't using what at the TPL fair value through profit loss trading securities are adjusted to fair value gains and losses Go to the income statement under us GAAP And diapers and then finally available for sale securities under You make an election you can either use the U S GAAP approach where available sales securities are adjusted to fair value gains and losses Go to OCI just like us GAAP or you can make a choice under to account for avail for sales securities using FB TPL Fair value through profit loss Let me say that again for available for sale securities you have you make an election under You can either use the U S GAAP approach Meaning available sales securities would be adjusted to fair value gains and losses go to OCI or you can elect under to account for available sell securities using FBT DPL fair value the profit and loss just like trading just like Held to maturity If you elect to use it for held to maturity you would adjust available sales securities to their fair value gains and losses would go to the income statement Now what I want to get into is one of The most important areas in terms of and how it's different from us GAAP And what I'm talking about is the area of fixed assets There are some significant differences in Ivers regarding how to account for fixed assets compared with us GAAP First of all under Eiffert There are three categories of fixed assets First category property plant equipment It's a it's a category we're very familiar with property plant equipment It's the same as us GAAP in terms of what would be what would be included under that heading But Ivers has a couple of other classifications of fixed assets which us GAAP does not have I first has investment properties Investment property is property held to earn rental income or capital appreciation or both Again under is another category of fixed assets called investment property Investment property is property held earn rental income or capital appreciation or both And then under Ivers there's also biological assets plants animals under biological assets Are disclosed separately this assuming they have future economic benefits I mean we are assuming these are plants or animals that have future economic benefits but in I fruits biological assets are separately disclosed to separate category of fixed assets All right Now how do we account for fixed assets under Well let's start with biological assets On with biological assets under you make an election you can either elect to use the cost model Now the cost model means that the biological assets would be on the balance sheet at the original cost minus any accumulated depreciation minus any impairment loss I'll say it again If you elect to use the cost model for biological assets those biological assets will be on the balance sheet at their original costs Minus accumulated depreciation minus any impairment loss What if it recovers What if there's been an impairment loss and it recovers in value it would be recorded You know generally I firs would record a recovery in in in market except for what Goodwill Right Is that for Goodwill Just like us GAAP would not record it there They agree but generally Ivers records recovery and value Okay All right So for biological assets if a company elects to use the cost model Those assets will be on the balance sheet of the original cost minus accumulated depreciation minus any impairment loss And again if it does recover it would be recorded Or for biological assets you can elect to use the fair value model Now to use the fair value model Again there has to be a ready market for these biological assets and under the fair value model periodically you would adjust the biological assets to their fair value Gains losses would go to the income state Now in other words it's FB TPL You can elect for biological assets to use F V TPL fair value through profit loss Periodically adjust the biological assets to the fair value gains and losses Go to the income statement and listen no depreciation is taken No depreciation is taken in the fair value model Let's talk about investment property for investment property You make an election You could elect for investment property to use the cost model And if you elect to use the cost model the investment property will be on the balance sheet you know and its original cost minus accumulated depreciation minus impairment loss that's cost model So if a company elects to use the cost model under efforts for investment property that investment property will be on the balance sheet and its original cost minus accumulated depreciation minus any impairment loss What if it recovers Recoveries are recorded under efforts except for Goodwill It wouldn't record a recovery in market of Goodwill Now also for investment property you can elect to use the fair value model you know just like biological assets for investment property You can elect to use the fair value model and now you're getting used to it It's really FV TPL fair value through profit and loss where periodically you would adjust The investment property to its fair value gains and losses go to the income statement and no depreciation is taken the TPL So you can elect to use the fair value model Now let's talk about property plant equipment Now for property plant and equipment you have to decide for each class of property plant equipment In other words for each class whether it's Land that's different That's a class furniture and fixtures you know ships for everyone class of property plant equipment You make an election for each class that the entire class you make an election You can either use the cost model or the revaluation model Again for every class of property plant equipment whether it's land that's a separate class Furniture and fixtures It's a separate class equipment separate class for each class You make an election you can either use the cost model or the revaluation model Now the cost model would mean that that asset will be on the balance sheet at its original cost minus any accumulated