FAR CPA Exam Review

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Hello, and welcome to the bisque CPA review and our 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 class. And in this FAR CPA Review course, we're going to be covering several topics that are hitting the financial exam. We're going to be talking about the proper accounting for inventory, fixed assets.

And also intangibles before we start the class. I just want to say a word about the best way to use this glass. The important thing is to try to avoid just sitting back passively, watching the class, try to be an active participant. Take good notes later in the class. When we go to problems, the important thing will be to shut FAR CPA Review course down.

Do the problems yourself, get your answers before you come back and do the problems with me. I think you'll find if you do these simple things, you get much more out of this class. And of course it's what we both want. So try to be an active participant as we go through this class.

Let's begin by talking about the proper accounting for inventory. That inventory is a major asset on the balance sheet and. The accounting for inventory is a pretty large topic. So the first thing I'd like to do is try to knock it down to size just a little bit. And I think this will help try to remember that if you're in the FAR CPA Exam and you get questions on accounting for inventory, remember that?

Any question on accounting for inventory one way or another has to fall into one of three topics. Let's just list them down. It's either going to be topic. Number one. Which is costing the original costing of merchandise topic. Number two, measurement, the measurement of inventory, or number three valuation.

And in this FAR CPA Review course, when I say valuation, I'm talking about the proper valuation of the ending inventory, but really any question on inventory accounting, one way or another is going to fall into one of those three topics costing, measuring, or valuing inventory.

Let's talk about costing the original cost of the merchandise. Now you certainly know that the primary basis of accounting for inventory is historical costs, but I want you to remember that when we say historical costs for merchandise. Over and above the cash price you pay for the inventory. You must capitalize to inventory all the costs you incur to bring that merchandise into a condition and location for sale.

And that's known as the condition and location for sale rule, because you always want to remember. That's what we mean by the historical cost for merchandise. Over and above the cash price you pay for merchandise. Obviously the cash price you pay for merchandise will be capitalized to the inventory account, but over and above the cash price you pay for merchandise, you must capitalize to inventory all the costs that you incur to bring that merchandise into a condition and location for sale.

Things like purchasing costs, handling costs, warehousing costs. All these costs get capitalized to inventory and don't forget freight in transportation in is part of the cost of merchandise. Not frayed out as a selling expense. It belongs below gross profit. So don't make a sloppy mistake, but freight in transportation in is part of the cost of merchandise.

We must capitalize to inventory all the costs we incur to bring that merchandise into a condition and location for sale. Now, while it's true that the primary basis of accounting for inventory is historical costs. Also remember that ultimately inventory will be carried on the balance sheet at its original cost.

Or it's market value. Whatever's lower. So yeah, the primary basis of accounting for inventory is historical cost. No question, but in the final analysis inventory would be carried on the balance sheet at its original cost or its market value. Whatever's lower.

You have to know how to apply lower of cost of market to your inventory. And I'll tell you what makes this a little complicated. When you apply lower of cost of market to inventory, you have to know what market is now. Normally market is just replacement costs, but that's not necessarily true with inventory because there's a ceiling and market can never be higher than the ceiling.

And there's also a floor. And market can never be below the floor. And that's what complicates the process. So let me give you some definitions and you have to know these definitions. Let me define the ceiling. Now, as I say, there's a ceiling and market can never be higher than the ceiling. The ceiling is called net realizable value.

That's what they call the ceiling net realizable value. And it is defined as the selling price for the product. Minus the normal costs to complete and sell the item. Again, the ceiling net realizable value is defined as the selling price minus the normal costs to complete and sell the item. What they sometimes call disposal costs.

But that'll give you your ceiling. If you take the selling price minus the normal costs to complete and sell the item minus normal disposal costs that will give you net realizable value. That is the ceiling and market can never be higher than that. Now the floor. And there's no fancy name for it.

It's called the floor. The bottom. The floor is defined as that ceiling net realizable value minus a normal gross profit on sale. That's how you define the floor. It is that ceiling net realizable value minus a normal gross profit on sale. That'll give you the floor market can never be below that amount.

So that's what complicates this. When you try to apply lower of cost of market to your merchandise. As I say, market is not necessarily the replacement costs because you've got the ceiling and you've also got the floor. Let's do some problems. If you look in your viewers guide, you'll see we have products, a B, C, and D let's apply lower of cost of market to these products.

If you look at product a, the historical cost is $2 and 50 cents a unit. The replacement cost is $2 and 60 cents a unit. The normal selling price is $4. Normal disposal costs. A dollar, a unit and the normal gross profit margin is 70 cents per unit. So let's apply lower of cost of market to product a well, the first thing you want to do is calculate the ceiling.

Now, remember the ceiling is called net realizable value, and it would be defined as that selling price $4, a unit minus normal disposal costs a dollar. Let's agree that the ceiling for product a would be $3. The floor would be that ceiling net realizable value, $3. Minus a normal gross profit on sale in this case, 70 cents.

So the floor would be $2 and 30 cents per unit. All right. So step one, we calculate the ceiling. Step two, we calculate the floor. All right. Now, step three. You have to look at three numbers. Notice the threes go together. When I get to step three, I have to look at three numbers. I have to look at the replacement cost $2 and 60 cents a unit, the ceiling, which is $3 a unit, the floor, which is $2 and 30 cents a unit.

I look at those three numbers. And you have to remember that whatever numbers in the middle is your market. Just remember middle number is always market. Now the number in the middle here would be $2 and 60 cents. That's the middle number you might want to circle it and put a little M there. That's your market M stands for middle M stands for market, but the middle number is always market.

All right. Now, one last step. The last step is to say it is the lower of costs. Historical cost, which is $2 and 50 cents a unit or market, which I now know is two 60. What would I do? I stay at cost. The answer would be two 50 because cost is lower. Cost is lower than market. So I simply would stay at cost and that's really the process calculate the ceiling, calculate the floor, calculate market calculate lower of cost or market.

That's really the only way to do this. Calculate the ceiling, calculate the floor, calculate market calculate lower of cost or market let's do product date, historical costs to $6. A unit replacement cost is $5 and 25 cents. Selling price. Eight 50 disposal costs three 50 and there's a normal gross profit on sale of 80 cents a unit.

All right, let's go through the let's go through the process. Step one, calculate the ceiling. The ceiling would be that selling price $8 and 50 cents a unit minus a normal disposal cost per unit. The normal cost to complete and sell $3 and 50 cents a unit. The ceiling net realizable value would be $5 a unit the floor.

Would be that ceiling $5 minus a normal gross profit on sale. 80 cents. The floor would be $4 and 20 cents. All right, now what's your step three. You look at three numbers. Look at the floor, $4 and 20 cents a unit, the ceiling $5 replaced in cost, $5 and 25 cents. The number in the middle is $5.

The middle number is always market. So you might want to circle that. Put a little M there M stands for middle M stands for market. Middle number is always market of those three. So now my last step is to say it is the lower of cost, which is $6 a unit or market, which I now know is five. I would use five it's, lower it's, lower of cost or market because market is lower than cost.

I would use $5. What's the journal entry here. OD I writing my inventory down a dollar. If I, in other words, if I have a hundred thousand units in my ending inventory, I'm going to take a hundred thousand units times a dollar. I'm writing my inventory down from $6, a unit down to $5 a unit. So I would take the a hundred thousand units and my ending inventory times a dollar, and I would take an inventory loss to my income.

I would debit a loss. I would take an inventory loss to my income statement of a hundred thousand and I would credit inventory 100,000. I'm writing my inventory down to market. Let's do product C historical cost is $10. A unit replacement cost is $9. A unit. The selling price is 15 normal disposal costs $2 and a normal gross profit is $3 and 50 cents a unit.

So let's go through our steps. Step one, calculate the ceiling. The ceiling would be the selling price. 15 minus normal disposable cost of a dollar. The ceiling would be. $13 a unit. The floor would be that ceiling net realizable value, $30 a unit minus a normal gross profit on sale. $3 and 50 cents. A unit.

The floor would be $9 and 50 cents a unit. All right, step three, look at three numbers. Step one, calculate the ceiling. Step two, calculate the floor. Step three. Look at three numbers. I look at the floor, $9 and 50 cents a unit, the ceiling, $13 a unit. Replacement costs $9 a unit. I know whatever number is in the middle.

And that's nine 50 here. The number in the middle is always your market, middle numbers market. So you might want to circle that floor circle the nine 50, put an M next to it. That's your market. Now what's your last step for your last step is to say it is the lower of cost, which is $10 a unit or market, which I now know is nine 50.

I'll write down to nine 50 flour. I use markets lower. Nine 50 let's do product D historical costs, $150. A unit replacement costs $175. A unit normal selling price. 200 disposal costs are 10 and normally the gross profit is $80 a unit. So let's go to the step. Step one, calculate the ceiling. The ceiling is defined as that selling price 200 minus normal disposable costs, 10.

I think we agree that the ceiling net realizable value would be $190 a unit the floor. Step two, we calculate the floor. That would be that ceiling net realizable value 190 minus normal gross profit on sale. 80, the floor would be 110. All right. So step one, we calculate the ceiling 190 per unit. Step two, we calculate the floor.

It's 110. What's step three, look at three numbers. I look at the floor, $110 a unit, the ceiling, 190 replacement cost one 75 circle the one 75, whatever number is in the middle. Look at the ceiling. Look at the floor. Look at replacement costs. Look at those three numbers, whatever number is in the middle of that, your market circle, it put an M there's your market.

What step for your fourth step is to say it's the lower of cost, which is $150 a unit or market, which we now know is one 75. What would I do? I'd stay at cost. Cost is lower. Cost is lower than market. So I would just, I would make no adjusting entry at all. I would just stay at cost 150. Now you might say Bob, isn't there an easier way to do this.

There really isn't. This is about as, this is the only way you can break it down. Steps. Step one, calculate the ceilings. Step two, calculate the floor. Step three. Look at those three numbers. Get your market. And then step four. It's the lower of cost or market. Let's try it. Multiple choice on it. I'd like you to shut FAR CPA Review course down, do the first two questions and your viewers guide to questions one and two, and then come back.

We'll go through them.

Welcome back. Let's do these questions together in number one, they say the following information pertains to an inventory item. The cost is $12. A unit. The selling price is $13 and 60 cents. A unit normal disposal costs are 20 cents. A unit normal gross profit margin is $2 and 20 cents. A unit and replacement cost is $10 and 90 cents a unit.

And they say under the lower of cost of market rule, this inventory item would be valued at what you've got to go through the steps. Step one, you calculate the ceiling. The ceiling is called net realizable value, and it's defined as that selling price. $13 and 60 cents a unit minus normal disposal costs in this case, 20 cents a unit.

So let's agree that the ceiling net realizable value would be $13 and 40 cents a unit step to calculate the floor. The floor is defined as that ceiling net realizable value, $13 and 40 cents a unit minus a normal gross profit on sale. $2 and 20 cents a unit. So the floor would be $11 and 20 cents a unit what's step three, you look at three numbers.

You look at the floor, $11 and 20 cents a unit, the ceiling, $13 and 40 cents a unit and replacement costs $10 and 90 cents a unit. And whatever number is in the middle numbers always market. That's your market. What's the number in the middle $11 and 20 cents. In this case, the floor is the market.

Middle number is always market. And then what's your last step for it's the lower of cost, which is $12 a unit or market, which I now know is 1120. I use 1120 cause it's lower. And the answer is C calculate the ceiling, calculate the floor, calculate market calculate lower of cost or market. Let's go to number two.

Number two says the original cost of inventory item is below net realizable value, but above net realizable value, less normal profit margin. The inventory items replacement costs is below net realizable value lesson on the profit margin under the lower of cost of Margaret rule. Inventory will be valued at what?

So are you in the you're in the exam? You have this question now. There are no numbers. It's just theoretical now. And I think you can see what they're trying to do here. What they're hoping to do with a question like this is stare at it. That's what they want. They want you to sit in the FAR CPA Exam for 10 minutes going right.

It's above this. It's below this it's between this and waste all kinds of time. And you may have already thought of this. What is the best way to simplify question? This make up numbers. They didn't give us numbers, but we can make them up. You got scrap paper in the exam, use it. I would make up numbers.

Now the only tricky thing is you have to make up numbers that fit the facts. I'll show you the numbers I made up. You make the numbers as easy to work with as you can. They said the original cost of an inventory item. I'm going to assume that's $10. Let's say the original cost of the inventory is $10 a unit.

Is below and RV, let's say NRV is 15. That fits. So the original cost 10 is below NRV 15, but it's above net realizable value. Let's know the profit margin. So it's above the floor. So cost is above the floor. I'll make the floor five because the cost 10 is above the floor. Okay. And then they said the replacement cost is below the floor.

Then I'll make replacement costs something below five. I'll make it two. All right now, how long would it take to make up numbers to fit the facts? Just a few seconds. And once you have numbers to fit the facts, now you solve it like a number problem. I look at three numbers, right? I look at replacement costs to the floor.

Five, the ceiling 15, the number in the middle is always market the middle number. Here's the floor five. There's my market. Then I say, it's the lower of cost, which is $10 a unit or market, which I now know is five. I'd use five, it's lower. I'd use the floor. And the answer is D I hope you see the real lesson you learn in a question like this.

The last thing you want to do is sit in and examine what's above this. It's below this and waste 10 minutes on it. No, make up some numbers, make the numbers, fit the facts and then solve it like a number problem. And you really greatly simplify it. All right. So that's topic number one, costing. We know that the primary basis of accounting for inventory is historical costs.

And make sure when you win the exam, you know what? We capitalize to the inventory account as part of the cost of merchandise, all the costs we incur to bring that merchandise into a condition and location for sale. But ultimately though inventory will be carried on the balance sheet at its original cost or its market value.

Whatever's lower. So when you, when the FAR CPA Exam make sure you know how to apply the concept of lower of cost of market to your inventory, let's go to topic number two, which is measurement.

Now, when you talk about measuring inventory, there are basically two pure approaches. It's either going to be a periodic approach or a perpetual approach. I want to make sure you see the difference in a periodic inventory system. What that basically means. Is that the company does use a purchases account.

It's really what it means in a periodic inventory system. The company does use a purchases account. So as they go through an accounting period, every time they purchase merchandise, they debit purchases. They credit accounts payable, they debit purchases, credit accounts payable, they debit purchases, credit accounts payable.

Then when they get to the end of the accounting period, they're going to know that total purchases for the period. Because they kept track of them. And when they add their total purchases to the beginning inventory that gives them the goods that were available for sale, then periodically, which is where the name comes from.

You go in your warehouse, you take a physical count and you find out two things, you find out what's their ending inventory. And when you subtract the ending inventory from what was available, that gives you the cost of the goods that you sold. So you see why they call it a periodic inventory system.

They call it a periodic inventory system because you're finding out two critical pieces of information, ending inventory and cost of goods sold periodically. When you warehouse and take a physical cow, you're finding out those two essential pieces of information, ending inventory and cost of goods sold periodically.

All right. Now, what does a perpetual system mean? I know you're ahead of me in a perpetual system. The company does not use a purchases account. That's really what it means. When a company uses a perpetual inventory system, there is no purchases account. So as they go through an accounting period, every time they purchase merchandise, they debit inventory, credit accounts payable.

There is no purchases account. Every time they purchase merchandise, debit inventory, credit accounts, payable, debit inventory, credit accounts payable. Then when they make a sale, they make two entries. Not only do they debit accounts, receivable, credit sales, the entry any company would make, but they make a second entry where they debit cost of goods sold for the cost of the merchandise shipped and credit inventory.

So you see the result of this. If every time I purchase merchandise, I debit inventory. And every time they make a sale, I credit inventory down. I end up with a perpetual running total of my inventory balance. I also end up with a perpetual running total of my cost of good soul. That's why they call it a perpetual system because you end up with a perpetual running total of your inventory balance.

And you also end up with a perpetual running total of cost of goods sold in a perpetual system. Would you ever have to take, would you ever need to take a physical count? Yes. In inventory accounting, it's very hard to get away from a physical count cause that's really the bottom line. That's how you verify the records.

Now, even in a perpetual system, eventually you'd have to take a physical account to verify the records. Why? Because of breakage theft, spoilage, shoplifting, shortages in accounting, we call it shrinkage because of shrinkage, even in a perpetual system. At some point, certainly on an annual basis, you'd have to take a physical count to verify the records again, because to verify the records because of breakage theft, spoiled, shrink, and shoplifting shortages again in accounting, we just lump it all together and we call it shrinkage.

All right. So if you wouldn't be down to there, we're done with measurement.

Now we're going to get to the biggest of the three topics, the most heavily tested of the three topics costing, measuring valuing inventory. And that is valuation. And as I said earlier, anytime I say valuation in this FAR CPA Exam Review course, I'm talking about the proper valuation of the ending inventory. So let's get into that now.

That one way you can place a value on ending inventory is specific identification where you go through your warehouse item by item, and you specifically identify the cost of each piece of merchandise. That's on hand. That's called specific identification. Where again, you go through your warehouse, painstakingly item by item, and you specifically identify the cost of each piece of merchandise.

That's on hand. That's one way you can place a value on ending inventory specific identification. Now, having said that there are some problems with specific identification is very time consuming. It's very expensive. It may not be practical. No company of any real size it's not practical.

And it might even be impossible. Just think for a minute, how could specific identification be impossible? What if the ending inventory was destroyed in a fire, a flood? Now specific identification would be impossible. Let me get to my point. My point is we have to have other methods. Of estimating the value of ending inventory without using specific identification.

Because again, specific identification is time consuming. It's expensive. It may not be practical and it might even be possible. So there has to be other ways of estimating the value of ending inventory without using specific identification. And that's what we're going to get into next. We're going to look at these different approaches, different methods of estimating the value of vending inventory without using specific identification.

And the first method I want to look at is the gross profit method

companies can use the gross profit method. To estimate the value of vending inventory, primarily in interim financial statements. That's where you'll see it. Companies can use the gross profit method to estimate the value of their ending inventory in interim statements, quarterly statements. Also, you can use the gross profit method to estimate the value of vending inventory.

When ending inventory has been destroyed, in a fire or flood, something like that. That's where it's used. Now, before we do a problem on this method, I want to just take a second and make sure that you're very clear on the difference between a gross profit margin and a markup on cost percentage.