depreciation minus any impairment loss And if it recovers it would be recorded That's the cost model again and again Right So for property plant equipment for it for each class you decide if you want to use the cost model that asset will be on the balance sheet and its original cost minus accumulated depreciation minus any impairment loss And if it recovers it would be recorded or you can elect for property plant equipment Each class you can use the revaluation model Now under the revaluation model periodically you would adjust the asset to its fair value So now the asset will be on the balance sheet at its fair value minus subsequent appreciation In other words now depreciation would be taken based on that new value in the revaluation model periodically you would and there's and there's no guidance how often you would revalue just has to be with sufficient regularity but it doesn't have to be it doesn't have to be every year There's really no guidance on how often you have to revalue but it has to be of sufficient regularity But periodically you would adjust the asset to its fair value subtract subsequent depreciation and any impairment loss And if it recovers it would be recorded Now one thing I want to mention that when you apply the revaluation model to property plant and equipment and let's say I've decided to use the revaluation model for equipment that whole class Okay So A company is elected to use the revaluation model for a whole class of property plant equipment called you know equipment That means periodically we're going to adjust it to fair value Let's say the fair value has gone up for the equipment That means I would debit equipment I'd write it up to fair value And I credit listen revaluation surplus It's very important that you understand this entry If you're going to use the revaluation model on a class of assets like equipment Periodically I just the fair value let's say fair value has gone up I would debit equipment and I would credit what it's called revaluation surplus And that revaluation surplus that goes to OCI That's an element of other comprehensive income down in stockholders' equity And then what happens when I dispose of the asset that gain that I put in revaluation surplus would be transferred to retained earnings So let me go over that one more time If I elect to use the revaluation model For a whole class of property plant equipment like equipment and at year end on reevaluate the equipment's gone up in value I would debit equipment write it up to fair value And I credit an account called revaluation surplus You might see that account name in the FAR CPA Exam and that revaluation surplus goes directly to stockholders' equity as an item of OCI And then in the future when I dispose of the asset that revaluation surplus gets transferred to retain during it's ultimately try some questions on this Please do 12 to 19 and then come back Welcome back Let's look at these questions together In number 12 they asked under efforts which of the following is not a class not a class of long lived assets What you know That biological assets investment property C and D are long lived assets Financial assets can be long lived in tangible assets can be long lived you know equity investments are long-term investments And by the way when you talk about equity investments I meant to mention that IFR is U S GAAP Really the same with equity investments If a company has significant influence over another company They can either use the equity method or F T P L fair value through profit loss That's true under us GAAP and Ivers either the equity method or fair value through profit loss but anyway equity investments long lived but it's gotta be a inventory is always a current asset Number 13 which of the following is not a true statement not a true statement regarding The accounting and reporting requirements related to property plant and equipment under both Ivers and us GAAP a says both and us GAAP require a provision for asset retirement costs to be recorded when there's a legal obligation No that's that's true statement They both require that if there's a legal obligation to do so B sets changes And depreciation method residual value you know salvage value useful life are treated as a change in accounting estimate requiring prospective treatment under us GAAP retrospective application under heifers That's false That's not true under both us GAAP and diapers  under both usGAAPp and diapers a change in salvage value residual value estimated life Change in depreciation method These are changes in estimate prospective approach under us GAAP and efforts So answer B is false and not true 14 under eye fruits which of the following is not an acceptable method of accounting for inventory Well you know lifeboat is not acceptable under Gross profit methods Okay The retail methods Okay Weighted average is okay But life was not accepted in heifers Number 15 is about Murray company and it says Murray company maintains its County records under efforts during the year Marie sold the machine That had been accounted for using the revaluation model So they're selling off a machine that's been accounted for under that revaluation model the sales price 150,000 the machines book value on the date of sale 80,000 and notice down in stockholders' equity OCI is that revaluation surplus of 9,000 Remember we talked about that that if you elect to use the revaluation model for property planting equipment when you revalue Property plant or equipment to its fair value You know if it's gone up in value you debit the asset and credit revaluation surplus and that revaluation surplus is down in stockholders' equity It's part of OCI which of the following is correct regarding the sale Well how do we handle the sale Well when you now sell off the asset first thing you do is debit that revaluation surplus 9,000 and credit retained earnings 9,000 I mentioned that earlier that that revaluation surplus gets transferred to retained earnings When you dispose of the asset So on the date of sale they would debit revaluation surplus 9,000 credit retained earnings 9,000 and then handle the sale As you always would Debit cash 150,000 credit The asset for its carrying value 80,000 and credit gain on sale 70,000 You make those two entries First debit revaluation surplus credit retained earnings And then just handle the sale in the normal way Debit cash 150,000 grant the asset for its carrying value 80,000 and then you credit gain on sale 70,000 So with those entries in mind the answer is C the gain of 70,000 would go to profit loss And the 9,000 revaluation surplus does get transferred to retain earnings Number 16 on January one PACS company Pat's company acquired for 18,000 a new piece of equipment with an estimated useful life of 10 years The equipment requires the addition of a custom made component Costing 3000 has to be replaced every four years patches the straight line under Ivers What was the depreciation expense for the year ended December 31 Well it's a good question for us to do because here's another little picky difference in efforts under efforts if different components of a fixed asset have different periods of benefit under efforts if different components of a fixed asset have different periods of benefits Under heifers you are required required to depreciate them separately So under IFR is what we would do is take the $18,000 equipment over its useful life straight line divided by 10 straight line years That would be $1,800 of depreciation every year but we'd separately depreciate the component that has a different period of benefit We would take the $3,000 component It has a used the component has to be replaced every four years divide by four straight line years we would take $750 depreciation on the component So the depreciation for the year would be 1800 plus seven 750 answer D 25 50 You see why Because under different components of a fixed asset that have different periods of benefit are required to be depreciated separately So I took that $3,000 component With only a useful life For four years I divide by four line years I take $750 depreciation on the component 18,000 excuse me 1800 of depreciation on the machine Total appreciation is 1800 plus seven 50 25 50 Now under GAAP under GAAP you can you can actually go either way GAAP would let you Depreciate the components separately or under GAAP you could instead just take the 21,000 over 10 years and pick answer C again GAAP GAAP You can go either way GAAP You could appreciate the components separately or you could just take the 21,000 over 10 straight line years and go for answers C GAAP would allow C or D but under it has to be D because you are required different components with different periods of benefit separately Number 17 under efforts which of the following is false concerning the accounting for long lived assets assets property plant equipment are accounted for under your either the cost model or the region evaluation model But that's a true statement We wanna know which one is false B reverse the love impairment losses Is recorded with the gain going to the income statement That's true statement under heifers D the revaluation surplus account is transferred to retained earnings when P and G is sold That's true We're looking for the false statement and see is false So he says under the revaluation model property plant equipment is adjusted to fair value with any gain or loss going to the income statement No no it's adjusted the fair value The gain of loss goes to OCI that revaluation surplus account So we were looking for the false statement and C is false 18 An antidote Alexa use the revaluation model under lifers which of the following items correctly reflects how assets would be adjusted and where the gain of loss would be reported Well asset basis out of the revaluation model the asset basis is adjusted to fair value and the gain loss the gain of loss Eventually ends up in retained earnings answer B Remember it initially goes to revaluation surplus in OCI but when you dispose of the asset we transfer the amount of in re revaluation surplus that amount you know OCI goes to retained earnings So eventually it does go to retained earnings Okay 19 on the right fruits When an entity an entity chooses the revaluation model as An accounting policy for measuring property plant equipment which of the following is correct How about a when an asset is revalued the entire class of property plant equipment to which the asset belongs must be revalued That is a true statement member When you choose the revaluation model it's applied to an entire class equipment or land on entire class That's a true statement If you had our class on Leeson's you know that a lessee has a capital lease if any one of four criteria are met And the memory tool that I gave you in our class on leases was two 75 90 That helps you remember the criteria remember T all if there's a transfer of ownership bop if there's a bargain purchase option 75 if the term of the lease is equal to or greater than 75% of the remaining life of the asset or a 90 if the present value of the lease payments are equal to or greater than 90% of the fair value of the asset that's the criteria Any one of those four criteria met have during the lease There's a transfer of ownership If during the lease There's a bargain purchase option The lessee has the option to purchase the asset at a bargain price Or if the term of the lease is equal to a greater than 75% of the remaining life of the asset or if the present value of the lease payments are equal to or greater than 90% of the fair value of the asset any one of those criteria met you know in us GAAP the lessee has a capital lease Well under Ivers under IFR is it's a little different And as we said at the beginning of this FAR CPA Exam study course, Perhaps Yeah The most significant difference between and us GAAP is that us GAAP it is argued is a rules-based approach Us GAAP lays down bright line rules to Bob's 75 90 that you have to follow where IFR is is more of a principles-based