I have to make sure that you're comfortable with this difference, because if you're not comfortable with this difference, it can get you messed up. So let me just take a minute and make sure that you. Are completely comfortable with the difference between a gross profit margin and a mock-up on cost percentage.

I'll just give you a very simple example. Let's say that I'm a business and I only sell one thing. I just sell video cameras. That's all I sell. And let's say that video cameras cost me $1,000 each. All right. So that's all I sell are video cameras. And video cameras cost me $1,000 each. And let's say this year I sold one.

If I sold one, we know my cost of goods sold would be a thousand. Now let's say also that I use a 25% markup on cost. What does that mean? If I use a 25% markup on cost, all that means all it means is that I sell merchandise. At 125% of what it costs me. It's all, it means that I sell merchandise at 125% of what it costs me.

So what would my sales be? 125% of a thousand or 1000, two 50. That's really all that means. But notice this. If my sales are 1002 50, my cost of goods sold is a thousand notice. My gross profit is $250, so it turns out I made a $250 gross profit on a $1,250 sale. Take two 50 over 1002 50, my gross profit percentage.

My gross margin is 20% of sales. And of course, you know what gross margin means. If you see a gross profit percentage of gross margin, 20%, that means 20% of my sales is gross profit. If I take 20% of 1002 50, it gets me back to two 50. And another thing I know if my gross profit percentage is 20% of sales, my cost of goods sold is 80% of sales.

Cause that's always a function of a hundred. If I take 80% of 1002 50, it gets me back to a thousand because if gross margin is 20% of sales, cost of goods sold has to be 80% of sales. I'm leading to a point. I want to make sure that if you had to in the exam, you could convert from a mock-up on cost percentage.

To gross profit and cost of goods sold. Trust me, it's a handy thing to be able to do. So I just want to take a minute and make sure that you're in the exam. You're able to quickly convert. If the FAR CPA Exam gives you a mock-up on cost percentage, you can go to gross profit cost of goods sold. So you might want to jot this down, make sure it's in your notes.

When you're going to use this shortcut, you're going to use this shortcut. If the FAR CPA Exam gives you a mock-up on cost percentage, but you want to know gross profit you want to use, and you want to know cost of goods sold. Here's the shortcut. Just take the markup and divide by 100, plus the markup. That's all you have to do.

Take the markup and divide by 100, plus the markup. So you see how it would work in this problem. This company's mock-up on cost was 25%. So what I would do in the FAR CPA Exam is take 25 over one 25, 25 it's member. It's the mockup over a hundred plus the mock-up. So I would take 25 over one 25, which is one fifth.

I know that one fifth of sales would be gross. Profit. Four fifths of sales would be cost a good soul. You just can't do it faster than that. Right? 25 over one 25 is one fifth or 20%. 20% of sales would be gross. Profit. 80% of sales would be cost of goods sold. Let's do another one. What if you're in the FAR CPA Exam and they say a company uses a 50% Mark of bunk costs.

What can you quickly do if they was a 50% markup on cost, take 50 over one 50. Remember it's the mockup over 100 plus the markup. So you would take 50 over one 50, which is one third. You know that one third of sales. Would be gross profit. Two thirds of sales would be cost a good soul. You just can't do it faster than that.

Let's do another one. You're in the exam. They say a company uses a 20% markup on cost. If they tell you that a company uses a 20% markup on cost, you're going to take 20 over one 2020. Over one 20 is one 16th. I just always use fractions 20 over one. 20 is one sixth. I know one sixth of sales would be gross.

Profit five sixth of sales would be cost a good soul. Just a very handy thing to be able to do quickly. So with that in mind, let's go to a problem. If you look in the viewers guide, we have a little problem on the gross profit method. We're told that this company's beginning inventory, $200,000 purchases during the year $450,000 sales during the year 500,000.

And this company does use a 25% markup on cost. Notice the ending inventory was destroyed in a fire. So the question in the FAR CPA Exam would be. No, what's the fire loss. If your ending inventory was destroyed in a fire, what's your fire loss or what was the value that ending inventory before the fire? I'll tell you what I like with this.

If you get a problem like this in the exam, I'm a big believer in use what, right away. If I had a problem like this, I would go to my scrap paper and put down the skeleton, the cost of goods sold. As I say, I'm a big believer in, use what, you're in the exam,  the format of cost of goods sold, why not use it?

So let's say you go to your scrap paper, just put the skeleton down for cost of goods sold. We know that's beginning inventory. Plus purchases equals goods available for sale. Less ending inventory equals cost to goods sold. So we got that down. Now let's fill it in as far as we can in this problem. Do we know beginning inventory?

It's given 200,000. Do we know the purchases it's given 450,000. So we know goods available for sale would be 650,000. Do I know the ending inventory? No, it was destroyed in a fire. I don't know that it was destroyed. How about cost of goods sold? I can figure it out. Can I say, I don't know, cost of goods sold, but I can figure it out.

Let me ask you a question. If this company uses a 25% markup on cost wouldn't cost, a good sold B 75% of sales. Let me ask you that again, because this company uses a 25% markup on cost wouldn't they cost of goods sold be 75% of sales. No, that's the mistake. A lot of students make, see the problem with that is you're treating that markup on costs like a gross margin.

It's not a gross margin. It's a mock-up on cost percentage. So how do we convert? From a mock-up on cost percentage back to gross profit back to cost of goods sold. Let's do it. We're going to take the mock-up 25 over 100. Plus the markup 25 over one 25 is one fifth. I know that one fifth of sales or 20% would be gross.

Profit. Four fifths of sales or 80% would be cost of goods sold. If I take 80% of 500,000, I know cost of goods sold would be 400,000. Let me just do that again. I took the mock-up 25 over one 25, 25 and one two over one 25 is one fifth, one fifth of sales or 20% would be gross. Profit four-fifths or 80% of sales would be cost of goods consult.

So I take 80% of 500,000. I know cost of goods sold would be 400,000. Now I can solve it. If goods available for sale, total 650,000 and cost of goods sold is 400,000 ending inventory had to have a value of. 250,000. There's your fire loss? That's the value of vending in the door before the fire. In other words, how much from six 50 would give me 400,000 or just subtract the 400,000 from the six 50, but you can plug the ending inventory that must've had a value of 250,000.

That must have been the value of ending inventory before the fire. That must be your fire loss. It's just a way of estimating the value of ending inventory without using. Specific identification. I'd like you to try a couple of more questions. I'd like you to shut FAR CPA Review course down to questions three and four, and then come back.

Welcome back. Let's do three and four together. And number three, we have a flood. It's destroyed the inventory and they want to know what am I have inventory was lost in the flood. And this is a classic case of where we would use the gross profit method. And, I like the skeleton of cost of goods sold.

So you're in the exam, go to your scrap paper, put down the skeleton, the cost of goods sold, and let's fill it in as far as we can. We know it beginning inventory. It's given 35,000. We know the purchases during the year 200,000. So we know goods available for sale 235,000. Now we don't know ending inventory because it was destroyed in a fire, but we can figure out cost to goods.

Sold. Notice the gross profit margin is 40% of sales. If gross margin is 40% of sales, cost of goods sold is 60% of sales. That's a function of a hundred. It does make it a little easier when the FAR CPA Exam does not give you a markup on cost percentage, they just give you a gross margin. Hey, gross margin is 40% of sales.

Cost of goods sold is 60% of sales. So I'm going to take 60% of two 50. The sales cost of goods sold must be 150,000. Now I can solve it. If goods available for sale, total 235,000 and cost of goods sold was 150,000 ending inventory must have had a value of. 85,000, but it's not answer B be careful. They said, what am I have inventory was lost in the flood.

Now it's true that the value of ending inventory before the flood was 85,000, they said that 30,000 of inventory was not damaged by the flood. So 55,000 of inventory must've been lost in the flood. And the answer is a in number four, they want to know what would be purchases. Here again, this is another case something's missing from cost of good salt use what you know, go right to your scrap paper, put down the skeleton, the cost of goods sold.

We know beginning inventory. It's given 30,000. We don't know purchases. That's what's missing. We don't know goods available for sale. We do know ending inventory was 18,000. Do we know cost of goods sold? Sure. We can figure it out because if the gross margin is. 20% of sales cost of goods sold must be 80% of sales.

That's a function of a hundred every time. So take 80% of 275,000 cost of goods sold. It must've been 220,000 because if gross margin, 20% percent of sales cost of goods sold must be 80% of sales. So I took 80% of 275,000 cost of goods sold. Must've been 220,000. So now we just basically work backwards.

If cost of goods sold is 220,000 ending inventory was 18,000 available. Must have been 238,000. Now if beginning inventory was 30,000 and available was two 38 purchases. Must've been two Oh eight. Answer B anytime something's missing from cost of goods sold, get the skeleton down of cost of goods sold and start to work with it.

Start to fill it in.

Continuing with our discussion on different methods of estimating the value of ending inventory without using specific identification. Of course, another way to estimate the value of ending inventory. Without using specific identification is to make an assumption about the way inventory costs are flowing.

And there are basically three it's either going to be first in first out or FIFO last in first out or LIFO or weighted average, let's start with FIFO. I'm sure you know that if a company chooses a first in first out cost flow assumption, they are assuming. The first merchandise purchased is the first to be sold first in, first out.

But what's very important is to make sure you're comfortable with the impact on the financial statements from choosing FIFO. Just think about it for a minute. If I'm going to make an assumption that the first merchandise purchase is the first to be sold first in, first out, then my older merchandise prices are going to be in cost of goods, sold on the income statement.

My most recent merchandise prices will be in inventory on the balance sheet. That's the base. That's the impact on your statements? If you're assuming that the first merchandise purchased is the first to be sold first in, first out, that effect would be that older merchandise prices would be in cost of goods.

Sold on the income statement. My most recent merchandise prices would be in inventory on the balance sheet. So let's think about this. How do we feel about the balance sheet? Pretty strong because the argument would be because your most recent merchandise prices are an inventory on the balance sheet.

Your balance sheet does reflect the type of current financial resources that the company has invested in merchandise. The balance sheet is very well served by FIFA. And I know you're with me. If you want to attack FIFO, you go to the income statement. The problem with FIFO is that cost of goods sold on the income statement is made up of older merchandise prices.

And they may not be relevant anymore. You have to argue that the company could be in a period of dramatically changing merchandise prices, whether it's inflation, deflation, that's the problem that there could be dramatically changing merchandise prices. And now cost of goods sold on the income statement is made up of old a merchandise prices.

And as I say, they may not be relevant anymore. And you know where I'm leading with this, the matching concept. Our objective on an income statement is to have a proper matching between this year sales and this year's expenses, right? That's our objective on an income statement. That's the matching concept, having a proper matching between this year sales and this year's expenses while with Pfeifle, you're not doing that with Five-O on your income statement.

You end up matching this year sales with older merchandise prices. That may not be relevant anymore. I want you to be real. I want you to remember that FIFO does cause a distortion in the matching concept, and that all makes a lot of sense. When you remember the bottom line is that Five-O is a balance sheet method.

Five-O bottom line is a balance sheet method. Why? Because the recent merchandise prices are on the balance sheet. The balance sheet does reflect the type of current financial resources that the company has invested in merchandise. Let's go to life phone. Now when a company chooses a last in first out cost flow.

Now they're assuming that the last merchandise purchased is the first to be sold last in first out LIFO, and really in every respect. Life is the exact opposite of FIFO. So think about the impact on the financial statements. If I'm going to assume that the last merchandise purchase is the first to be sold.

Now my most recent merchandise prices are in cost of goods, sold on the income statement. All the merchandise prices are in inventory on the balance sheet. So how do we feel about the income statement? Very strong, because now my income statement is matching. Current sales this year sales with this year's merchandise prices, cost of goods sold is made up of my most recent merchandise prices.

So lifeboat is very consistent with a matching concept because now on our income statement, we are matching this year sales with this year's merchandise prices. And of course, if you want to attack life, Oh, you go to the balance sheet. The problem with light Bo is inventory on the balance sheet is made up of older merchandise prices.

They may not be relevant anymore. As I say, a company could be in a period of hyperinflation deflation. And the problem with life though, is on the balance sheet. Your inventory basically gets older and more and more out of date. It can get to the point where your balance sheet does not reflect in any way, the type of current financial resources that the company has invested in merchandise.

And it all makes perfect sense. When you remember the bottom line, lifeboat is an income statement approach. Remember that basic difference. FIFO is a balance sheet method. Why? Because the recent prices are on the balance sheet. Lifeboat is an income statement method. Why? Because the recent prices are in cost of goods sold on the income statement.

That is the essential difference. FIFO is a balance sheet approach. Life O is an income statement approach. I'd like you to try a couple of questions, try five and six and come back.

Welcome back. Number five says a company decides to change their inventory valuation method from  to life though. Notice in a period of rising prices. If you go from Five-O to life, though, in a period of inflation, what's the effect on ending inventory? What's the effect on net income? Just think about this.

Five-O let's think about ending inventory don't we know that Fibo is a balance sheet approach. So with Bifo, the recent prices are on the balance sheet in inventory and the recent prices are higher. Because it's a period of rising prices. So if you go from fight for the life, in terms of the balance sheet, aren't you going from recent prices under FIFA, which are higher to older prices under life.

Oh. Which are lower inventory is going down. So you want decreased under that column. How about net income? With . Older prices are in cost of goods sold. So you're going from all the prices and cost of goods sold to new a prices under life. Oh. In cost of goods sold. So the new prices are higher. Cost of goods.

Sold is higher. Net income is lower and the answer is C decrease under both number six, generally, which inventory costing method approximates. Most closely the current cost for what cost of goods sold and inventory. What's going to approximate current costs for cost of goods sold. We know it's going to be life because life was an income statement approach.

The recent prices are in cost of goods sold for ending inventory. You want five focus. Bike was a balance sheet approach. Recent prices are on the balance sheet in ending inventory. So the answer is a.

Let's talk about weighted average. Let me give you the formula for a way to the average cost per unit. If you want to figure out a way to average costs per unit. You simply take cost of goods available for sale and divide by the number of units available for sale. That's the formula for a weighted average cost per unit.

It's simply cost of goods available for sale divided by the number of units available for sale. So if I just make up some numbers, if my cost of goods available for sale written $20,000, and I had 10,000 units available for sale than my weighted average cost per unit. Would be $12. So if at year end I have a thousand units in my ending inventory, times $12, my weighted average cost per unit, my ending inventory would be valued at $12,000.

That would be the proper valuation of the ending inventory, $12,000 under weighted average. Now, one thing I worry about. Don't confuse a weighted average with a moving average. Let me show you a moving average. Let's say we start January one. I've got a thousand units in my beginning. Inventory value to $2 each.

So my beginning inventory is valued at $2,000. Then let's say on February 3rd, we purchased 500 units for $5 each. If I purchase 500 units for $5, each that's a $2,500 purchase. Add that to my beginning inventory, 2000 now I have $4,500 invested in inventory divided by the 1500 units on hand on that date.

My weighted average cost per unit as of February 3rd is $3. See, that's the key to a moving average in a moving average. Every time you purchase units, you strike a new weighted average cost per unit on that day. So if on February 23rd, you sell 200 units. They get costed out at that unit price. So if on February 23rd, we sell 200 units.

They get costed out at $3 a unit. So my inventory would drop $600 from 4,500 down to 3,900. Let's say on March 4th, we purchased another 300 units for $11 each. If we purchased another 300 units for $11, each that's a $3,300 purchase. Add that to my. Inventory balance at that point 3,900. Now I have $7,200 invested in inventory.

How many units do I have? I had 1500 units. I sold two that brought me down to 1300. Then I purchased 300. I have 1600 units divided into $7,200. Invested my weighted average cost per unit. As of March 4th would be $4 and 50 cents per unit. As I say, the key to a moving average is every time you purchase units, you strike a new way to average cost per unit.

On that day. And of course you would use a moving average with a perpetual inventory system. You would use a simple way to average with a periodic system. Remember that you're going to use a moving average with a perpetual inventory system. You would use a simple way to average with a periodic system.

I'd like you to try seven and eight and then come back.

Welcome back. Let's do these questions together in seven and eight, we're talking about a perpetual inventory system and a number seven they say on removing average, what would be inventory January 31? Notice they started January one. With a thousand units in the beginning, inventory valued at a dollar each.

So beginning inventory would be valued at a thousand dollars. Then on January 7th, they purchased another 600 units for $3. Each that's an $1,800 purchase. So now they have what, $2,800 invested in inventory divided by the 1600 units on hand. At that date, the weighted average cost per unit as of January 7th is a dollar 75.

As I said, that's the key to a moving average. Every time you purchase units, you strike a new way. That average cost per unit on that day. And now that's a dollar 75. So on January 20th, when they sell 900 units, they get costed out at that unit price, a dollar 75. So inventory would drop 1005 75. Now you have 1002 25.

Invested in inventory after that drop, then on January 25th, you purchased another 400 units for $5. Each that's a $2,000 purchase. Add that to the 1000 to 25. You had invested in inventory on that date, the value of inventory as of January 31, would the answer be 3000 to 25? That's a moving average. Now number eight says it's still a perpetual inventory system, but now that you was life okay.

Last in first out with a perpetual inventory system. So let's work it through again, they start January one with a thousand units, valued at a dollar. Each beginning. Inventory is valued at a thousand dollars. Then on January 7th, they purchase another 600 units for $3. Each that's an $1,800 purchase, but remember, I'm not going to strike a weighted average cost per unit on this day because it's not weighted average it's life.

Okay. In conjunction with a perpetual inventory system. So if on January 20th they sell 900 units. How do we handle that last in first out? So the 600 units that we purchased back on January 7th, they would go out the door first, last in first out and 300 units from our beginning inventory, it would go out the door.

So now what I have on hand after that sale is still 700 units from my beginning inventory valued at a dollar each 700. So when I purchase. The units on January 25th for $2,000. Now, again, it's answer B. I have $2,700 invested in inventory as of January 31. What I want to get into next is the retail method.

We're continuing our discussion on different ways of estimating the value of ending inventory without using specific identification. And the retail method is used by retailers, obviously. And if you imagine a company like Walmart, Walmart probably has, tens of thousands of products all on the shelves bought at different prices.

So specific identification is just not practical, especially for interim financial reporting. So this is the type of company that would use the retail method. Now, before we look at a problem, I'll just tell you that anytime you see a problem on the retail method, there are two essential pieces that you have to figure out to solve it.

So you might want to just drop these down. Anytime you see the retail method, there are two critical pieces to this puzzle. Number one, you're going to have to calculate the cost to retail ratio. That's number one, you're going to have to figure out the cost of retail percentage or the cost of retail ratio.

And number two, you're going to have to figure out ending inventory at retail. Those are the two essential pieces of this puzzle, the cost to retail ratio and ending inventory at retail. Let's go to question number nine, Dean company uses the retail method to estimate their ending inventory for interim financial reporting purposes.

Now you see the kind of information that we're given. We know the beginning inventory, February one at cost and at retail, we know the purchases at cost and at retail, we know the Mark ups. We know the Mark Downs. We know the sales, we know the shoplifting losses. Then they say at the bottom, now this is a mouthful.

They say under the approximate lower of average cost of market retail method. As I say, that's a mouthful under the approximate lower of average cost of market retail method is another name for this. This is also called in the exam, conventional retail. All right. So it's another way to think of this.

When you see lower of average cost of market retail, it's conventional retail. So under conventional retail, What is Dean's estimated inventory, July 31. As I said, anytime, you see a retail question, there are two essential pieces. You have to figure out. Number one, you have to figure out the cost of retail percentage or the cost of retail ratio.

Let me give you the formula. If you're going to work out the cost to retail ratio in the numerator, you want goods available for sale at cost in the numerator. You want goods available for sale at cost and in the divisor you want goods available for sale at retail. That's how you figure out the cost of retail ratio.

It's good to fail for sale at costs, divided by goods available for sale at retail. So let's figure it out. If you go to the cost column, we know beginning inventory cost is 180,000. Purchases. It cost 1,000,020 thousand just to align there. So goods available at cost adds up to 1 million, 200,000. We've got that.

Now let's figure out goods available at retail. Now you might want to put a little check Mark next to each number. I say, I'm going to pick up beginning inventory at retail, 250,000 plus purchases at retail. 1,575,000. Plus the markups 175,000. I'm going to ignore the markdowns. I'll say why in a moment you add that up goods available at retail comes out to 2 million.

So I think you see my point. If I take goods available at cost 1 million to divide by goods available at retail, 2 million, my cost to retail ratio, my cost to retail percentage is 60%. You need that percentage. So my cost to retail ratio is 60%. Now, just a quick point. Why did I ignore the markdowns?

Because anytime the FAR CPA Exam says the phrase. Lower of cost or market in a retail question. When you see that phrase, lower of cost of market in any retail question, it always means the same thing. Put the ups, not the markdowns and the ratio. That's always what it means. When you see the phrase lower of cost of market and any retail question, it always means the same thing with the mock ups, not the markdowns and the ratio.

And if you play with it, you'd see why it works out that way. If I put the markups, not the markdowns in the divisor. Remember, the markdowns will be a minus. It makes the re the ratio a little lower. It suppresses it a little bit. What it tries to do by putting the markups, not the markdowns in the divisor, in the ratio.

It tries to suppress the ratio, make it a little lower tries to approximate, lower of cost to market. But you just have to know that little quirky point that if they say that phrase, lower of cost of market and retail question, they're always telling you to do the same thing with the markups, not the markdowns and the ratio, which we did.

All right. So we know the cost of retail ratio is. 60%. What's the second piece of the puzzle. I have to have ending inventory at retail, which is a fairly easy number for Walmart to figure out we know goods available at retail. That's in our divisor 2 million. Now, how do I figure out ending inventory at retail?

Take out what they sold. 1,000,007 Oh five. Take out Mark Downs. I'm going to take out the markdowns. Now I don't ignore the markdowns. They're just not in the ratio. When you see lower of cost to market markdowns are not in the ratio, but I have to consider them. So back out the markdowns of 125,000 take out breakage, theft, spoilage, shoplifting, any kind of shrinkage back out the 20,000.

And we know that ending inventory at retail comes out to $150,000. As I say, that's a fairly easy number for Walmart to figure out. Now, my last step is to say, If my ending inventory at retail is $150,000. And my cost of retail ratio is 60% that ending inventory at cost must be 60% of 150,000 answer a 90,000.

That's how it works. If my ending inventory at retail is 150,000 and my cost to retail ratio is 60%. Then ending inventory at cost must be about 90,000 answer rate. It's a way of estimating. The cost of what's on the shelves without using specific identification.

Now, the last method I want to show you in terms of valuing, ending inventory without using specific identification is dollar value LIFO. When a company uses dollar value life. Oh, they don't count physical units. They don't count. They don't care how many physical units they have in inventory. What they count is dollars.

In other words, when a company uses dollar value, life lifeboat, one unit of inventory to them is one us dollar invested in inventory. That's how they look at it. One us dollar invested in inventory is one unit of inventory to them. That's really how simple this is. That's dollar value life. Oh, I don't count physical units.

I count dollars. So when I used all the value life, Oh, one us dollar invested in inventory is one unit of inventory for me. And it really is that simple, but what complicates, this is inflation because the dollar changes as well. So let's go to a problem. And your viewers guide you'll see the acute company.

It says the acute company manufacturers, a single product on December 31. Year 10 acute adopted the dollar value LIFO inventory method. The inventory on that date using dollar value life O was determined to be 300,000. I think you ought to circle that 300,000 and label it. That's called the light bulb base.

So when you convert it to dollar value life, Oh, you had $300,000 invested in inventory. In other words, you had 300,000 units in inventory because one us dollar invested in inventory is one unit of inventory. To me. That's your life old base. I think you also should write down. That the base year index is always 1.0, make sure you write that down base.

Your index is always 1.0, in this method, our job is to keep track of inflation since the base year. And you always start with a clean slate. So your base, your index is always 1.0, because again, your job in this approach is to keep track of inflation since the base year. And you always start with a clean slate.

Now, if you look at the chart they gave us inventory data for succeeding years are as follows. A year goes by, by the end of year 11, we have 363,000 invested in inventory. But notice the price index is now 1.1 that tells you there's been 10% inflation since the base year. At the end of year 12, we have 420,000 invested in inventory.

But notice the index is 1.2 that tells you there's been 20% inflation since the base year. And then by the end of year 13, we have 430,000 invested. But now the index is 1.25 that tells me there's been 25% inflation since the base year, they say compute the inventory amounts at December 31 years, 11, 12, and 13 under the dollar value life.

Oh, method. Now this really is a matter of steps. And I think you'll see, once we do a couple of years, you just get used to the basic approach, the basic steps. So let's do year 11 a year goes by, right? We get to the end of year 11. We now have 363,000 current dollars invested in inventory. Those are all current dollars.

That's what we keep track of. But the problem is there's been 10% inflation since the base year. Now the index is 1.1 step one, every time, step one in a problem like this is you divide by the price index. To get back to base your dollars. So I'm going to take that 363,000 divided by 1.1, in terms of base your dollars, that comes out to 330,000.

So try to remember that's always step one divided by the price index, and that'll get you back to base your dollars. So if you take that 363,000 divided by 1.1, in terms of base your dollars, that comes out to 330,000. Now listen carefully. How many base your dollars were invested last year? The base 300,000.

So in real terms, when I pull out the inflation, we have more invested in inventory this year than we did last year. What we added this year was a $30,000 layer. You have to be able to find that layer. That's a big part of it. All right. Now, if you're with me on how I found the layer, now, the most important thing, what do I take to my balance sheet for inventory at the end of year 11?

What I'll take to my balance sheet for inventory at the end of year 11. I've got my base 300,000. I haven't touched that, but now I've added a two eight, 2011 layer of 30,000 times. 1.1. You have to remember that in dollar value life. Oh. Every layer is valued at its own index. Again in dollar value life, every layer is valued at its own index.

Why? Because if we did add the inventory, we added this year's dollars. We can add old dollars. It's not possible. See what we did this year is we added 33,000 current dollars to what we already had invested what I'll take to the balance sheet at the end of year 11. Is 333,000. That is the proper valuation of the ending inventory under dollar value life out.

Let's do another year. See if it gets more comfortable for you. Another year goes by, we get to the end of year 12, we now have 420,000 current dollars invested in inventory. That's what they keep track of. And this approach, what's the current dollars. We have invested 420,000, but the problem is there's been 20% inflation since the base year.

Notice the index is 1.2. What's my first step. Every time I always divide by the price index to get me back to base your dollars. So I'm going to take that 420,000 divide by 1.2, in terms of base your dollars, that comes out to 350,000. Now be careful how many. Base your dollars were invested last year, three 30, not 300.

Don't go back to the base. A lot of students do that. Now the question is how many base your dollars were invested last year? 330,000. So in real terms, we added another $20,000 layer. You've gotta be able to find that layer. Now, if you, with me on that now, the most important thing, what do we take to the balance sheet for our inventory at the end of year 12?

We've got the base. 300,000. We haven't touched that. We've got the year 11 layer of 33,000 that hasn't been touched, but now I've added a year 12 layer of 20,000 times 1.2, that comes up to 24,000. Every layer gets valued at its own index. Because again, if we did add to inventory, we added this year's dollars.

We can't add old dollars. It's not possible. What we did this year is at 24,000 current dollars to what we already had invested what we'll take to the balance sheet at the end of year 12. Is 357,000. That is the proper valuation of the ending inventory under dollar value, light bulb. Let's do another year.

Another year goes by, we get to the end of year 13. We now have 430,000 current dollars. Those are all current dollars invested in inventory, but the problem is there's been 25% inflation since the base year. Step one, we always divide by the price index to get us back to base your dollars. So I'm going to take that 430,000.

I'm going to divide by 1.25 in Kim's in terms of base your dollars, that comes out to 344,000. How many base your dollars were invested last year? Three 50. So in real terms, inventory's gone down. I hope you see what just happened there. When I divide that. 430,000 by 1.25, in terms of base your dollars, that comes up to 344,000.

Last year, I had 350,000 base your dollars invested. So in real terms, when I pull the inflation out, we have less invested in inventory this year than we did last year. There's been a $6,000 decline. I hope you see how to find that decline. All right. So now that we have the decline, what you're about to say.

Is why they call this dollar value life. Remember, this is not just called the dollar value method. It's called dollar value life though. You know why it's called LIFO because if inventory ever goes down as it did here, the last layer you added is the first one you begin to cost out. Last layer added is the first one you begin to cost out last in.

First out. So now you're seeing the lifestyle aspect to it because if inventory ever goes down, last layer that was added is the first one you begin to cost out. So with that in mind, what do I take to my balance sheet for inventory at the end of year 13? I've got my base 300,000 that hasn't been touched.

I've got my year 12 layer of 33,000. Hasn't been touched, but that year. 12 layer the year 12 layer that was 20,000 based dollars times 1.2 drop 6,000 based dollars to 14,000 based dollars times. 1.2, that layer is now valued at 16,800. You see what happened there? When inventory drops, the last layer that you added is the first one you begin to cost out.

So that 2012 layer. That was 20,000 based dollars times 1.2 drops 6,000 based dollars to 14,000 based dollars times 1.2, every layer gets valued at its own index. So that layer is now valued at 16,800. So what do I take to my balance sheet for inventory at the end of year 13, my base 300,000, the 2011 layer of 33,000.

And now the year 12 layer is down to 16, eight. 349,800. That will be the proper valuation of the ending inventory under dollar value life up. It's I think one of those approaches that wants you to do a few years, you start to get used to it. Now, one little wrinkle. I have to mention. If you look at how they set this problem up.

We know that the base your index is always 1.0, because our job in this approach is to keep track of inflation since the base year. So when they told me the index at the end of year 11 was 1.1 that told me there was 10% inflation since the base year, when I got to the end of year 12, the index is 1.2 that told me there were, there was 20% inflation since the base year.

And when I got to the end of year, 13 index was 1.25 that told me there was 25% inflation since the base year. Now listen carefully when they give you in your index, the inflation, since the base year, there's a name for that. That's called the double extension approach. So that's called the double extension approach to dollar value life.

When they give you the inflation since the base year. And I'll tell you that normally the FAR CPA Exam will give you the double extension approach. That's what they seem to like the double extension approach, where they give you in the price index, the inflation since the base year. But I have to warn you on this.

They could give you each year's inflation. Let me show you what you'd have to do. What if I'll use the same numbers we get to the end of year. W first of all, we know, by the way, the name for this is called the link chain approach. When they give you each year's inflation, that's called the link chain approach.

$2 value life though. And the FAR CPA Exam might throw a curve at you. And that's why I'm worried about again, normally the FAR CPA Exam likes the double extension approach to dollar value life though, where they just give you the inflation since the base year. But if they start giving you each year's inflation, that's called the link chain approach to dollar value life though.

And I'll use the same numbers now, as always, we know the base, your index is always 1.0 that never changes because again, our job in this approach is to keep track of inflation since the base year. Now we get to the, at the end of year 11. Now there's been 10% inflation since the base year. Now the index is 1.1.

That first year wouldn't be any different. That's the index I'd use one point. I would use 1.1. Now where it gets different is at the end of year 12. Now they're saying there's been 20% inflation in the last year. That's what the FAR CPA Exam would have to tell you that has been 20% inflation just for year two.

So how do I figure out. The inflation since the base year, I'd have to multiply 1.1 times 1.2. I'd have to multiply 1.1 times 1.2. So my index for year 12 would be 1.32. I multiply 1.1 times 1.2. That's what you have to do. Take last year's index 1.1 times 1.2. So that would give me the index of 1.32, that there's been 32% inflation since the base year.

That's the index that all the other steps would be the same, but that's the index. I would use 1.32. What if they told me that there was 25% inflation in the next year 13? If there was 25% inflation in year 13, that just gives me that year's inflation. What, how do I figure out the inflations is the base year?

Multiply that 1.25. Times 1.32. And that would tell me the index will be 1.65. That's been 65% inflation since the base year. It just, it's just one more step. You have to work in. If it's linked chain, they just giving you each year's inflation. So you have to do that extra step to figure out the index that you need.

I don't know the FAR CPA Exam and throw that at. You are not normally what the FAR CPA Exam likes is the double extension approach. I'd like you to please do 10 and 11 and then come back.

Welcome back. Let's do these questions together. And number 10, they say wall adopted the dollar value life though. Inventory method. As of January one of the current year, when the inventory was valued at 500,000, you know what that is? That's your life Oh base. And you also know that the base, your index is always 1.0, you always start with a clean slate in this method and you keep track of inflation.

Since the base year Walton tire inventory constitutes a single pool using the relevant price index of 1.1. So a year has gone by, there's been 10% inflation since the base year. Now the index is 1.1. Walt determined that at December 31 inventory was valued at 577,500 at current year costs. That's what they keep track of the current dollars.

They have invested in inventory. Now they have 577,500 invested in inventory. And, the basic process. Step one every time is to divide by the price index, get back to base your dollars. So I'm going to take that five 77, five divided by 1.1, in terms of base your dollars, that comes out to 525,000.

They did that for you. They did that division for you really, but the point is in real terms, We've added more to inventory because last year we had 500,000 base. Your dollars invested. Now we have five 25. So in real terms, when I pull the inflation out, we have more invested in inventory this year than we did last year.

What we added this year was a $25,000 layer. But now the important question, what do we take to the balance sheet as our inventory at December 30, one of the current year, while we've got our base 500,000. Hasn't been touched, but we've added a $25,000 layer times 1.1, because remember in dollar value life, though, every layer is valued at its own index.

Because if I did add inventory, I added this year's dollars. I can't add old dollars. It's not possible. So what I added this year was 27,500 current dollars to what I already had. My base 500,000. What I'll take to the balance sheet at the end of the year for inventory will be answered B five 27 five.

That is the proper valuation of the ending inventory under dollar value life. I'll look at number 11, January 1st year one, Paul adopted the dollar value life. Method. Inventory data for years, one and two follow notice. The day they adopt a dollar value, light bulb, they had $150,000 invested in inventory.

They don't count units, they count dollars and that's the life of base and notice the base your index is given. And it's always 1.0 because that's our job to keep track of inflation since the base year. And we always start with a clean slate. Now a year goes by. At December 31 year one, we now have 220,000 invested in inventory, but there's been 10% inflation since the base year.

So we always divide by the price index to get back to base your dollars. And if you divide that 220,000 by 1.1, in terms of base your dollars, that comes out to 200,000, they did that for you. But notice last year we had, or a year ago we had 150,000 base your dollars invested. So in real terms, we've added a $50,000 layer.

Same thing with here too. We get to the end of year two, we have 276,000 invested in inventory, but there's been 20% inflation since the base year. So I take that 276,000 divide by 1.2, in terms of base your dollars, that comes out to 230,000, which they did for you. How many base your dollars were invested last year?

Last year, 200,000. So in real terms in year two, we added another $30,000 layer, but now the important question. What would be the inventory taken to the balance sheet December 31 year two, while we got our base 150,000 not touched, we've got our year one layer of 50,000 times. 1.1, we added 55,000 year, $1 to what we already had.

And then we have our year two layer of 30,000 times 1.2, we added 36,000 year $2 to what we had. Every layer is always valued at its own index. Add it all up. Add up the base 150,000 the year one layer 55,000 the year two layer, 36,000. We take it. The balance sheet is answer C 241,000. The proper valuation of the ending inventory under dollar value life.

Oh, let's move on to something else.

What I want to get into next is fixed assets. Now, when we say fixed assets, we're talking about land and buildings and machinery and equipment and furniture and fixtures, but to be more precise, Always remember that when we're talking about fixed assets, we're talking about capital expenditures, meaning these are expenditures that benefit more than one accounting period, as opposed to what revenue expenditures, revenue expenditures only benefit the current period.

I pay my telephone bill. That's a revenue expenditure, only benefits the current period, but fixed assets represent capital expenditures in that they are expenditures that benefit. More than one accounting period. And by the way, that's where the word capitalized. Now, in terms of fixed assets, there are a lot of things the FAR CPA Exam can get into fixed assets are a fairly heavily tested area.

There's a lot of picky areas they can get into with fixed assets. Here's the first thing they'd like to get into what costs do we capitalize to fixed asset accounts? In other words, over and above. The cash price you pay for an asset. What costs do you capitalize for fixed asset accounts? What you're dealing with here is a rule.

Let me just give you the rule. The rule is that for fixed assets, we must capitalize all the costs we incur to bring that fixed asset. What condition and location for use that's known as the condition and location for use rule, because for fixed assets. Over and above the cash price, you'd pay for an asset.