approach generally lays down principles regarding Reporting and measurement and allows more judgment and applying the general principles And it's really illustrated with leases because here's the criteria under Ivers under lifers The lessee has a capital lease and by the way under a capital lease is called a finance lease It should be aware of that under as they call a capital lease a finance lease and under the less he has a finance lease If it meets any of this criteria any of it first if there's a transfer of ownership if during the lease the ownership of the asset transfers from the lessee to from the from the less or to the lessee if it you always look for that Hey if there's a transfer of ownership during the lease if the ownership of the asset transfers from the less order the lessee there's a transfer of ownership it's a finance lease Or if there's a bargain purchase option you know during the lease the lessee has the option to purchase the asset at a bargain price Is there a bop Is there a bargain purchase option It's a finance lease or or if the term of the lease is a major part of the economic life of the asset notice not equal to or greater than 75% No If the term of the lease is a major part of the economic life of the asset In other words under offers you know arguably 65% is enough because you have to use judgment It's not a bright line rule But if the term of the lease is a major part of the economic life of the asset it's a finance lease or or if the present value of the lease payments are equal to substantially all of the fair value of the asset Notice not equal to a greater than 90% No you have to use more judgment here because of the fair If the present value of the lease payments are equal to a are equal to substantially all of The fair value of the asset In other words you know arguably you know 85% you know 82% it's enough gotta use judgment or or if the asset is of a specialized nature If the asset is of a specialized nature and only the lessee can use the asset without substantial modification it's a finance lease again If the asset is of such a specialized nature that only the lessee can use the asset Without substantial modification it's a finance lease or or if the lessee were to cancel the lease the less orders losses would be born by the lessee It's a finance lease again If the lessee were to cancel the lease and the less or his losses would be born by the lessee It's a finance lease or or if any gains or losses on the asset accrue to the lessee if any gains or losses on the asset accrue to the lessee it's a finance lease And one more If the lessee has the option to continue the lease at a lower than market value rent it's a finance lease You see there's a lot more judgment involved again that last one If the lessee has an option to continue the lease at a lower than market value rent it's a finance lease So what you see in all that criteria even though it's a lot more extensive is that I for is allows more judgment It's not so much bright line rules more of a principles based approach Now in the area of pensions Here again If you had our class on pensions you may remember that there are six elements that make up the pension expense in us GAAP If a company has a defined benefit pension plan if a company has a defined benefit pension plan there are six elements that make up a pension expense for the year And the memory tool that I gave you an act class was sir Pat S I R P a T the S service costs always a plus I interest on PBO interest on projected benefit obligation always a plus our return on plan assets That's a minus that lowers the expense It's good for the company P is prior service cost amortization it's applause a is actuarial gain loss If it's an actuarial gain it's a minus is good for the company Lowers the expense Actuarial loss is bad for the company increases the expense and then T transition asset transition obligation Transition assets Good for the company lowers the expenses to minus transition obligations plus it increase the expense So that's the memory tool that I gave you in our class on pensions Well under it's very similar under the memory tool for the six elements that make up the pension expense in the defined benefit plan would be S I R P a S Sir pass the S is the same service costs always a plus high interest on PBO Always a plus our return on plan assets always a minus If it's a return the actual return it's a minus P price service cost amortization a plus actuarial gain A loss gain is good for you It's a minus loss is bad for you It's a plus So the only difference it's all the same S I R P a is all the same as us GAAP The difference in IPS The last element is not transitioned asset or obligation The last element is settlement or curtailment settlement or curtailment This is some agreed upon settlement It could be it could be with a union It could be with your employees It could be it could be a legal judgment It could be a result of arbitration but some agreed upon reduction of benefits And it would be a minus right It will be a minus because it's good for the company lowers the expense So that's the difference in efforts that instead of sir Pat for the six elements it's surpass that last element now becomes settlement and curtailment Some agreed upon settlement some agreed upon reduction of benefits and that's good for the company So it's a minus unless it was a reversal Of a settlement and curtailment if it was a reversal of a settlement and a curtailment it would be a plus But I I just don't think that the FAR CPA Exam is likely to get into that another little picky difference with pensions Now that you have to think back to the class we had on pensions that actuarial gain a loss Remember if a company let's say had a 40,000 or actuarial loss for the year they don't just put it Under us GAAP You don't just put 40,000 in as the fifth element members little calculation You go through you look at two numbers First you look at the market-related value plan assets I'm just gonna make up some