We must capitalize all the costs we incur to bring that fixed asset into a condition and location for use. So let me give you some examples, machinery and equipment over and above the cash price you pay for machinery and equipment. You have to capitalize freight charges insurance during transit installation charges.

And don't forget if there's a testing period. If there's a testing period, before you put machinery and equipment into production, all the costs that you incurred during that testing period, would all be capitalized to the machinery and equipment account. How about land? What costs are you going to capitalize to a land account, over and above the cash price you pay for the land, which is obvious, but for land, you're going to capitalize the attorney's fees.

Now be careful they could call it title, search costs for grading the land. Clearing the land draining the land, surveying land. These all costs. These are all costs that you capitalize to a land account because these are costs you incur to get the land in addition for use. So attorney's fees, title, search, grading, clearing, draining surveillance plan.

All these costs get capitalized to the land account. How about a building? For buildings over and above the cash price you pay for the building. You're going to capitalize architect's fee. Engineering fees and building permits, things like that, all get capitalized to the building account. And while we're talking about buildings, there's one more thing you should be aware of.

And that is capitalized interest. Let's talk about capitalized interest. Here's the point. If a company borrows money to construct a building. Or any asset I want to emphasize that capitalized interest does not just relate to buildings. It applies to any asset the company is constructing for its own use.

But back to my point, if a company borrows money to construct a building or any asset, they must capitalize interest during the period of construction. That's the requirement that we must capitalize interest during the period of construction. This is another cost. That's get that gets capitalized to fixed asset accounts.

You must capitalize interest during the period of construction. Let's go to a problem. Number 12,

12 says her has a fiscal year ending April 30th on may, one of the previous year. Her borrowed $10 million at 15% interest to finance the construction of a building repayments of the loan are to be commenced in the month. Following completion of the building during the current year ended April 30 expenditures for the partially completed structure, total $6 million.

So notice 6 million of the 10 million that they borrowed has been spent on construction costs in the first year. And you might want to underline, it's an important point. The expenditures were incurred evenly. That's an important point. They were incurred evenly throughout the year. They say interest earned on the unexpended portion, amounted to 400,000 and they want to know what you capitalize for interest.

Now, I want you to see that there's a couple of ways students might be tempted to go here. They might go well, what's capitalized interest. Take the interest rate. 15% times the borrowing 10 million and say it's 1,000,005. No, that's not how it's done. Or some students might go it's the interest rate?

15% times the borrowing 10 million, that's 1,000,005 minus the 400,000 of interest income that you're on the unexpended funds. That's 1,000,001 that gives you answer day. That's not it either. You might think maybe it's the interest rate. 15%. Times the construction cost 6 million that's 900,000.

That's not it either because as you would probably guess there's a trick to this, you knew there would be the trick. Is this, that what the company must do is capitalize interest on average expenditures. That's what they must do. Capitalize interest on average expenditures. So here's how you do capitalizing interest.

When you going to do capitalized interest, you don't look at the borrowing. You do look at the construction costs of $6 million. That's what you look at. Why? Because the argument is that they now have $6 million of borrowed money in this project. That's the basic argument that they now have $6 million of borrowed money in the project.

And because they said. That we must capitalize interest on average expenditures. There's one more adjustment we need to make now listen carefully. As long as those construction costs are incurred evenly and notice they said they were. And I think realistically in the FAR CPA Exam they would be, if they tell you that the construction costs were incurred evenly through the year.

You just take that 6 million divide by two, if you divide by two, that gives you an estimate of your average expenditure. So the average expenditures would be 3 million times the interest rate, 15%, and the answer is C your capitalized interest would be 450,000 notice. We don't worry about that interest income earned on the unexpended funds.

That's just interest income that doesn't play into it because it doesn't alter the fact that we have $6 million of borrowed money in this project. And as I say, as long as the construction costs are incurred evenly through the year, you just divide by two and that'll give you an estimate of your average expenditures, 3 million times get a straight 15%.

And that gives you the capitalized interest, which is answer C. Now, Justin, I think the FAR CPA Exam would probably do that. I think more than likely they'd have the construction costs incurred evenly, but what if they didn't, let's go to the second year. What if we now get into the second year? Let me show you what happens when we go to the same problem.

If we got into the second year, do you see what happens? The $6 million of borrowed money that we have in the project from year one would still be invested for all 12 months of year two, right? The $6 million of borrowed money that we have in the project from year one would still be in the project for year two and be invested for all 12 months of year two.

Now let's say in addition to that 6 million. They incur another 1 million, 200,000 of construction costs on March one. They incur another 1 million, 200,000 of construction costs on March one. That borrowed money is going to be in the project for 10 months by I'm assuming a calendar year here. So thank her.

Another 1,200,000 of construction costs on March one, assuming a calendar year. That borrowed money would be in the project for nine months, March, April, may, June, July, all the way through December. So that borrowed money would be in the project for nine months. Excuse me, 10 months from March one to the end of December, you'd give it a weight of 10 twelves.

That would be a million dollars of average expenditures. Let's say they incur another million, 200,000 of construction costs on October one. That borrowed money would be in the project for October, November, December three months. So I'd give it a weight of three twelfths, a quarter that's another 300,000 of average expenditures.

So what would be your average expenditures for the second year? The $6 million of borrowed money from year one that would carry over to year two, plus a million plus 300,000. My total average expenditures for the second year would be 7 million, 300,000 times the interest rate, 15%. That's how you would do it the following year.

So I'm just pointing out that if they don't say that the construction costs are incurred evenly, then you have to weight the borrowed money. By how many months it's been in the project. At the halfway point of the year, they put some borrowed money in the project. You give it a weight of a half times the interest rate.

If they put so much borrowed money into the project after nine months, they'll that borrowed money would be in the project for three months, give it a weight of three twelves. So if they don't say that the construction costs were incurred evenly, then you have to wait the borrowed money by how many months has been in the project.

I'm not sure the FAR CPA Exam would do that, but you never know. I think more than likely, they'll just say those construction costs are incurred evenly. If they're incurred evenly. You just divide by two, that gives you an estimate of your average expenditures in this case, 3 million times, 15%. So capitalized interest would be answer C 450,000.

Let's look at number 13, 13 says a company is constructing an asset for its own use construction began the previous year. The asset is being financed entirely with a specific new borrowing construction expenditures were made last year. And this year at the end of each quarter, the total amount of interest costs that would be capitalized in the current year would be determined by applying the interest rate on the borrowing times.

What it's not a total expenditures, it's not Dee total expenditures. It's always the interest rate times average expenditures, but here's what you had to think about is this C would it be the average expenditures? For the asset, just for the current year or B the average expenditures for the asset for both years, it would be B that would be B.

You see why? Because as in my example, the $6 million of borrowed money that was in the project in the first year would carry over and still be invested for the second year. That's why you have to consider both years, because in the example I gave you. That's $6 million of borrowed money from the first year of the project would still be invested for the entire year of the second year of the project.

That's why you have to consider the borrowed money for both years. That's why the answer is B not C it's a tricky point.

What I want to get into next is how you handle improvements to fixed assets. How do we handle improvements? And I think, what the issue is. If we make an improvement to a fixed asset, we paint something, we replace a gear, the FAR CPA Exam gets very picky on this. You make an improvement to a fixed asset.

I think, the basic issue is should we capitalize that improvement or should we expense that improvement? That's the question. Isn't it. We make an improvement to a fixed asset. Is that improvement capitalized or is it expense? I want to start. With some categories, because you'll see when you do questions on this, that sometimes in the exam, it comes down to terms.

So let's go over some terms. The first term you might see is Betterment's an example of a betterment would be putting a new roof on a building. Just remember, betterments are always capitalized. What I'm saying is if the CPA exam call something a betterment, don't argue with it. Betterments are always capitalized.

Again, for example, you put a roof on a building, a new roof on a building. That's a betterment and betterments are always capitalized. And again, my point is if the CPA exam calls something a betterment, you don't argue with, it's gotta be capitalized. Another category watch out for additions, extensions, enlargements.

An example would be putting a new wing on a building. Just remember that additions, extensions, enlargements are always capitalized. My point being that if the CPA exam calls something, an addition, if they call something an extension, if they call something on enlargement, you don't argue with it. It's gotta be capitalized, has to be.

And then the last category would be extraordinary repairs. No example would be putting a new motor in your machine, putting new motors in all your machines. These are extraordinary repairs. Just remember extraordinary repairs. Are always capitalized. My point again is that if the CPA exam call something on extraordinary repair, you don't argue with it.

It's got to be capitalized automatically. So watch out for these terms. Sometimes in the exam, it really comes down to terms how the FAR CPA Exam refers to something. That'll tell you that it has to be capitalized, but as I've already said, the FAR CPA Exam gets very picky on this. And I'm going to give you a rule that should answer.

Whatever they dream up. Here's a rule you can always lean on. Just remember you must capitalize an improvement. If it does any one of four things, again, you must capitalize an improvement. If it does any one of four things. Number one, if it extends the useful life of the asset, if it extends the use the life of the asset capitalize, or if the improvement increases the number of units produced by the asset capitalize.

All right. So if the improvement extends the useful life of the asset capitalized, or if the improvement increases the number of units produced by the asset capitalize or if an improvement increases the quality of the units produced by the asset capitalize. If the improvement increases the quality of the units produced by the asset, capitalize one more or one more.

If the improvement increases the efficiency of the asset capitalize. So remember any one of those four conditions met. If it extends the life increases, the number of units produced increases the quality of units produced or increases efficiency you have to capitalize. And a quick way to remember it, just remember queen Q E N quality increased extends.

Life efficiency, increased. Number of units produced. Number of units increased. Just remember queen any one of those four conditions are met automatically capitalize. And of course, if none of those conditions are met expensive, that's your dancer, whatever they dream up. I also want to talk about how we handle impairments to long lived assets and also in tangibles.

How do we handle an impairment to a long lived asset or an intangible? When you're talking about impairments to long lived assets or intangibles, there's really three broad categories. First, there are long lived assets are intangibles that are held for use. That's the first category. If you have long lived assets or intangibles that are held for use, how do you know they're impaired?

That a long lived asset or an intangible you're holding for use. It's impaired. If the carrying value on the books is greater than any expected future cash flows from that asset. That's how, it's impaired. If the carrying value on the books is greater than any expected future cash flows from that asset, you know what you could sell it for, it's impaired.

If it's impaired, what do you do? You're going to debit a loss, take a loss to the income statement and credit the asset. You're going to write the asset down to fair value. That's what you're supposed to do. If the carrying value on the books is greater than any expected future cash flows from that asset, what you could ever sell it for, then that asset is impaired.

So you debit a loss, take that loss to the income statement, credit the asset, write it down to fair value. What you're doing is writing the asset down to fair value and that fair value becomes the new basis of the asset. And that new basis will be depreciated over the assets remaining life don't touch prior periods.

No that new basis would simply be depreciated over the assets remaining life. And what if it recovers? What if it recovers in value re recoveries are not recorded. So if it recovers in value, it's not recorded. Now the second category would be long lived assets or intangibles held for sale. That's the second category long lived assets or intangibles held for sale.

What is held for sale mean sale is probable within 12 months. So when I say we have long lived assets or intangibles held for sale, always means sale is probable within 12 months. Now, how do we know if a long lived asset or intangible that's held for sale? How do we know it's impaired?

It's impaired? If the carrying value on the books is greater than the selling price minus any cost to sell. If the carrying value on the books is greater. Then the selling price minus any cost to sell. In other words, if the carrying value on the books is greater than what you're going to net out of that sale it's impaired.

So what do you do? Same entry, Devin, a loss, take a loss to the income statement, credit the asset, write it down to fair value and depreciation would stop. Now. Depreciation would stop. Now there's a third category. The third category would be long lived assets. Or intangibles held for disposal other than by sale.

Now, when I say other than by sale, we're saying it could be an asset that you will, you might abandon, you could intend to exchange it for another asset. Distributed to owners. You don't have that third category, long lived assets or intangibles that are held for disposal other than by sale and buy other than by sale.

It could mean that you intend to abandon the asset exchange the asset distributed to owners. And there's really a simple rule here. If you have long lived assets or intangibles held for disposal, other than by sale, the basic rule is you treat that asset as held for use. Just treat that asset as held for use until you dispose of it.

So you just go right back to what we just said about held for use, because you're just going to treat these assets as held for use until you dispose of the assets. I'd like you to try a couple of more questions, please try 14 and 15 and then come back.

Let's do these questions together. And number 14, they want to know what you would capitalize for the cost of the land. You're going to pick up the 135,000 cash paid for the land. You're also going to pick up the title, search the attorney's fees of six 25 and the assessment for the sewer lines.

That's a cost you incur to get the land in a condition for use. Pick that up. I don't think that's first three would bother you now the 21,000 excavation for construction of the basement. That's going to be capitalized to the building account. But how about the last one? How about removal of the old building?

This land had an old unwanted building. It cost us 21,000 to get rid of the old building. Minus the 5,000 we get for scrap. What do we do with that 16,000? Does that get capitalized to the land account or the new building? And it is land. It is land. The answer is C. Why? Because the cost of destroying that old building.

Is a cost. We incurred to get the land in a condition for use. It's really a straight application of the rule that cost of destroying the old building really is a cost that we incurred to get the land in a condition for you. So it does go to the land account, not the new building and number 15, July one, one of Rudd's delivery mans was destroyed in an accident on that date.

The Van's carrying amount was 2,500. Then on July 15th, two weeks after the accident. Rod received and recorded a $700 invoice for a new engine that was installed back in may. You know what that is? That's an extraordinary repair that would be capitalized to the fixed asset account. The van account, they get another $500 invoice for various repairs, ordinary repairs and maintenance would be expensed.

Then they get 3,500 from the insurance company. They want to know the gain. What's the entry. When they get that $3,500 cash from the insurance company, they're going to debit cash 3,500. They're going to credit the van for its carrying value. And the carrying value would be the 2,500. Plus the $700 new engine.

That's an extraordinary repair would be capitalized to the van account. So the carrying value, the van would not be 2,530, 200. And there is a gain from that transaction of 300. And the answer is B. And I want to point out that would be a gain from an involuntary conversion because you didn't mean to do it.

It was destroyed in an accident as opposed to what I go out and I sell the event at a game. That's why it's that's voluntary. But always remember gap doesn't care gap, doesn't care, whether gains or losses are voluntary, involuntary. They have to be on the income statement either way. So the answer is B.

What I want to get into next is how we handle. Exchanges of assets. I'm sure you've seen these types of problems before a company. No. Two companies exchange a delivery truck for a computer, an automobile for a piece of machinery. How do we handle exchanges of assets? How we handle exchanges of assets all comes down to one thing.

Now, does that exchange have commercial substance? That's the issue because how we handle an exchange of assets is all determined by that question. Does the exchange have commercial substance? Now, what do we mean by commercial substance? We mean, as a result of the exchange, will the cash flows of the companies involved change significantly in terms of risk or timing or amount that's commercial substance, as a result of the exchange, will the cash flows of the companies involved change significantly in terms of risk or timing or amount that's commercial substance.

But honestly, I think the FAR CPA Exam will make it very clear that there is commercial substance. And the basic point is this. When an exchange does have commercial substance, we have to use the fair value approach. What's the fair value approach. It means that the company must record the new asset at its fair value.

Let me give you an example. Let's say in an exchange that does have commercial substance. And as I say, I think the FAR CPA Exam will make it quite clear in an exchange that does have commercial substance, a and B exchange assets, H a and B exchanges assets. And let's say a gives up an old asset with a book value of 6,000 and a fair value of 20,000 a Al's who has to pay 4,000 cash in exchange for new assets.

So eight gives up an old asset with a book value of 6,000 fair value of 20,000. And they also has to pay 4,000 cash in exchange for new asset. Now, what did we just say? When an exchange does have commercial substance, you have to use the fair value approach, which means if you're a, you have to record the new asset at its fair value.

How do you get the fair value of the new asset? You have to look at the fair value of what you're receiving or the fair value of what you're sacrificing. Whichever's more clearly evident noticing this problem. I don't know the fair value of the new asset. So I look at the fair value of what a gave up to acquire the asset.

And through that we infer the fair value, the new asset. In other words, because a gave up an old asset that's worth 20,000. And also kicked in 4,000 cash. Since ed gave up 24,000 in value to acquire the new asset, we infer that the new asset must be worth 24,000. So he is going to debit the new asset for its fair value.

24,000 a is going to credit the old asset for its book value 6,000, by the way, that never changes. You always credit the old asset for its book value, its carrying value. In this case, 6,008 credits cash 4,000 because they paid cash. And notice eight credits gain on exchange 14,000. Why? Because when an exchange does have commercial substance, you record the new asset at its fair value and recognize gains or losses whatever's indicated by the exchange.

Let me give you another example in an exchange that does have commercial substance a gives up an old asset with a book value of 6,000 and a fair value of 20,000 in exchange. Four 8,000 cash and a new asset. So now is receiving cash. So he gives up an old asset with a book value of 6,000, the fair value of 20,000 in exchange for 8,000 cash and a new asset.

What do we know? We know that when an exchange does have commercial substance, we have to use the fair value approach, which means that a has to record the new asset at its fair value. How do we get the fair value, the new asset? We use the fair value of what we receiving or the fair value of what we're sacrificing.

Whichever is more clearly evident. What's more clearly evident in this problem is the fair value of what they gave up. Since a is giving up an old asset, that's worth 20,000. We have to infer that a must be receiving 20,000 in value. So here's the thing country a is going to debit cash. 8,000 notice a is receiving cash aid has got to debit cash 8,000.

And debit the new asset 12,000, because we have to infer that a must be receiving 20,000 in value. So a is going to debit cash 8,000 and debit. The new asset must be worth about 12,000 a is going to credit the old asset for its book value, always 6,000 and credit gain on exchange 14,000. Why? Because when an exchange does have commercial substance, we recognize gains or losses, whatever's indicated by the exchange.

Give you another example. Okay. In an exchange that does have commercial substance a gives up an old asset with a book value of 6,000 and a fair value of 1000 in exchange for new assets acres up an hold asset with a book value of 6,000, but a fair value of 1000. In exchange for new asset. What do we know?

We know that when an exchange does have commercial substance, we have to use the fair value approach. And that means that a must record the new asset at its fair value. How do I get the fair value of the new asset? I use the fair value of what I'm receiving or the fair value of what I'm sacrificing.

Whichever is more clearly evident. What's more clearly evident in this problem is the fair value of what a is giving up since a is giving up an old asset worth a thousand. We have to infer that a must be receiving a thousand and value. So he is going to debit the new asset for a thousand credit, the old assets for its book value 6,000 and debit loss on the exchange 5,000, because we know when an exchange does have commercial substance, we recognize gains or losses whatever's indicated by the exchange.

Now let's talk about how we handle an exchange that does not have. Commercial substance. What if an exchange is lacking in commercial substance? If an exchange is lacking in commercial substance does not have commercial substance. We don't use the fair value approach. We use the book value approach.

Again, if an exchange does not have commercial substance, if it's lacking in commercial substance, you don't use the fair value approach. We use the book value approach and what's the book value approach. We record the new. At the book value of the old plus any cash paid, you simply record the new at the book value of the old plus any cash paid.

And if there's a gain indicated, generally speaking, it's ignored. Let me give you an example. Let's say a and B exchange assets, and let's say this exchange does not have commercial substance. It is lacking in commercial substance, a gives up an old asset with a book value of 10,000 and a fair value of 25,000.

In exchange and also AA has to pay 2000 cash. So he gives up an old asset with a book value of 10,000, a fair value of 25,000 a it has to pay 2000 cash in exchange for new asset. And this exchange does not have commercial substance while, as when an exchange does not have commercial substance, we'll use the book value approach.

So a is going to record the new debit new. For 12,000 credit, the old for its book value that never changes credit. The old friends book value 10,000 and credit cash. 2000 notice a would simply record the new at the book value of the old 10 plus any cash paid to a would record the new at 12,000. And if there's a game indicated and there is here, there's a huge gain indicated because the old asset has a fair value of 25,000.

There's a big gain indicated, but when there's a gain indicated generally speaking, it's ignored now. I should quickly say that. I say that generally speaking gains were ignored. The exception would be when an exchange is lacking commercial substance and this cash received. You have to be careful of that because cash received is a partial realization of the gain.

So even when an exchange does not have commercial substance, again, normally you just record the new at the book value of the old plus any cash paid. If there's a gain indicated generally you just ignore it. But the exception to that would be. When this cash received is considered to be a partial realization of the gain, even though there's no commercial substance.

So in other words, if 5% of the consideration I'm receiving is in the form of cash. I do have to recognize 5% of the gain indicated, if 12% of my consideration that I'm receiving is in the form of cash, even though there's no commercial substance, I do have to recognize 12% of the game because cash received.

Is a partial realization of the game. So that's the exception, but generally you just record the new at the book value, the old plus in cash pay. And if there's a game indicated, generally speaking, it's ignored. Let me give you another example in an exchange that does not have commercial well, substance Eddie gives up an old asset with a book value of 10,000 and a fair value of 2000 in exchange for new asset.

So AA is giving up an old asset with a book value of 10,000 and a fair value of 2000 in exchange for new assets. What are you going to do? Normally I'd record the new at the book value, the old plus and the cash paid, but not here. Notice in this case, even though there's no commercial substance, I would record the new and its fair value 2000.

That's the fair value of what I gave up. I used the fair value when I'm receiving or the fair value. What I'm sacrificing, whichever is more clearly evident. Notice I'm giving up an old asset. That's only worth 2000. So the new asset must be worth about 2000 notice in this particular case. I'm going to debit the new asset for fair value.

2000. Why? Because there's a loss indicated losses are never ignored. Losses must always be recorded. So in this case, I would debit the new for its fair value. 2000 credit, the old Fritz book value 10,000, that never changes. And I would debit a loss of 8,000 because again, even though there's no commercial, substance losses are never ignored, losses must always be recorded.

So just in case they throw that curve at you, you can't ignore losses. But generally when there's no commercial substance, just record the new at the book value of the old plus and cash paid. And if there's a game, just ignore it. Unless this cash received. That's the exception, 18% of the consideration is cash.

You would have to pick up 18% of the game, even though there's no commercial substance, I'd like you to do 16 and 17 and then come back.

Welcome back. Let's take a look at these questions together. In number 16, bald is exchanging a truck in exchange for shares of base. And they said the exchange does have commercial substance. And as I've been saying, I think the FAR CPA Exam will make that quite clear. And the point is when an exchange does have commercial substance, we have to use the fair value approach, which means that if you're bald, you should record the investment in ACE at its fair value.

How do we get the fair value of investment in eights? We use the fair value of what we're receiving or the fair value of what we're sacrificing. Whichever is more clearly evident. What's more clearly evident. Here is the fair value of what Balt is giving up. Balt is giving up a truck that's worth 3000.

So we have to infer that Balt must be receiving 3000 in value. So bald is going to debit investment in ACE for its fair value, 3000 credit, the truck for its book value. Twenty-five hundred and credit gain on exchange 500, because we know when an exchange does have commercial substance, we recognize gains or losses whatever's indicated by the exchange.

So when they ask at the bottom, what amount would bought report as investment at ACE, it would be answer a 3000 and notice the book value of Aisha shares. That's not the same thing as fair value. So we wouldn't go by the book value. Those shares now are best. Our best estimate of the fair value of that stock is looking at the fair value of the truck.

They gave up book value of the shares. Wouldn't be adequate in this sort of analysis in number 17 in an exchange that does have commercial substance Bay traded equipment with an original cost of a hundred thousand, the accumulated depreciation of 44 similar equipment. By the way, it doesn't matter whether it's similar or dissimilar.

That's not the determining factor. What's the determining factor commercial substance. And they said this exchange does have commercial substance and notice the new equipment does have a fair value of 120,000 and they want to know the carrying value of the equipment received. We know very quickly that if the exchange does have commercial substance, Then they should use the fair value approach, which means that they should record the new equipment at its fair value.

How do I get the fair value of the new equipment? Use the fair value of what I'm receiving or the fair value? What I'm sacrificing, whichever is more clearly evident. What is clearly evident here is the fair value. What is receiving? This is much easier. They said the fair value of the new equipment is 120,000.

We know the fair value what they is receiving. So they would debit the new equipment for its fair value, 120,000 Emmy answer. Is D when an exchange has commercial substance use the fair value approach record the new asset at its fair value and recognize gains or losses whatever's indicated by the exchange.

Now, you know that when you talk about fixed assets, Inevitably, what you have to talk about is depreciation. And I want to go through all the depreciation methods that you have to know for the exam, and I'm even going to cover the basic ones. Because I worry a little bit about salvage value. I've just noticed that when students mess up on the basic methods, it tends to be on salvage.

So let's pay particular attention to what methods back out, salvage, what methods ignore salvage. So I'll just give you a very simple example. Let's say a company goes out, buys a machine for $20,000. They estimate the risk, some salvage of 5,000. They estimate the useful life of the machine is five years.

And they also estimate the machine will produce 15,000 units over its life, trying to make the numbers very simple. Now the most basic method of course is straight line. I know you're not going to mess up on straight line, but just to say it straight line would back out salvage in straight line, you would take the original cost of the machine 20,000.

Yes. You would take out the salvage of five. So that's $15,000 over five straight line years, in straight line you would take $3,000 depreciation every year for five years. Now productive output depreciation. Sometimes they call it the units of production method in the productive output method of depreciation.

We're going to take the original cost of the machine 20,000. Yes, we do. Back out the salvage, some students aren't sure. So we would back out the salvage of 5,000. So that would be $15,000 and we would divide by the 15,000 units. We estimate the machine will produce over its life and what we do in this method.

It's take a dollar of depreciation for every unit produced that's productive output depreciation. And again, just make sure it's clear. Yes, we do take out salvage in productive output depreciation. Now I want to get into accelerated methods of depreciation. Now, with accelerated methods, we're going to take more depreciation in the early years of a fixed asset life and less depreciation in the later years of a fixed asset life.

I'm sure you know that essentially what depreciation is a method of allocation. It's a method of allocating the cost of a fixed asset to all the accounting periods that'll benefit from that fixed asset. That's what depreciation is. It's a method of allocation. It's a method of allocating the cost of a fixed asset to all the accounting periods that will benefit from that fixed asset.

And as I say, with accelerated methods, We're going to take more depreciation in the early years of a fixed asset life and less depreciation. In the later years of a fixed asset life, let's start with some of the year's digits. We'll use the same machine that I've been using. What if we depreciate this machine under some of the year's digits?

Remember in some of the year's digits, what we do is add up the digits of the useful life. In my example, the machine has an estimated life of five years. So we would add up one plus two plus three plus four plus five. But remember, there's a shortcut to that. But you haven't seen it in a long time.

The shortcut to adding them digits is N times. And plus one over two and times and plus one over two. So if it's a five-year life, five times five plus one, five times six is 30. Over two is 15. If it's a 10 year life, 10 times 11 is 110. Over two is 55. If it's a seven year life, seven times eight is 56.

Over two is 28. It's really quick. So we add up the digits one through five, they add up to 15 and. In some of these digits, the first year we're going to take five fifteenths. And then the second year we're going to take four 15 and then the third year we're going to take three fifteens, then two fifteens, then one 15th of what.

20,000 or 15,000. And it is 15,000 in some of the year's digits. We do take out the salvage. A lot of students mess that up, but we do take out salvage. So in the first year, we'll take five, 15 to 15,000 or $5,000 of depreciation. Second year we'll take four, 15, so 15,000 or 4,000 of depreciation and so forth.

And so on. Now, the method we're going to look at is double declining balance. Now with double declining balance. The name of the method really says literally what has to be done. It means literally what it says. It is literally double the straight line rate times and ever declining balance. It is double the straight line rate times and ever declining balance.

So using the same machine. If it's a five-year life, what's the straight line rate one fifth every year or 20%. We're going to double that to 40% times 20,000. This is the method where you wouldn't back out the salvage. So in year one, we're going to take $8,000 depreciation. How about year two in year two, it would still be 40%, but the balance has declined.

Now you take the original cost of the machine 20,000 minus the accumulated depreciation, 8,000. Now the carrying value, the machine is 12,000 times 40%. So when you're two, we would take 4,800 of depreciation. Now be careful this method, you don't back out salvage, but when you get to salvage, you stop be careful there.

This is the method where you don't back out the salvage, but you only depreciate down to salvage. When you get to salvage, you stop. Remember that another method, the FAR CPA Exam likes same machine. 150% declining balance. Now with 150% declining balance, it's one and a half times the straight line rate times of declining balance.

So using the same machine, what's the straight line rate? The estimated life is five years. So the straight line rate is one fifth every year or 20%, one and a half times. That is 30% times, 20,000 notice in these declining balance method. We don't back out the salvage. So in year one we would take $6,000 depreciation in year two.

It would still be 30%, but the balance has declined because the original cost of the machine is 20,000 minus the accumulated depreciation of 6,000. Now the carrying value of the machine is 14,000 times 30%. So when you're two. We would take 4,200 of depreciation and here again, we ignore salvage, but when we get to salvage, we stop salvage.

Isn't backed out in the calculation, but we only depreciate down to salvage. We know under gap, you can't knowingly depreciate below salvage. So we don't take salvage out in the calculation. But when we get to salvage, we do stop. I'd like you to try 18 and 19 and then come back.

Jack let's do these questions together. And number 18, we're talking about Spiro corporation that use the sum of the year's digits method of depreciation. For a piece of equipment, they bought January of the current year for 20,000. There is a salvage value for this equipment of 2000. The estimated life is four years and they want to know the carrying value of this equipment at the end of the third year.

So you've got to work it out. So let's work it out. You know what, some of the year's digits we have to add up the digits of the useful life here. It's a four-year life. So we would add up one plus two plus three plus four adds up to 10, or the shortcut four times five is 20. Over two is 10. So in the first year we would take four tenths of what, 20,000 or 18,018,000, because some of the year's digits does take out salvage.

So in the first year we would take $7,200 of depreciation. In the second year, we would take three tenths of. 18,000 or 5,400 of depreciation in the third year, we would take two tents of 18,000 or 3,600 of depreciation. So if you add it up, what is accumulated depreciation by the end of the third year?

It's 7,200 plus 5,400 plus 30 616,200. If you take the original cost of that equipment, 20,000 minus the accumulated depreciation 16 to. The carrying value of that equipment. By the end of the third year, under some of the year's digits would be answered C 3,800. In number 19, we're told that rye purchased a machine with a four year life.

That's the estimated life. They estimate there's a 10% salvage value and they bought the machine for $80,000 in the current year, January one of the current year. In the income statement for the third year, what would be depreciation expense under double declining balance? Here again, we know that when you see double declining balance, the name of the method tells you really what you have to do.

It means literally what it says. Double the straight line rate times never declining balance. We know the straight line, right? If it's a four year life, the straight line rate would be one fourth every year. Double declining balance. We doubled that to two fourths or 50%. So a straight line rate would be one fourth every year or 25%.

We're going to double it to 50%. So in year one, we would take 50% times 80,000. You don't take out salvage. As in these declined balance approaches, you don't back out salvage. So you would just take 50% of 80,000 in year one. You would take 40,000 of depreciation. How about year two in year two?

It's still 50%. But the balance has declined. Take the original cost of the machine, 80,000 minus the accumulated depreciation 40,000 now value of the Shane is 40,000 times 50%. So in the second year we would take 20,000 of depreciation. But they're asking about the third year, what happens in the third year.

It's still 50%, but what's. The balanced declined to what's. The carrying value of the machine will, the original cost was 80,000 minus 40,000 of depreciation for the first year 20,000 depreciation for the second year, the 60,000 of accumulated depreciation. So now the carrying value of the machine is 20,000 times 50%.

We would take answer B 10,000 of depreciation for the third year, which is what they wanted.

Now I have to assume that straight line productive output depreciation, some of the year's digits, double declining balance, 150% declining balance depreciation. I have to assume that you no doubt have seen all those methods before, but the last. Depreciation method we're going to look at, might be new to you could be.

What I want to get into next is group and composite depreciation. Let me give you some definitions. First of all, understand that some companies in order to save bookkeeping costs, that's why they do this to save bookkeeping costs. They don't appreciate individual assets. They depreciate groups of assets.

Now group depreciation is a grouping of similar assets. So you would group delivery trucks into a group depreciate the group that is group depreciation. It is a grouping of similar assets. You group delivery trucks into a group and appreciate the group come posit. Depreciation is a grouping of dissimilar assets.

So with composite depreciation, you would group delivery, trucks, automobiles. And computers into a group and appreciate the group that's composite appreciation. Now make no mistake about this. All the numbers are the same. All the calculations are the same with group and composite depreciation, but you just have to know that the only difference between group and composite depreciation is that group depreciation is a grouping of similar assets.

Composite depreciation is a grouping of dissimilar assets. All the calculations are the same to show you the sort of calculations. That you have to make in group and composite depreciation. Let's go to a question. Let's go to number 20. Number 20 says a schedule of machinery owned by Leicester is presented below notice machine a costs 550,000 with an estimated salvage of 50,000 and an estimated life of 20 years.

Machine B. Cost 200,000 with 20,000 of salvage and a useful life of 15 years. Machine C costs, 40,000, no salvage with a useful life of five years. It says Leicester computes depreciation on the straight line method, based on the information presented, what is composite life? What they're asking you for here is the group life or the composite life.

All right. Now, listen to me carefully. With group and composite depreciation. I don't care what they ask you for. You always start the same way. You always start by calculating the straight line depreciation for each asset in the group. Again, all we start by calculating the straight line depreciation for each asset in the group.

So let's do that. I take machine a cost 550,000 back out the 50,000 salvage. That's what? That's 500,000 over 20 straight line years. Let's agree that in straight line we would take $25,000 depreciation every year. Machine B cost 200,000 with 20,000 salvage. That's 180,000 over 15 straight line years.

Let's agree that in straight line, we would take $12,000 depreciation every year, and then finally machine safe. Costs 40,000, no salvage over five straight line years in straight line, we would take $8,000 depreciation every year. Now you add it up. If I add up 25,000 plus 12,000 plus 8,000, notice the total straight line depreciation for all the assets in the group, 45,000.

See you need that number. I don't care what they ask you for. You have to have that number. And the fact is that the total straight line depreciation for all the assets in the group. 45,000. Now let's answer the question. They want to know the group life or the composite life. Here's how you do it. If you go back to the schedule, add up the cost of all the assets, I'm going to add up five 50 plus 200 plus 40.

Draw a line under that 40,000. Notice the total cost of all the assets in the group. 790,000. Now draw a line under salvage. Notice the total salvage value. Add up 50 plus 20, the total salvage value for all the assets in the group adds up to 70,000. Here's how you work out the group life or the composite life.

Take the total cost of all the assets in the group. 790,000 minus the total salvage value for all the assets in the group. 70,000. What is that? That's 720,000 and divide by 45,000 divide by the total straight line depreciation for all the assets in the group and your group life or your composite life.

His answer be 16 years. That's the group life or the composite life. They could ask you for that. Now, one more thing. Same problem. What if they wanted the group rate or the composite rate? I'm just trying to show you everything they could ask for here. What if they had the same problem and they wanted the group rate or the composite rate listen carefully.

If they want the group rate or the composite rate, you start the same way you need that 45,000. You're going to have you have, you're going to have to figure out the total straight line depreciation for all the assets in the group, 45,000. So you would take that 45,000 and divide by the total cost of all the assets.

790,000, not seven 20. Don't back out salvage here. Why? Because salvage is already reflected in the 45,000. You don't want to double count it. So you still need though, the total straight line depreciation for all the assets in the group, 45,000. Divided by the total cost of all the assets in the group seven 90 and the group rate comes out to 0.05, six, nine.

They could ask you for that. That's the group rate or the composite rate. Remember I said that companies use these methods to save bookkeeping costs and you see why it saves bookkeeping. How does this company get their depreciation expense for the year? They just go to the computer. Look at the cost of all the assets in the group, multiply by 0.05, six, nine.

That's the depreciation expense for the year. That's a bookkeeping, right? You just go to the computer, just look at the total cost of all the assets in the group multiplied by 0.05, six, nine, the group rate. And that is the depreciation expense for the year. And of course, periodically you adjust the rate.

If there's been any material changes. Now, one more thing. What happens. In group or composite depreciation. If you sell an asset out of the group, let me give you an example. Let's say a company uses group or composite depreciation, and they take an asset out of the group that costs 10,000. And they sell it for 3000.