numbers Let's say the market related value plan assets is is a hundred thousand Then you look at PBO let's say projected benefit obligations 80,000 Those are the two numbers you have to look at You look at the market related the market related value plan assets Let's say it's a hundred thousand and you look at PBO projected benefit obligation is 80,000 Take the larger of the two whatever number is larger that's the number you use So because the micro related value plan assets is larger I'll use the a hundred thousand multiplied by 10% Why 10% it's just a threshold in the opinion it's supposed to multiply it by 10% That comes out to 10,000 Notice the actuarial loss that I made up 40,000 is greater than that 10,000 by 30,000 Under us GAAP You take the difference again the actuarial loss is 40010% of the market related value plan assets is 10,000 So there's a $30,000 difference because the actuarial loss was $30,000 higher than that threshold You would take that 30,000 and divide by the average remaining service period for the employees Let's say that's 10 years Let's say the average many service period for the employees is 10 years You divide by 10 and you would put $3,000 as your fifth element And it would be a plus because it's a loss it's bad for the company So it'd be 3000 The difference in IFAs IFAs doesn't go through all that I would just put the whole 40,000 in as the fifth element I know you like divers better but that's what I would do I would just take the whole 40,000 actuarial loss as the fifth element In the area of bonds they're basically accounted for in IFR is just as they are in us GAAP but there is a little difference you should be aware of And it has to do with convertible bonds Let's go to a problem I'd like you to go to problems 20 and 21 Let's look at it together It says on December 31 Charles corporation issued a million dollars of convertible bonds at one Oh six on the same day Charles issued bonds without any conversion feature for 98 Now question 20 says under us GAAP what amount would Charles record as discount or premium on the issuance of the bond Well here's the entry in us GAAP and us GAAP Charles goes out and sells a million dollars worth of bonds at one Oh six and Charles would debit cash 1,000,060 thousand Charles was going to debit cash 1,000,060 thousand Charles would credit bonds payable for the face amount of the debt a million and credit Premium on bonds 60,000 answer B answer B In other words notice even though this is a compound instrument convertible bonds are a compound instrument It has elements of debt and elements of equity under U S GAAP When you issue convertible bonds you don't try to separate out the value of the conversion feature You don't try to separate the debt component from the equity component under us GAAP Basically just treat it as an issuance of debt So you would debit cash for 1,000,060 thousand credit bonds payable for the face amount of the debt a million and credit premium on bonds 60,000 That's why the answer is big Now Number 21 says under lifers what would Charles record as discount or premium on the issuance of the bonds Well under all compound instruments must be divided up into their debt and equity components See that's the difference This is a compound instrument It has elements of debt and elements of equity And under all compound instruments must be divided up into their debt and equity component So here's the entry in Ivers Charles goes out and sells a million dollars with the bonds at one Oh six So they would debit cash 1,000,060 thousand credit bonds payable for the face amount of the debt a million But now you'd look at it this way You'd say well if on the same day Charles has issued bonds without any conversion feature for 98 That difference between 98 one Oh six that 8% difference must be the value of the conversion feature The equity component that gives you an objective basis to value the conversion feature the equity component The difference between bonds without a conversion feature 98 and bonds with a conversion feature one Oh six That 8% difference is a reasonable way to value the conversion feature So we're going to take that 8% difference times a million and credit additional paid-in capital 80,000 So once I took that 8% difference times a million and credit additional paid-in capital 80,000 and now the entry doesn't balance I need a $20,000 debit to balance the entry out That's the discount on the bonds the bonds actually solver discount When you back out what what really came in for the equity component of the instrument The bonds really sold for a discount of 20,000 And the answer is a just remember under all compound instruments must be divided up into their debt and equity components Let's talk about Deferred taxes now I'm sure you're aware that under us GAAP we account for temporary differences using the liability method Well that's true in as well under we account for temporary differences under the liability method but there is a little difference here in the liability method Let's go to problems 2022 and 23 go to 22 and 23 It says at December 31 Barron Inc is reporting the following deferred tax assets and liabilities They have a current deferred income tax asset with France 25,000 a noncurrent deferred income tax liability of a hundred thousand with France our current deferred income tax liability of 35,000 to Germany and a noncurrent deferred income tax asset Of 60,000 to Japan Number one says under us GAAP how would these assets and liabilities be reported on the December 31 balance sheet Well see if this rings a bell remember on the under us GAAP we are required to report on the balance sheet for deferred tax assets and deferred tax liabilities the net current amount and the net noncurrent amount That's us GAAP under us GAAP on a balance sheet The way we report deferred tax assets deferred tax liabilities is to report net current amount net noncurrent amount So when us GAAP notice I have two current items I have a current deferred tax asset of 25,000 to