So we have a company uses group or composite depreciation, and they take an asset out of the group that costs 10,000. They sell it for 3000. What are you going to do? They're going to debit cash 3000. That's what they collected. And we know they're going to credit the asset for 10,000. Now the entry doesn't balance, I need a $7,000 debit to balance the entry out.

What do I do? I just debit accumulated depreciation, 7,000. And I want you to listen to me, it's an important point because in these methods, we're not depreciating individual assets. We won't have a carrying value for an individual asset. Again, because of these methods, we're not depreciating individual assets.

We don't have a carrying value for an individual asset. So in these methods, there's never any gain or loss from the sale of an asset. I'll say it again because of these methods. We're not depreciating individual assets. We're not going to have a carrying value for an individual asset. So when these methods there's never any gain a loss from the sale of an asset.

And does that save bookkeeping? Look at question number 21. See if it makes sense. 21 says when equipment is retired, look at the entry that we just went through. Debit cash, 3000 credit, the asset 10 debit accumulated depreciation, 7,000. That would be a retirement. When equipment is retired, accumulated depreciation is debited.

In my example, for 7,000, that would be for the original cost. 10 less, any residual recovery three. That's true. Under either approach, group or composite. Yes. Under both answer D would be double. Yes. I hope that question makes sense to you. Now we're done with depreciation. We're done with fixed assets and now I want to move on to something else.

What I want to get into next is research and development costs. Let me give you the bottom line. The bottom line. Is this any item? That is defined as a research and development cost. And I'll give you some definitions in a moment, but the bottom line is that any item that is defined as a research and development cost must be expensed as incurred.

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

Companies are not allowed to defer R and D costs. No R and D costs must be expensed as they are incurred. Let me give you some definitions and I'm going to mention some definitions because once in a while, the FAR CPA Exam gets picky. Every now. And then in a question you really have to, you really have to know what research is, what development is.

So let's talk about it. Research is a critical investigation. It is a critical investigation aimed at the discovery of a new product or a new process, or even the improvement of an old product. Or an old process. And I'll say that again, but I want you to notice how broad it is. Research. It's a critical investigation aimed at the discovery of a new product or even a new process, or even the improvement of an old product or an old process.

It's very broad what's development is taking that research, taking new knowledge and translating it. Into a plan or a design or a prototype. That's the development phase, that's development, taking new knowledge, taking research, and then translating it into a plan or a design or a prototype.

Now you can already see that this isn't a tough area. We know that any item that is defined as a research and development cost, we know the definitions. I asked to be expensed as incurred companies are not allowed to capitalize R and D costs. Companies are not allowed to defer R and D costs.

They must be expensed as their incurred. Now, one little tricky thing you have to be careful about. You'll see that one way. the FAR CPA Exam is always tested. This is in a multiple choice. They love to give you a list of costs. And have you pick out the research and development costs? They do that a lot. You'll see a multiple choice.

There'll be a list of costs and they want you to pick out the research development costs and what they could put into a list of costs would be this. Bob has people you might see in a list of costs, set up costs, preparing for actual production. What if you saw that in the list set up costs, preparing for actual production?

Is that R and D? No, it's not. And I want to give you a little tip here. Just remember this point. Once a company is doing anything related to the actual production of the product. I'll say it again. Once a company is doing anything related to the actual production of the product, even setting up, preparing for the actual production of the product by definition, they are no longer in research and development for that product.

See, that's the cutoff point. And I just think it's good to know that for an exam. That's where it cuts off. See, once a company is doing anything. Related to the actual production of the product. Now, even setting up, preparing for the actual production of the product by definition, they are no longer in research and development for that product.

That's exactly where it cuts off. And as I say, I just think in an exam, it's just good to know. Where does it cut off now? One more little tricky thing. Be careful of any R and D costs that has quote, alternative future uses. You have to be careful of any R and D costs. That has alternative future uses.

I'll give you an example. Here's the classic case. Let's say a company buys a laboratory building for research and development. We have a company, they buy a laboratory building for research and development. I think you can agree with me that something like a laboratory building will probably not be consumed.

In the current R and D project, something like a laboratory building probably has alternative future uses. So here's the point, even though the lab was built for R and D the lab would be capitalized and only the depreciation expense on the lab would be part of R and D costs for the year. Hope that makes sense to you.

Something like a laboratory building is probably not going to be consumed within the current R and D project. Something like a lab. Probably has alternative future uses. So even though the lab, it was built for R and D the lab does get capitalized and only the depreciation expense on the lab.

Would it be part of your R and D costs for that year and remember, same thing with machinery, same thing with equipment, normally things like laboratory buildings, machinery equipment, normally. These items have alternative future uses. And when they have alternative future uses, they do get capitalized and only the depreciation expense on those items would be part of your R and D expense for that year.

So just watch out for that. That can be a little tricky, try a couple of questions, please. Please do 22 and 23 and then come back.

In number 22, we have a classic sort of multiple choice that they would ask on research and development where they say at the bottom, in the year end income statement. What would Cody report as R and D expense? What is your. Research and development expense. We have a list to go through. How about the design of tools, jigs, molds, and dyes involving new technology?

Yeah. That's development. That's what development is taking new knowledge, new technology, and then translating it into a plan, a design, a prototype in this case tools, jigs molds dies. It's exactly what development is. How about modification? Formulation of a new process? Yeah. Research.

Research is broad enough to encompass the creation of a new process. The improvement of an old process research is broad enough to pick that up. How about troubleshooting in connection with breakdowns during commercial production? No. No. If you're in commercial production by definition, you're no longer in R and D for that product.

How about adaption of existing capability? To a particular customer's needs as part of continuing commercial activity. No, if it's part of continuing commercial activity, it's not R and D. So your research development expense for the year would be the 125,000 plus the 160,000 answer D number 23.

Again, they want to know which of the following would be research and development costs. It's not D market research. How about C? How about research and development performed under contract for others? That's their R and D. If you're doing research and development for others on contract that's their research and development.

It's revenue for you. It's not your research development costs. Offshore oil expo exploration is defined oil. That's the cost of developing more oil Wells. That's not develop a new product or a new process, the improvement of an old product, old process. That's not research and development answer a development or improvement of techniques and processes.

Research is broad enough to pick that up. And the answer is a.

Let's talk about intangible assets. And I think, when we say intangible assets, we're talking about copyrights, patents, trademarks, Goodwill, as an intangible, a franchise. Is an intangible. A leasehold improvement would be an intangible secret formulas would be an intangible. These are your basic intangible assets, copyrights, patents, trademarks, Goodwill, a franchise leasehold improvements, secret formulas.

As I say, these are your basic intangible assets. Now with intangibles, there are a couple of areas of the FAR CPA Exam likes to get into first. They could ask you what costs. Do you capitalize for a copyright for a patent for trademark? I'm trying to make my points broad because the FAR CPA Exam is very broad on this.

That is the broad question. What costs do we capitalize for an intangible? If they ask you that, watch out for three things, what costs do we capitalize for an intangible? Number one, we capitalize purchase price. In other words, if I purchase your copyright. For $8 million. I capitalize the 8 million.

If I purchase your trademark for a hundred million dollars, I capitalize the a hundred million. I do capitalize purchase price. Also, number two, we capitalize legal and other fees, legal and other fees to register a copyright, a patent, a trademark. Again, I'm trying to make my, my, my notes broad here. We're going to capitalize.

Number two, legal and other fees to register a copyright, a patent, a trademark, whatever it is. And then don't forget number three, because the FAR CPA Exam likes it. Number three, we also capitalize legal fees in successful defense. We capitalize number three legal fees in successful defense of a copyright, a patent or trademark, whatever it is.

What if the defense is unsuccessful? I think, if the defense is unsuccessful, we expense the legal fees, right? If the defense is unsuccessful, we expense the legal fees. And we also write off the patent because we no longer have legal rights to it. And the FAR CPA Exam is asked that, Hey, if the defense is unsuccessful, not only would you expense the legal fees, but you'd also write off the patent because you no longer have legal rights to it.

But we do capitalize legal fees in successful defense of a copyright, a patent or trademark, whatever it might be. Now, another point, please remember. On the other hand, there's only one thing we capitalize for Goodwill. Only one thing gets capitalized as Goodwill. Goodwill is what a company is willing to pay over fair market value to acquire another company's net assets.

That's what Goodwill is. Only one thing gets capitalized to a Goodwill account. Goodwill by definition is what a company is willing to pay over fair market value to acquire another company's net asset. That's what Goodwill represents is when a company is willing to pay over fair market value, not over book value, over fair market value to acquire another company's net assets.

That's the only thing that goes to a Goodwill account. Now be careful the FAR CPA Exam will throw junk at you on this. They'll say a company in cursed incurs costs to develop Goodwill. Restore their Goodwill in the community, maintain their Goodwill in the community, enhance their Goodwill in the community. the FAR CPA Exam loves to give you all this junk where they'll say a company incurs costs too, to develop Goodwill in the community, restore their Goodwill in the community, enhance their Goodwill in the community.

What do you do with costs like that? They're expensed as they're incurred. So if a company encourages costs to develop Goodwill, re meet re maintain Goodwill, enhance Goodwill, restore, Goodwill costs like that are expenses. They're incurred. I say again, the only thing you capitalize to Goodwill is what a company is willing to pay over a fair market value to acquire another company's net assets.

Now, inevitably, when you talk about intangibles, we have to talk about amortization. How do we amortize intangibles while you have to remember. That intangibles fall into two broad categories. Don't forget this two broad categories of intangibles. First category. There are intangibles with finite useful lives.

That's category. Number one, there are intangibles with finite useful lives, a copyright, a leasehold improvement, a patent. There are intangibles with finite useful lives and here's the point. If a company has an intangible with a finite useful life, they must amortize that intangible over their best estimate of that useful life.

If a company has an intangible with a finite useful life, they must amortize that intangible over their best estimate of the useful life. And to come up with that best estimate of useful life, you have to consider legal requirements. Regulatory requirements business needs, but that's the bottom line. If you have an intangible with a finite useful life, a copyright, a leasehold improvement, you must amortize that intangible over your best estimate of the useful life.

And to come up with that best estimate of useful life, consider legal requirements, regulatory requirements, business needs. If your best estimate of useful life is 114 years use was 114 years. Now the second category, there are intangibles with an indefinite useful life category. Number two, there are intangibles with an indefinite useful life.

Goodwill is the classic case. Goodwill is an intangible with an indefinite useful life. A trademark usually has an indefinite useful life. And here's the point. If a company has an intangible. With an indefinite useful life. It's not amortized. It's not advertised. It's tested for impairment at least annually.

So one more time. If a company has an intangible with an indefinite useful life, Goodwill is the big one. A trademark it's not advertised. It's not advertised. It's tested for impairment at least annually. And the basic test for impairment is basically this. If the carrying value on the books, For the Goodwill for the trademark.

If the carrying value on the books is greater than its fair value. If the carrying value on the books is greater than the fair value it's impaired. So you debit a loss, take a loss to the income statement and credit Goodwill, right? Goodwill down to fair value. That's the entry that you make. You test it for impairment, at least annually.

I'd like you to try number 24 and come back.

Welcome back in number 24, we're talking about a patent and they say at the bottom, what I'm out with Jay report as the patent net of any accumulated amortization? The first question is would there be amortization on this patent? Yes, because it's an intangible with a finite useful life. So this intangible would be amortized because after all a patent, isn't intangible with a finite useful life.

Now, a couple of things you have to think about here, what would you capitalize for the patent? You're going to pick up the $34,000 of legal and other costs to register the patent. Pick up that 34,000, that would be capitalized to the patent account. How about the hundred and 36,000 of.

Research and development costs that led directly to this patent is not what they said. They incurred 136,000 of research and development costs that led directly to this patent. You can trace those research and development costs directly to this patent. Would you capitalize that or expensive? Expensive?

Don't let them talk you into something. R and D costs are expensed as they're incurred. So don't want to talk even if, even though they said, yeah, but these R and D costs led directly to this patent. It doesn't change the fact that R and D costs are expensed as they're encouraged. So let's agree. All we're going to capitalize to the patent account is the 34,000 of costs to register the patent.

Now, how many years are we going to amortize this over? Are we going to amortize over the 20 years? That's the legal life or 10 years the economic life. That's right. 10 years, the period of economic benefit. It doesn't matter that it has a legal life of 20 years all week about is the period of economic benefit.

We amortize an intangible with a finite useful life over our best estimate of its useful life. And our best estimate of its useful life in this case would be the period that the company is going to get economic benefit, which would be 10 years. So I'm going to take that 34,000 divided by 10 straight line years.

What is that? That's 3000. 400 of amortization for a full year on the patent. Do I want a full year? No, because the patent was granted on July one. We're at December 30, one only six months have gone by take a half a year's amortization, which is 1700. So when they asked me at the bottom, what would they report is the patent net of accumulated amortization.

It would be the. Cost capitalized for the patent 34,000 minus the accumulated amortization, which would just be 1700. I have to use amortization. The answer is a carrying value of that. Patent is now 32,300. In number 25, J bond bought a piece of equipment for research and development. And the basic facts are that the equipment has a useful life of 10 years.

But the R and D projects going to go for five years and they're asking you at the bottom, what would you expense for this equipment? Let's cut right to the chase. What's going to come down to B vs C if you think we should appreciate that equipment over the life of the project, which is five years, you pick answer B you'd expense one fifth every year.

But if you think you should expense that equipment over the life of the equipment, It's answer's C expense one 10th every year. What do you think? B or C? I hope you with me. It's neither. It's neither. Why? Cause they said something else. I hope you noticed it. They said towards the bottom, the equipment can be used only for this project.

Notice that line, the equipment can be used only for this project. When they say that the equipment can only be used for this project. That's their way of telling you there's no, what. There are no alternative future uses. If the equipment can only be used for this project, there are no alternative future uses.

And the point is, if there are no alternative, future uses you expense a hundred percent year one like any other R and D costs. And the answer is a remember, the only exception is alternative. Future uses. When a cost does have alternative future uses, we can capitalize it and depreciate it. But if there are no alternative future uses that you would expense a hundred percent year one, like any other R and D costs, it doesn't fall into that exception.

And the answer is a, I've got to ask you this. What if they said the equipment does have alternative future uses? What if they threw that in? What if they said the equipment does have alternative future uses now, would it be B or C? It would be answers C we would depreciate over the life of the equipment.

One 10th every year, because we're going to use the equipment way beyond the five-year project, right over its whole 10 year life of the equipment. So it would be answered. See if it did have alternative future uses, but because the equipment can only be used for this project, there are no alternative future uses.

We expense a hundred percent year one like any other R and D costs. And that's why it is answer a please do 26 and 27 and then come back.

welcome back. And number 26, they say on June 30th, union purchased Goodwill of 125,000. When they acquired the net assets of apex. Remember that's what Goodwill it's w what's what you're willing to pay over. Fair market value. To acquire another company's net assets. So when acquiring apex and acquiring the net assets of apex, they've purchased Goodwill of 125,000, then they say during the year union incurred additional costs to develop Goodwill by training employees, that's expensed as incurred, hiring additional employees expense as it's incurred.

Union's December 31 balance sheet would report Goodwill of answer D 125,000. That's the only thing you bring to a Goodwill account. What a company is willing to pay over fair market value for another company's net assets. All those other costs would be expensed as incurred. In number 27, we're dealing with a leasehold improvement on December one of the current year Clark leased office space for five years, the monthly rental is 60,000.

They paid the following. They want to know what the current year expense relating to the office space would be. The current year's expense would only be for December one month. Notice they paid the first month's rent 60,000. We pick that up. That was the rent for December. How about the last month's rent?

No, that's prepaid rent. That won't be expensed till the last month. That's on the balance sheet is prepaid rent. That's not red expense. The security deposit. Notice it's refundable at the end of the lease. That's a receivable, that's not rent expense. And then the installation of new walls and offices.

That's a lease hold improvement. It's an intangible asset. We capitalize it and amortize it over the 60 months of the lease. It's a five-year lease 60 months. That's a leasehold improvement. Take that 360,000 divided by the 60 months in the lease, we're going to take $6,000 of amortization on the leasehold improvement.

Add that to the 60,000 for December's rent. The rent for December would be 66,000. Answer B.

In 28, 29 and 30. What we're dealing with is software that you're developing to be sold as a product. Now, this isn't software you're using as an application, for payroll, something like that. No, this is software. You're going to Mark it as a product. And I want to do these questions with you because this is a couple of quirky things about software that your marketing is a product.

If you go to 28 and 29, 28 says during the year Pitt incurred costs to develop and produce a low-risk computer software product as follows notice they had. Cost to complete a detailed program design $13,000 costs incurred for coding and testing to establish technical feasibility. You might want to bracket the 13,000 and the 10,000 together.

That's all research and development costs. That's how software costs that you're developing as a product, get handled. All the costs you incur until you actually establish technical feasibility is research and development. It's expensed as incurred. I'll say it again, all the costs you incurred until you establish technical feasibility until you actually have something that's feasible.

All those costs are just purely speculative. They are just research and development costs expensed as incurred. So as I say, you might want to bracket the 13,000, the 10,000, just right next to it. R and D. Now, once you've established. Technical feasibility, then you're in a different phase. They say they have other coding after you might want to circle the word.

After establishing technical feasibility, other testing after you've established technical feasibility, the cost of producing. Product matters masters and training manuals that 24,000, that 20,000 and the 15,000 bracket, those three numbers together. That's your capitalized software costs. I'll say it again, all the costs you incur until you establish technical feasibility until you have something that's feasible.

All that's research and development gets expensed as incurred. But then once you've established technical feasibility, you're in a different phase. Other coding after you've established technical feasibility, other testing after you've established technical feasibility, producing product masters training manuals, that phase the 24,000 to 20,000 and the 15,000 that 59,000.

That's what you'd capitalize on your balance sheet as capitalized software. So in number 28, they want to know what would be capitalized software. The answer is C 59,000. Now the last two items, duplication costs and packaging, the 25,000 and the nine that goes to inventory. So duplication costs, packaging costs that goes to inventory.

So that answers number 29. What goes to inventory? The 25 and the nine. 34,000. So you just have those three distinct phases until you establish technical feasibility. It's all research and development. It's all purely speculative. Once you've established technical feasibility, then you have all the coding of the testing.

That's your capitalized software. And then duplication costs, packaging that goes to inventory. And then finally, number 30, they say on December 31 bid had capitalized software. So it's given that they have capitalized software for a new computer software product with an economic life of five years sales for year two, with 30% of the expected total sales.