France a current deferred tax liability to Germany of 35,000 I would net the two They're both current since they're both current I would net them and I'd record a net Current deferred tax asset of 10,000 Look at answer B do you see why I'm going to have a current deferred tax asset a net current deferred tax asset of 10,000 excuse me a net current deferred tax liability of 10,000 because I net the current amounts I have a current deferred tax asset of 25,000 to France a current deferred tax liability of 35,000 in Germany I net them it's a net current deferred tax liability of 10,000 Now how about the non-current I have a noncurrent deferred tax liability with France of a hundred thousand a noncurrent deferred tax asset with Japan of 60 to both non-current I net them And again the answer is B I end up with a net noncurrent liability of 40,000 because that's made up of the noncurrent deferred tax liability to France and the noncurrent deferred tax asset to Japan I can net them They're both non-current So I ended up with a net noncurrent liability of 40,000 that's us GAAP on a balance sheet For deferred tax asset and deferred tax liabilities we are required to report it net current amount that noncurrent amount Now number 23 sets under efforts How would these assets and liabilities be reported Well I already know to answer D why Because under heifers all deferred tax assets and liabilities are noncurrent I'll say it again Under efforts all deferred tax assets and deferred tax liabilities are non-current There's no current deferred tax assets and liabilities in IFAs under all deferred tax assets and liabilities are non-current Now if you look at answer D I already know it's D cause zero undercurrent which is that tells me it has to be D but can I net the non-current items You can net the noncurrent items and others If you have a noncurrent deferred tax asset and a noncurrent deferred tax liability you can net them only if they're to the same taxing authority Again if you have a noncurrent deferred tax asset and a non-accredited a tax liability you can net them only if they're with the same taxing authority So if you look at this for France that current deferred tax asset of 25,000 that would be noncurrent for France I have a noncurrent deferred tax asset of 25,000 Again that would now be noncurrent I have a noncurrent deferred tax liability of a hundred thousand to France Since they're both to France they both have the same taxing authority I could net them And show a net noncurrent liability of 75,000 Then I also have the liability to Germany That's non-current now and a noncurrent deferred tax asset with Japan 60,000 So just to point out that all deferred tax assets and liabilities a non-current and I first and if you have a noncurrent deferred tax asset and a noncurrent deferred tax liability you can net them in I first only only if they're with the same taxing authority If you look at question number 24 24 it says on the rifles which of the following statements is true Look at a different tax assets and deferred tax liabilities are calculated under the liability method That is a true statement You know both us GAAP and does use the liability method Look at Bay Bay says deferred tax assets and liabilities must be separated into current And non-current now that's false There's no current Deferred tax assets and liabilities And I first see says a deferred tax asset from France can be netted against a deferred tax liability from Germany not the same taxing authority That's not true And then Dee says future tax rates cannot be used if they're only substantially inactive No they can be under heifers As long as the tax rate is substantially enacted you know all over but the shouting all over about the final signature You can you can use the future tax rate the last topic we're going to get into in terms of the differences between us GAAP and efforts is consolidations and You'll be happy to know that both us GAAP and uses the acquisition method to prepare consolidated financial statements So there's no difference there both us GAAP and heifers they both use the acquisition method in preparing consolidate financial statements but there is one little picky difference And I think the only way to understand it is to go to a problem So I'd like you to go to 25 and 26 It says on December 30 one of the current year pastor corporation purchased 80% of the outstanding shares of snack for 1,000,001 on the purchase date the book value of the subs net assets equal to a million the fair value equal to a million to this business combination Like all business combinations under us GAAP or firs is accounted for under the acquisition method Now number one sets under us GAAP what would be reported as Goodwill and what would be reported as the non-controlling interest Well it's a good little review for us I hope you remember how to do this How do I work out How do I figure out the Goodwill Well I basically set up a formula I say well if the parent bought 80% of the stock For 1,000,001 I set up my equation I know that 80% of X 80% of all the sub stock X must be worth 1,000,001 Then whatever I do to one side of an equation I do to the other So I divide both sides by 80% And if you divide 1 million one by 80% comes out to 1 million 375,000 that tells me X a hundred percent of the sub stock must be worth 1 million three 75 So that's the point If someone had purchased a hundred percent of the subs shares they would have had to pay 1 million three 75 for net assets worth 1,000,002 I look at the fair value of the subs net assets on the date of purchase not the book value So if somebody purchased a hundred percent of the sub stock they would have had to pay 1 million three 75 for net assets with a fair value of 1,000,002 So total Goodwill in this acquisition comes out to 175,000 looking at answers See there's the Goodwill Remember one of the objectives of the acquisition method is to record the Goodwill at its full fair value Now another objective of the acquisition method is to record