And they want to know at the bottom, what percentage of the original capitalized software would be reported? At the net amount on the December 31 year two balance sheet. Notice if I use straight line, I've got my capitalized software, that's a given, I've got my capitalized software on the balance sheet.

They said the economic life was five years. So if I use the straight line approach, I would amortize one fifth every year or 20%. So in that in year two, I would amortize 20%. So what would be left on the balance sheet is answer C 80%. Hope you see that. If I use a straight line approach here, They said the economic life is five years.

So in straight line, I would advertise one fifth every year or 20%. So what would be left on the balance sheet for capitalized software would be a hundred percent minus 20% or 80% answer C. Now the other approach is to use the percentage of sales approach since they developed, since they generated 30% of the sales they expect to get from that product in year two, in the percentage of sales approach, I would advertise 30% of the software costs.

So if I advertise 30% of the software costs what's left on the balance sheet is a hundred percent minus 30%, or answer a 70%. And here's the rule of thumb. You look at the straight line percentage, look at the percentage of sales approach, take the larger of the two. That's what they let you do with capitalized software.

In terms of amortization, you look at the straight line percentage, look at the percentage of sales approach whatever percent is larger, that's what you would take. And they do that because. Trying to try to estimate the life of software's very tough. Sometimes that's very speculative as things get old and out of date very quickly.

So if in year one, you've generated 30% of the sales you expect to ever receive from that product. They'll let you amortize. 30% of the costs was left on the balance sheet is 70% just remember to take the larger of the two. So the answer is a that's what's on the balance sheet now 70%, and then they throw in the net realizable value.

Is 90%. The only reason that would be relevant is if it was very low, if they said net realizable value was 50%, you'd have to write down to 50% because if all you're ever going to net out of the product is 50%. You can't have it on your balance sheet at 70%, you'd be overstating it. So that's how that would work in.

So that's what they're just trying to throw you off there. But if they said all you're ever going to net from the product is 50%. That's its net realizable value will then you can't have it on the balance sheet at 80% or 70%, you'd be overstating. It you'd have to write it down to 50%. I don't think the FAR CPA Exam would do that.

I think they're much more interested in you knowing that basic rule of thumb, that when you're amortizing capitalized software costs, look at the straight line percentage. Look at the percentage of sales approach. Take the larger of the two. And that's why, again, in this question, The answer is a, and that's the last question we're going to do in this FAR CPA Exam Review course.

I just want to finish by wishing you the best of luck on the FAR CPA Exam from all of us at the bisque review. Do a good job on the exam. Best of luck on the test.

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Hello and welcome to the 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 class. And in this FAR CPA Review course, we're going to be covering two major topics, the accounting for leases, and also the accounting for pensions.

Before we begin, I want to mention that the best way to use this class is to treat it like any other class, try to avoid just sitting back passively, watching the class, be an active participant. Take good notes. Later in FAR CPA Review course when we do problems, the best thing to do is shut FAR CPA Review course down, work on the problems, get your answers before you come back and we discuss the problem together.

I think you'll find that if you do those simple things, you get much more out of this class and it's what we both want. So with that said, let's get started.

Let's begin with the accounting for leases. And I think, that the basic issue with any lease is simply this. If I'm a lessee and I signed a lease, the issue is am I using that lease? To just rent the property. Am I just renting or am I using that lease in substance to purchase the asset? That's the issue.

Let's get some terminology down. If I'm a lessee and I signed a lease and I'm using that lease to adjust rent the property. If I'm just renting, we call that an operating lease. But if I'm using that lease. In substance to purchase the asset, we call that a capital lease. Now it's the same idea on the lesser side.

And remember in the CPA exam with leases, they could have questions on the lessee side or the less or side. And it's the same idea on the less sore side. If I'm a West whore and I signed a lease. If I'm using that lease to just rent out my property. If I'm just renting out my property, we call that an operating lease.

But if I'm a lessor and I signed a lease and I'm using that lease in substance to sell the property, if in substance, the lease is a way to sell the property. Then there are two possibilities for the less or. It could be a sales type lease, or it could be a direct financing type lease. Those are your different possibilities.

Let's start with the easiest part of this and that is operating leases.

As I said, if I'm a lessee and I signed a lease and I'm using that lease to adjust rent the property, we know we, we call that an operating lease. And if I'm just renting the property, what it simply means. Is that all the lease payments that I make will be debited to rent expense. It really is that simple.

I'm a lessee. I signed an operating lease. I'm just renting the property. So all the lease payments I make will be debited to rent expense. Now, how could they complicate this? Just give you something to look out for. Watch out. On even rental payments, be careful of uneven rental payments. I'll give you an example.

Let's say I'm a lessee. I signed an operating lease and the lease payments are going to be 10,000 every year for 10 years, 10,000 every year for 10 years. But to get me to sign the lease, the less order says, Bob. The first two years rent or free, we'll think about it. If the first two years rent or free, what do I end up paying?

I end up paying 10,000 every year. For eight years, I pay $80,000 for 10 years rent take 80,000 divided by 10. My rent expense for year one is $8,000. Not zero. Don't forget that on even rental payments are still incurred evenly. It doesn't matter how you pay it. You incur it evenly. You know what I'm saying?

Fundamentally, if you get a question on an operating lease, it's all about a cruel accounting set, same idea on the less sore side, if I'm sore and I signed an operating lease, I'm just using that lease to rent out my property. So all the lease payments I collect. I'll credit to rental income. It really is that simple.

I'm a less, or I have an operating lease. I'm just renting out my property. So all the lease payments I collect will be credited to rental income and they can do the same thing here. Watch out for uneven receipts. I'll get, I'll use the same numbers. I'm a lessor. I signed an operating lease. The lease payments are going to be 10,000 every year for 10 years, but to get the lessee to sign the lease, I say the first two years rent or freight.

If the first two years rent are free, what do I end up collecting? I ended up collecting 10,000 every year. For eight years, I collect $80,000 for 10 years rent take 80,000 divided by 10. What I earned in year one is $8,000. Not zero. Don't forget that on. Even receipts are still earned evenly. It doesn't matter how you collect it.

You earn it evenly, right? Let's go back to the lessee side. Let's think about some basic things they could throw into a problem on an operating lease for a lessee. Now, as we know, we're going to have to watch out for dates. We know that on even rental payments are incurred evenly. What else could they throw in?

What if the lessee pays prepaid rent? If the lessee pays prepaid rent, remember prepaid rent is an asset. It's not expense to the proper period. Another one. What if the lessee pays a non-returnable deposit? If the lessee pays a nonreturnable deposit, you set up an asset and you advertise it to rent expense over the term of the lease.

It's non-returnable. So if the lessee pays a non returnable deposit, then the less you should set up an asset and advertise that to rent expense over the term of the lease. What if the less he pays a returnable deposit? If it's returnable, the lessee would set up an asset, a receivable don't advertise it.

It's returnable. They're going to get it back. So we'll just set up an asset or a receivable and don't amortize it. What if the lessee pays an initial direct cost, like a finder's fee, if the lessee. Pays an initial direct costs like a finder's fee. They should set up an asset and advertise it to expense over the term of the lease.

One more thing. What if the lessee makes a leasehold improvement? Be careful if you see a leasehold improvement, remember a leasehold improvement is capitalized and advertised. Over the useful life to meet the lessee again at lease hold improvement gets capitalized and advertised over the useful life.

To me, the lessee, I'll give you a quick example. Let's say that I have an operating lease on my office building and I'm the lessee. And I put in brand new hardwood floors. Now the hardwood floors have a useful life of a hundred years. My lease runs out in four years and I'm going to leave the building.

What am I going to do with those hardwood floors? We know it's a leasehold improvement. I'd capitalize it. And I would advertise those hardwood floors over how many years, a hundred years, or for the useful life. To me, that's the remaining period of my lease. And I intend to leave the building.

So it's over the useful life. To me, not the useful life of the floors. Let's go to the last source side. What are some things that could throw into. An operating lease question on the West source side. Again, always watch out for dates, as we've already said, watch out for uneven receipts. If you are the less or uneven receipts are still earned evenly, what if the less or what if the less sore collects rent in advance?

If the less or collect rent in advance, that's a liability. If you're less often you collect rent in advance. That's a liability. It's not revenue rental revenue to the proper period. What if you're a lesser and you collect a non returnable deposit. If you collect a non-returnable deposit, you set up a liability and you advertise it to rental income over the term of the lease.

What if you're the lessor and you collect our returnable deposit? Will, if it's returnable set up a liability, a payable, don't amortize it. Cause you're going to have to pay it back. What if the less, or has an initial direct cost, like a finder's fee? What if the lessor pays some sort of initial direct costs, like a finder's fee?

That they should set up an asset and amortize it to expense over the term of the lease. As I said, fundamentally, you're in that exam, you get a problem on an operating lease. It's all about a cruel accounting. I'd like you to try some operating lease questions. And your viewers guide. I'd like you to do questions one, two, and three.

And as I suggested earlier, shut FAR CPA Review course down, work on those three questions, get your answers and then come back.

Welcome back. Let's do these questions together in number one, we know it's not reading least. Because they say it. So that settles that and notice we're on the lessee side. So what do we know? We know if you're a lessee, you signed an operating lease, all the lease payments that you make will get debit at the rent expense.

And that's what they want to know when this question what's the rent expense for the year? We're going to pick up the annual rent of 96,000. How about that? $24,000 bonus that park had to pay? That's an initial direct cost. Isn't it? That bonus would be an example of an initial direct cost.

So what park would do is set up an asset and advertise that over the 10 year term of the lease. So I'm going to take that 24,000 divided by 10 we'll pick up 2,400 of that. And then don't forget, there's that extra 5% penalty we agreed in the lease that if our sales ever exceeded 500,000, we'd have to pay a 5% premium.

And notice that the sales were 600,000 were a hundred thousand over that threshold times 5%. That 5,000 is also part of this year's rent. So just add it up 96,000 plus 2,400 plus 5,000. The rent expense for this year would be answers C 103,400. In number two. Notice once again, we know it's an operating lease because.

They state that it is. And notice we're on the less oral side. So what do we know? We know if you're a less or you signed an operating lease, you're just renting out your property. So all the lease payments that you collect will be credited to rental income, and that's what they want to know. They want to know the rental income for the year.

Notice that the rental income for the first year is $8,000, but to get the person to sign the lease. We said the first six months are free. So if the first six months are free, what they're going to collect in the first year of the lease is not 8,000. It's 4,000. And then in years, two, three, four, and five, they're going to collect 12,500 each year, another 50,000.

So if you have the less, or you're going to collect in total $54,000 for five years rent, so take 54,000 divided by five. What you earned in the first year is the answer C. 10,800, because we know on even receipts are still earned evenly. It doesn't matter how you collect it. You earn it evenly in the third question again, we're told it's an operating lease and we're on the lesser side, renders the less, or, and again, we start by knowing that if you're a less or you signed an operating lease, you're just renting out your property.

So all the lease payments you collect. Will be credited to rental income. And that's what they want to know. What's the rental income for the year? The lease payment we're going to collect every year is 50,000, but they're asking for the net rental income for the year, we're going to have to back out our expenses.

What are our expenses? We'll obviously you're going to back out the $12,000 depreciation. You're going to back out the $9,000 for property taxes, insurance. And how about that finder's fee of 15,000. You know what that is? That's an initial direct cost. And if the less, or has an initial direct cost, like a finder's fee of 15,000, they set up an asset and amortize it over the term at least 10 year lease.

So divide by 10 we'll advertise 1500 to this year. So add up all the expenses they add up 9,000 plus 12,000 is 21,000 plus 1500 is 22 five. Take your 50,000 rental revenue minus your expenses. 22 five, the net rental income for the year. Answer a 27 five. Now, if you, with me on those questions, you can see that operating leases again are fundamentally about a cruel accounting, but now we're going to get into something a little bit more complicated, and that is a capital lease.

I'm going to start on the lessee side. I'll get to the less sore side later, but we know if you're a lessee and you sign a lease and you're using that lease in substance to purchase the asset. If in substance, the lease is a way to purchase the asset. We call that a capital lease. Now here's the first thing that comes up in the exam.

When you're in the exam, how do you know that you have a capital lease? How do you know that in substance, the lease is a way to purchase the asset? There's some criteria and you're going to have to know it. Let's go over the criteria. The lessee has a capital lease. If any one of four criteria are met anyone, number one, if there's a transfer of ownership, always look for that either during the Leafs or at the end of the lease.

Does the ownership of the asset transfer from the lessor to the lessee always watch for that? Is there a Trent, is there a transfer of ownership or number two, is there a bargain purchase option? In other words, either during the lease or at the end of the lease? Does the lessee have the option to purchase the asset at a bargain price?

Is there a bargain purchase option or number three is the term of the lease equal to, or greater than 75% of the remaining life of the asset is determined the lease equal to or greater than 75% of the remaining life of the asset, or one more, or is the present value of the lease payment. Is the present value at lease payments equal to, or greater than 90% of the fair value of the asset.

If any one of those four criteria are met, the lessee has a capital lease in substance. The lease is a way to purchase the asset. Now let me just state the obvious. There's no way you can win the FAR CPA Exam and not know that criteria cold as you're going to see in this FAR CPA Review course. You have to know that criteria to break down multiple choice, to work out any problem on leases, you have to have that criteria in your mind.

So I'm going to give you a memory tool. Just remember to bop 75 92 bop, 75 90. It's a fast way to remember the criteria. Let's go over what it stands for the TL. Hey, is there a transfer of ownership? Either during the lease or at the end of the lease, does the ownership of the asset transfer from the West or to the lessee or number two, is there a bop?

Is there a bop? Is there a bargain purchase option or what's 75 is determined the lease equal to, or granted that notice equal to, or greater than 75% of the remaining life of the asset or 90, at 90 means is the present value of the lease payments is the present value of the lease payments equal to.

Or greater than notice, equal to, or greater than 90% of the fair value of the asset. Any one of those four criteria are met. It is a capital lease. Now, once you get that criteria down, now we're ready to approach a problem. Let's go. And your viewers guy to illustrate a problem. Number one.

And illustrated problem. Number one, they say that Alessi signs, a lease contract, which transfers ownership January one, year one, I would circle transfers ownership and right above it, Tio, what do we already know? We already know what's a capital lease. That's how you take the exam. When you're in the exam, you're always thinking to pop 75 92 bop, 75 90.

We know if any, one of those four criteria are met, it is a capital lease. There's a transfer of ownership that settles it. It is a capital lease. Then they go on to say that the minimum lease payments, the MLP, the minimum lease payments are going to be $10,000 every year for five years. And notice the first payment is due December 31.

Let's pause here. Let's talk about something for a moment. You always have to remember that a lease contract represents an annuity. You know what an annuity is, it's a series of equal periodic payments over a specified number of periods. We know that at least contract always represented annuity in that it is a series of equal periodic payments over a specified number of periods.

And I bring this up because. When you see an annuity as we have here, you have to remember that there are two types of annuities. Let's go over. The first type of annuity is called an ordinary annuity or a deferred annuity or an annuity and arrears. Just remember that with an ordinary annuity, the equal payments are made at the end of every period.

In other words, the end of every month, the end of every quarter, the end of every year, that's what makes an ordinary annuity. When the equal payments were made at the end of every period, the other type of annuity is called an annuity due. Sometimes they call it an annuity in advance. Just remember that with an annuity due or annuity in advance, the equal payments are made at the beginning of every period.

The beginning of every month, the beginning of every quarter, the beginning of every year, that's what makes on annuity do. And I bring this up because. In these least problems, it's going to be critical that you nailed down very quickly. What sort of annuity you're dealing with. It's always going to be an important issue and at least problem, you've got to nail down.

What sort of annuity you're dealing with? How about this problem? What sort of annuity are we dealing with? The lessee signed the lease contract January one. Notice the first payment is due at the end of the first year, December 31. This. Is an ordinary annuity. You have to know that let's read on, they go on to say that the asset has a useful life of eight years with no salvage.

The lessee's incremental borrowing rate is 10%.

Now let's get into the factors. We don't want present value of a dollar. We want present value of an ordinary annuity, five periods of 10%, the factors 3.79. Let's do some entries on January one when the lessee signs this lease. Because as we know it as a capital lease, because we know in substance, the lessee is using the lease to purchase the asset, the West.

He's going to take that factor 3.79 times the equal payments in the lease 10,000. And they're going to debit leased property 37 nine. Notice the lessee is actually debiting a fixed asset. In substance, they purchase this equipment, whatever it is, this machine, this piece of equipment, they own it in substance, it's a purchase.

So the lessee is going to take that factor 3.79 times the equal payments, 10,000 debit lease property, 37,900 and credit lease liability 37 nine. So notice the lessee records a fixed asset at the discounted present value, the payments and the lesson. He records a liability at the discounted present value of the payments.

Let's go ahead a year. Let's say it's now December 31 year one. Here's your thinking? Because the lessee had a balance outstanding in their liability. All three-year one of 37,900 times. The interest rate, 10%, the less has gone to debit interest expense 3,790. What's the credit to cash 10,000. That's what the lease contract says.

The lease contract says that the lessee has to make a $10,000 payment every December 31. So less, he's going to credit cash, 10,000. Notice the entry doesn't balance. They need a debit of 6,000 to 10 to bounce the entry out debit lease liability 6,000 to 10. That's the pay down of principal for the first year.

And let me mention if we did a balance sheet a year ago, that's 6,000 to 10. Would have been the current portion of the lease liability because it's going to be paid off within a year. The rest of the lease liability would be noncurrent. And I want you to know that about lease liabilities. They do get divided up into the current and non-current portions.

Are we done with year one? No, don't forget that in substance, the lessee purchased this asset. They own this equipment. They own this a piece of machinery, whatever it is. Notice I'm looking at that debit. The leased property, 37, nine. They have a fixed asset on the books at 37 nine. Don't forget. They have to depreciate that fixed asset.

Let's say they use straight line depreciation. I don't know if you see the little trouble spot yet or not. Do you see the little troublespot if I'm going to depreciate that machine, that leased property, how many years would I use? What I do appreciate that fixed asset over the five-year term of the lease.

Or the eight year life of the property. I hope you see that wrinkle. A lot of students freeze right there. I have to depreciate the fixed asset, but over how many years, what I use the five-year term of the lease or the eight year life of the asset, there's a rule. There's a rule and you have to know it let's go over it.