the non-controlling interests at its full fair value And now we can figure that out too because now we know that if someone had purchased a hundred percent of the sub stock they would have had to pay 1 million three 75 What percent of those shares through the non-controlling interest shareholders own 20% lb owns 80% The non-controlling interest shareholders on 20% a 20% interest in 1 million three 75 is worth 275,000 Again it's answers C So under the acquisition method the way it's applied in the us GAAP Goodwill would be 175,000 The non-controlling interests would be 275,000 because that's the objective of the acquisition method to record the Goodwill at its full fair value and record the non-controlling interest at its full fair value Now number 26 says under efforts what would be reported as Goodwill in non-controlling interests in the consolidated balance sheet of ERN Well the answer is D there is a difference here Notice under Ivers you can use the same approach we use in us GAAP We can record Goodwill at its full fair value which is as we now know is one 75 We can record the non-controlling interests at its full fair value which we now know is two 75 That's perfectly acceptable under efforts or under efforts you can elect to record just the parent share of Goodwill That would be 80% of one 75 or 140,000 Again under heifers you can elect to record only the parent share of Goodwill That would be 80% of 175,000 noticing you're not going to record Goodwill at its full fair value You have you can make an election to just record the parent share of Goodwill which would be 80% of 175,000 or 140,000 And you can elect if you and you have to be consistent If you elect to do that you would also elect to record the non-controlling interest for just its share of identifiable assets In other words non-controlling interest will not get any share of Goodwill Because when you record just the pair of chair of Goodwill now you're going to record non-controlling interest just for its share of identifiable assets Now the fair value the subs net assets is that 1 million too right The fair value of the sub identifiable assets 1 million to non-controlling and to shareholders on 20% of those net assets or 240,000 you see why it's answer D in other words in that approach non-controlling interest isn't getting any share of Goodwill You're only recording the parents share of Goodwill And only recording non-controlling interest for its share of identifiable net assets So that's one very picky difference between how the acquisition method is applied in is as opposed to how it's applied in U S GAAP because in U S GAAP we always record it in the acquisition method We always record the Goodwill at its full fair value and we always record the non-controlling interests at its full fair value When we're talking about sec reporting we're really discussing the securities acts the securities act of 1933 and 1934 Let's talk about the securities act of 1933 The securities act of 1933 relates to IPO's initial public offering of securities IPO's And the purpose of the act is to provide investors with full disclosure relating to any initial public offering of securities That's the purpose of the act to provide investors with full disclosure relating to any IPO any initial public offering of securities And of course the purpose of the act is to prevent fraud and misrepresentation related to an IPO And if you fail to comply with the act which I wouldn't recommend if you fail to comply with the securities act of 1933 there are civil penalties you know fines and criminal penalties You go to jail you just you just can't do this All right So how do you comply with the act Cause if you don't comply with the act you're subject to civil penalties and also potential criminal penalties the way you comply with the act is that before any IPO before an initial public offering of securities the corporation must file a registration statement with the sec You cannot offer securities to the public before you filed the registration statement It's that simple That's how you comply with the act You have to file a registration statement with the sec before any IPO and you cannot offer securities for sale to anybody until you file the registration statement and you can't sell securities until the effective date which is always 20 days after the filing You can't sell securities until the effective date which is always 20 days after the filing Also you are required when you have when you have an IPO you're required To provide a prospectus to all potential investors that's required as well Now some securities are exempt from the securities act of 1933 commercial paper securities only stole only sold within one state you know intra state securities are exempt So there are some securities that are exempt but usually if there's an IPO Before there's an IPO You have to file a registration statement with the sec that's to comply with the securities act of 1933 Now the securities act of 1934 applies to subsequent trading of securities In other words the purpose of the act is to federally regulate all securities that are traded over the counter in interstate commerce That's the purpose of the act to federally regulate all securities that are traded over the counter and interstate commerce You know any security that's traded in any national stock exchange is regulated by the sec through the securities act of 1934 even if a security is exempt under the 33 act it still is regulated by the securities act of 1934 Now some some securities are exempt From the securities act of 1934 some securities are exempt you know obligations of the U S U S government you know treasury bonds municipal bonds You know there are some securities that are exempt but almost all securities traded over the over the counter in any national stock exchange are regulated by the sec And if you fail to comply with the act there are severe Civil penalties So how do you comply with the act Well the way you comply with the act is by following reporting requirements All right But first of all who has to meet these reporting requirements while the reporting requirements apply to companies that sell securities to the public after an IPO And as I may have mentioned even if you were somehow were exempt Under the 33 act you're still governed by the 34 act because you have to comply with the securities act of 1934 You have to you have to comply with reporting requirements If you're a company that's now selling securities after an IPO you also have to comply with the act You have to meet the reporting requirements If your stock trades in any national stock exchange And then finally you know even if your stock does not trade over the counter If you're a corporation with assets greater than 10,000,500 or more shareholders if the stock is not traded over the counter but if you're a corporation with assets greater than 10 million 500 or more shareholders you also have to meet these reporting requirements All right So what are the reporting requirements Well first of all you have to file the 10 K the 10 K is the annual report It's a comprehensive overview of a company's business and financial conditions That's the 10 K and the 10 K is due within 90 days from the close of the fiscal year You know the FAR CPA Exam Love's due dates The 10 K the annual report is due within 90 days from the close of the fiscal year Now the 10 K includes financial statements audited by a CPA it's expensive because the 10 K includes Audit and financial statements by a CPA It includes a management discussion and analysis It's a risk factor section and also any potential legal proceeding Then there's the 10 Q the 10 Q was the quarterly report file with the sec This is due within 45 days from the close of the quarter 45 days from the close of the quarter Now the 10 Q includes Quarterly statements reviewed by a CPA not audited but reviewed by a CPA It's less detailed than the 10 K but that again it doesn't have to be reviewed by a CPA Now there are three 10 QS filed every year And then the fourth 10 Q is included in the end report The 10 K then there's the eight K the eight K Is four extraordinary transactions If you change auditors again the eight K form eight K extraordinary transaction So if you replace your auditor you replaced the CEO you replaced the director mergers acquisitions you know material events and the AK is due within four days From the actual event And then finally you should be aware of what regulation S exits regulation SX regulates the form and the content of all financial statements filed with the sec that's regulation SX It regulates the format and the content of all financial statements filed with the sec So when you were in the FAR CPA Exam just make sure you know what the 10 K is when it's due the 10 Q when it's due the eight K when it's due and regulation SX Please do questions 27 to 32 and then come back Welcome back Let's look at these questions together Number 27 says the law that requires issuers of securities making public offerings for sale to register with the sec What law requires register a registration statement answer a the securities act of 1933 number 28 which of the following is the principal accounting regulation of the sec regulation SX Remember that regulates the form and the content of all financial statements filed with the sec 29 which of the following is a true statement relating to the responsibility for full fair disclosure In an sec registration statement a says it is the SCCs responsibility to ensure full and fair disclosure No it's not that's not that's not their responsibility It is the company that's going to issue the securities That's their responsibility be if important information is omitted from a registration statement the sec will not request an amendment Oh no They will see once the registration statement has become effective And securities have been sold The sec has no recourse If the registration statement turns out to have emissions no they file a stop order And that's why it's answer date but they they certainly have things they can do D says if a registration statement does not adequately disclose all material facts the sec may issue a stop order and that'll be that Okay Number 30 a company Is an accelerated filer that is required to file with the sec What is the maximum number of days Well the non-accelerated filer is is a corporation that has less than $75 million of securities in active trading You know what they call public float That would be a non-accelerated filer Again has Security is actively trading less than 75 million with they called public float actively trading less than 75 million That's a non-accelerated filer and they have to file the 10 K within 90 days close to the year on accelerated filer is a filer that has a public float here It is actively being traded of at least 75 million but less than 700 million That's an accelerated filer It's a corporation that has you know actively trading securities public flow of at least 75 a million but less than 700 million And they have to file within 75 days from the close of the year So the answer is big It's accelerated filer and then you have a large accelerated filer that's with securities trading more than 700 million and that public float of more than 700 million And They have to file their 10 K within 60 days from the close of the year But this is an accelerated filer 75 days answer B 31 The sec requires the sec required form use to report extraordinary transactions major events That's the eight K answer B 32 who must generally register with the sec Under the 33 act How about a security sold in the United States Unless they're exempt from registration that's pretty much it all securities old in the USS all all security sold in the United States unless they're exempt from the registration requirement that concludes our discussion of the SCC reporting requirements And also the differences between us GAAP and and from all of us at Bisk CPA review we want to wish you the best of luck on the CPA exam Do a great job Yeah