The rule is this. If the two are the bopper mat, if there's a transfer of ownership or a bargain purchase option, if the two of the bopper mint. Depreciate over the life of the asset. If the 75 and 90 criteria is met depreciate over the term of the lease, make sure that rule. If the two of the bopper met depreciate over the life of the asset, if the 75 and 90 criteria is met depreciate over the term of the lease.

Now, obviously in this problem, the criteria that was met is a transfer of ownership. So we're going to depreciate over the life of the asset. So if I'm the lessee here, I'm going to take that lease property 37 nine. No salvage. They said there was no salvage. There was salvage. I back it out, no salvage over eight straight line years, the life of the asset because of the transfer of ownership.

And I'm going to debit depreciation expense 4,007 37 50. And I'm going to credit accumulated depreciation 4,737 50. Don't forget to depreciate that fixed asset. A lot of students do. Let's go ahead. Another year. Same problem. Let's say it's now December 31 year two. The first thing we have to do is work out the balance in the liability.

We know that we had a balance in our lease liability when we started of 37,900, but at the end of the first year, we paid off 6,000 to 10 of principal. So that means that the balance that was outstanding in our liability all through year two, $31,690, 31,690 times. The interest rate, 10%. We're going to debit interest expense 3,169, debit interest expense, 3001 69.

What do I credit the cash 10,000? Because that's what the lease contract says. The lease contract requires that we make a $10,000 payment every December 31. So we're going to credit cash 10,000, the entry doesn't balance. I need a debit of 6,008 31 to bounce the entry out. You know what that is?

Debit lease liability 6,008 31. That's the pay down of principal for the second year. It's a plug. Okay. You really get that by getting that entry down. The difference between the interest expense and the payment. That's the pay down a principal. And obviously, if we'd done a balance sheet, if we had done a balance sheet a year ago, that 6,008 31 would have been the current portion of that lease liability, the rest would be noncurrent.

But always remember that lease liabilities do get divided up into their current and non-current portions. Are we done at the end of year two? No, don't forget to depreciate the fixed asset. This is a capital lease in substance. We purchased this equipment. So we're going to take that leased property.

37,900, no salvage over straight line years, the life of the asset, because this is a transfer of ownership and we're going to debit depreciation expense 4,007, 37 50 and credit accumulated depreciation, 4,007 37 50. That adjustment has to be made. Why? Because we illness equipment. We own it. Now it's a capital lease.

In substance, we use the lease to purchase the asset. All right. Now, in a sense that problem was really just to warm you up, get you in the mood. Now let's do another problem. Maybe a little bit more complicated.

Look at illustrator problem. Number two, the lessee signs, the lease January one year one it's a 10 year lease. The M L P the minimum lease payments are going to be 15,000 every year. And the first payment is due notice on the first day, the day we signed the lease, January one, this is an annuity in advance.

This is an annuity due because the equal payments are made at the beginning of every period. The first payment was made the first day of the lease, January one, it's an annuity and advance or an annuity do, as I've said, at least problems. You've got to be able to nail down what sort of annuity you're dealing with.

They say that the asset has a useful life of 15 years, no salvage. Then they say that at the end of the lease, the property has a fair market value of 25,000. But notice the lessee has the option to purchase the asset at a bargain price, 10,000. You know what that is? It's a bomb. Hey, that's a Bob, it's a bargain purchase option.

They have the option to purchase the asset. At the end of the lease at a bargain price. That's a bop. What do we know? What do we know already? It's a capital lease. Cause that's how I take the FAR CPA Exam to bop. 75 92 bop, 75 92, Bob 75 90. That's what you in your head, any one of those criteria are met.

It is a capital lease. So we know that now they go on to play a little game with interest rates. And the FAR CPA Exam does like this. They say that the lessees incremental borrowing rate is 12%, but the less oars rate implicit in the lease is 10% and that's known to the lessee. So you're in the exam. How would you know what interest rate to use the lessee's rate, which is 12% or the less ORs rate, which is 10%?

There's another rule. And you have to know it. Let's go over the rule. I know you'll love these rules, but it's a rule and you have to know it. The rule is we use the less orange rate. Use the rate implicit in the lease. Use the less ORs rate. If it's both, if it's both lower than the lessee's rate and known to the lessee, it's gotta be both lower than the lessee's right.

And known the lessee. That's the rule use the less oars rate, the rate implicit in the lease. When it's both lower than less these rate and known to the lessee has to be both lower and known and notice in this case, the less or his rate, 10% is both lower than the less he's rate 12. And they do know about it.

So we are going to use 10%. That's the interest rate. Let's get our factor. We don't want present value of an ordinary annuity. We want present value of an annuity in advance, 10 periods, 10%. The factor is 6.76. We're going to take that factor. 6.76 times the equal payments in the lease 15,000 that multiplies out to 101,400.

That is the discounted present value of those minimum lease payments 101,400, but I'm not done. What's different in this problem is that there's a bop notice at the end of the lease. The property has a fair value of 25,000, but the lessee has the option to purchase the asset at a bargain price 10,000.

When you're in the exam, you have to assume that's such a bargain. That's such a good deal, but the lessee, no doubt will take advantage of it. Theoretically, that's another 10,000 cash that flows out at the end of the lease. You have to discount that as well. So your job here is to discount all the cash outflows for the lessee.

Even the bop. And as I say that thinking is that's such a good deal. No doubt. The lessee would take advantage of it. So theoretically, that's another 10,000 cash that flows out at the end of the lease. Let's get our factor. Now we want present value of a single dollar, 10 periods of 10%. The factor is 0.38, six.

This is not a stream of payments. It's not an annuity. It's one lump sum, theoretically, that flows out at the end of the lease. So I want present value of a single dollar. 10 periods of 10%, the factors 0.38, six. I'm going to take that factor 0.38, six times the bop 10,000, that discounts the 3008 60. If you add it up the one Oh one four and the 3008 60, the discounted present value of all the cash flows.

All the cash outflows adds up to one Oh five, two 60. So on January one, year one, if I'm the lessee, I'm going to debit lease property in substance. I own this asset. I'm going to debit a fixed asset account, leased property for the discounted present value of all the cash outflows one Oh five, two 60. And I'm going to credit lease liability for the discounted present value of all the cash outflows one Oh five to 60.

What I'm asking you to remember is this bops get capitalized. Don't forget. Bops get capitalized. That's what we're learning here. You see a bop, it gets capitalized. Now when does the lessee make the first $15,000 payment? That's right today, this is an annuity in advance. This is an annuity due.

So the lessee makes the first $15,000 payment right away. So we're going to debit lease liability 15,000 and credit cash. 15,000. I think we can agree that at the first payment was made the first day, it would all be principal. There'd be no interest. It would all be principal, no time has passed. There'd be no interest factor.

So we'll just simply debit lease liability 15,000 and credit cash. 15,000. Now let's go to the end of the year. Now it is December 31 year one. Let's work out the balance in our liability. We know that the lease liability started with a balance of 105,000 to 60, but. This is an annuity in advance. So they made a $15,000 payment the first day it was all principal.

So right away that knocked the liability down to 90,000 to 60. Let's agree that they had a balance outstanding in their liability all through the first year of 90,000 to 60 times, the interest rate, 10%, they're going to debit interest expense 9,000 Oh 29.

What would I credit to cash? What do you think? I have credit to cash? Nothing. My lease contract says I make a $15,000 payment every January one. I'm at December 31 making my accruals. So I would credit interest payable, 9,000 Oh 26. Be careful. There's no payment till January one. We're at December 31 making our cruel.

Am. I done no tone. Forget to depreciate the fixed asset. Remember, this is a capital lease in substance. The lease was used to purchase this equipment, whatever it is, it has to be depreciated. Now let's assume that you straight line. Am I going to depreciate this fixed asset over the 10 year term of the lease or the 15 year life of the asset?

15. Why? Because there's a bop. We know. If the two of the bopper met depreciate over the life of the asset, if the 75 and nine criteria is met depreciate over the term of the lease, what if the, what if more than one criteria is met? What if there's a bop? And also the term of the lease is 75% or more of the life of the asset.

Then you depreciate over the life of the asset. Any time to a bopper men use the life of the asset for depreciation. Even if some other criteria are met, two of the bopper met. You have to depreciate over the life of the asset. Because there's a bop here, we're going to depreciate over the life of the asset.

So we're going to take that leased property. One Oh five to 60, that fixed asset, no salvage. They said there was no salvage. If there was salvage, I back it out divide by 15 straight line years. The useful life of the asset. We're going to debit depreciation expense, 7,000 Oh one seven and credit accumulated depreciation, 7,000 Oh one seven.

Don't forget to depreciate that fixed asset. I know you won't now the next time there'd be an entry, of course would be January one, year two. I'd have to make a lease payment because that's what my lease contract says. Our lease contract says that we have to make a $15,000 payment every January one. So on January one, year two, we're going to credit cash 15,000.

Now we debit that interest payable 9,000 Oh 26 and debit lease liability 5,009 74. That's the paid on a principle for the first year. And that's a plug. The difference between the interest and the payment that's are paid out of principle. And obviously if we'd done a balance sheet a year ago, That 5,009 74 would have been the current portion of our lease liability.

The rest would be noncurrent because we always remember that lease liabilities do get divided up into their current and non-current portions. All right, now let's go to the end of year two, it's now December 31 year two, the first thing we have to do work out the balance in our liability. And I hope you understand this is like a little side calculation that you'd have to do in the FAR CPA Exam and your scrap paper.

You've got to be good at manipulating this liability. So let's work out the balance in our liability. Our liability started January one, year, one at 105,000 to 60, but we made a $15,000 payment right away. It was all principle. So that brought the liability down to 90,000 to 60. And then we paid off 5,009, 74 principal at the end of year one.

So that means the balance that was outstanding. Our liability all through year two. 84,002 86. I'm going to take that liability. 84,002 86 times the interest rate, 10%. We're going to debit interest expense 8,004, 29. It's actually 8,004, 28 60 cents, but I'll just round it. Debit interest expense, 8,004, 29 and credit interest payable, 8,004 29, not cash because there's no payment until January one, because that's what the lease contract says.

The lease contract says that I make a $15,000 payment. Every January one, we're at December 31 making our accruals am I done with year two? Of course not. Don't depreciate the fixed asset. And I know you won't, we in substance have purchased this asset. We own this asset. It has to be depreciated. So I'm going to take that lease property one Oh five to 60, no salvage over 15 straight line years, the life of the property, because there's a bop.

I'm going to debit depreciation expense, 7,000 Oh one seven and credit accumulated depreciation, 7,000 Oh one seven. You never forget to depreciate that fixed asset. When's the next time there'll be an entry. That's right. January one, year three, because that's what my lease contract requires that I make a $15,000 payment every January one.

So on January one, year three I'll credit cash, 15,000. Now I'll debit that interest payable. 8,004 29, the entry doesn't balance. I need a debit of 6,005 71 to bounce the entry out. That would be a debit to lease liability 6,005 71, because that is the paid out of principle for the second year. I hope you're getting more comfortable with the flow.

Now I want to go back. To the first entry that we made in this problem. We know that way back on January one, year one, we had to get the discounted present value of all the cash outflows on the lease, even the bop. And it added up to 105,000 to 60. So what we did originally was debit lease property 105,000 to 60 and credit lease liability, 105,000 to 60.

That's the first entry that we made in this problem. Back on January one year. One. Just want to show you a couple of other wrinkles they can put into these problems. What if in the same problem they had said that the lessee had to pay $3,000 in initial direct costs, say for a finder's fee. If the lessee in this problem had to pay $3,000 in initial direct cost, like a finder's fee instead of debiting lease property one Oh five, two 60.

You would debit lease property one Oh eight, two 60. You'd still credit the liability lease liability one Oh five to 60. And you would credit cash 3000. I want to show you that entry just to make the point that an initial direct cost like a finder's fee would be capitalized. It would be capitalized. Same problem.

What if the problem said that the lessee has to pay $2,000 in annual execratory costs? If you see annual execratory costs, I would always think of it as annual maintenance, same idea. And the point is that annual execratory costs, annual maintenance is not capitalized it's expensive every year. So when you made in this problem, when you made your first payment of 15,000, you would debit the lease liability 15,000 debit, the execratory costs and expense 2000 and credit cash, 17,000.

I just want to make those points that initial direct costs like a finder's fee would be capitalized, but any sort of annual execratory costs, annual maintenance would not be capitalized. It's expensive every year. One more point. What if in the same problem, they said that the asset, the machine, the piece of equipment, it is has a cash price, a fair market value, a cash price of 95,000.

If the FAR CPA Exam told you that the leased property. The asset, the machine, the equipment, whatever it is, has a cash price of 95,000. Then you could not debit leased property one Oh five to 60. You cannot knowingly write an asset above its fair value above its cash price. So if they told you that the asset at a cash price of 95,000, I would debit leased property, not one Oh five, two 60.

I would debit leased property, 95,000 and credit lease liability 95,000 and the rest. The thinking would be, would have to be interest. In other words, in substance, the argument would be that in substance you're paying much more than 10% interest. The rest would have to really be interest because you can't write an asset above its cash price.

Now I'm not saying the FAR CPA Exam would do that a lot, but just another little trick they could throw in. They tell you that the leased property has a cash price of 95,000. Then you can't debit leased property one Oh five, two 60 and credit lease liability one Oh five to 60 because you can't write an asset above its cash price.

No, you really, in that case paying much more than 10% interest, you have at least property 95,000 credit lease liability, 95,000 it's cash price. And the rest would be written off the interest. And as I say, that's not something that exam does a lot, but it is a possible trick they could throw in. So be careful.

Now we've covered a lot of ground. I think it's time to see how you're doing on this. I'd like you to try multiple choice number four, to shut FAR CPA Review course down to number four and then come back.

Welcome back. And number four, if you go to the bottom, they say at inception of the Leafs, clay would record a lease liability of what? So they want to know the balance in the lease liability. And I have a question for you're in the exam. What is the only way that, you have a capital lease that's right to bop 75 92, Bob 75 90.

It's the only way, so let's go through the criteria in this problem. Is there a transfer of ownership? No. Did you notice, they said that at the end of the lease possession of the machine reverts back to Sachs the less or no, there's no transfer of ownership. Is there a bop? Is there a bargain purchase option?

No, they don't say anything about clay having the option to purchase the asset at a bargain price. What's 75 mean he'll be getting used to it. 75 means what is the term of the lease? Equal to, or greater than 75% of the remaining life of the asset. In this problem, what's the term of the lease 10 years.

What's remaining life of the asset. 15 terror, 15 is 66 and two thirds percent. No, the term of the lease is not equal to a greater than 75% of the remaining life of the asset. It's not what's 90 mean is the, what do I look at is the present value of the lease payments. We have to work it out. Let me ask you this, is this an ordinary annuity or annuity?

Do it's an annuity? Do I think I circled the word beginning. They say payments were made at the beginning of each lease year. So we know it's an annuity. Do annuity in advance. Let's get the factor. I want present value of an annuity in advance. 10 periods, 10%. The factor is 6.76. We're going to take that factor 6.76 times the equal payments in the lease.

50,000 notice that the present value, the lease payments in the lease comes out to 338,000. Is that equal to, or greater than 90% of the fair value of the asset? What's the fair value of the asset? 400,000. If you take 338,000 present value, the lease payments over 400,000, the fair value of the asset, it comes out to 84 and a half percent.

No. The present value of lease payments are not equal to, or greater than 90% of the fair value of the asset. Here's my question. If none of the criteria are met, what sort of leases this that's right. It's an operating lease. They just renting the property. There is no lease liability. And the answer is D be careful.

The only way, you have a capital lease is to bop 75 90. And as I say, if none of the criteria are met, it's an operating lease. You're using that lease to just rent the property. It's not a capital lease. There is no lease liability. And the answer is D and one of the lessons you learn in that question is that when you're doing lease questions, anytime you see a zero for an answer that always gets your attention, because if none of the criteria are met, it is zero.

So be careful, try a couple of more, please try five and six and then come back.

Welcome back. Let's do these questions together in number five. If you go to the bottom, once again, they want to know the balance and the lease liability. And as I said before, you're in that exam. The only way, you'll have a capital lease is to bop 75 90. So let's go through it in this problem. Is there a transfer of ownership?

No, the bottom, they said possession of the machine reverts back to Greg the less or no, there's no transfer of ownership. Is there a bop? No, they don't say anything in the problem about Haber the lessee, having the option to purchase the asset at a bargain price. There's no bop let 75 meat is the term of the lease equal to a greater than 75% of the remaining life of the asset.

In this problem, the term of the lease is 10 years. Remaining life of the asset is 12, 10 or 12 is 83%. You can stop right there. It is equal to a greater than 75% of the remaining life of the assets. 83%. It is a capital lease. Let me ask you this. Is this an ordinary annuity or annuity? Do ordinary annuity.

I circled the word end payments made at the end of each lease year. So let's get our factor. I want present value of an annuity and arrears. 10 periods, 10% factor 6.15. I'm going to take that factor 6.15 times the equal payments in the least a hundred thousand. And if I'm Haber the lessee, I'm going to debit leased property, a fixed asset, 615,000.

I'm going to credit lease liability, which is what they wanted for 615,000 answer. Be the discounted present value of all the lease payments because in substance, this lease was a way to purchase that asset. They own the asset, and I know it's a capital asset. Because the 75 criteria was met, number six and number six, we know it's a capital lease because they say it.

And I want to say this to you. If the FAR CPA Exam says this is a capital lease that ends, you don't have to worry about the criteria that ends the issue. It is a capital lease. I don't want you to think that the FAR CPA Exam will say it's a capital lease, but you have to figure out it's not really a capital lease. the FAR CPA Exam is not going to do that.

If the FAR CPA Exam says it's a capital lease, that ends the issue, it's a capital lease. Now we know that the lessee's incremental borrowing rate is 9%. We know present value of an ordinary annuity for nine periods. At 9% spy, 0.6, we got the factor. Now, what are the lease payments? The only tricky thing in this problem was that they said.

That the lease payments are 52,000 every year, but that includes $2,000 of real estate taxes annually. That's not a payment on the lease real estate taxes. Shouldn't be capitalized. The payments on the lease are 52,000. Back out those real estate taxes, 2000. The payments on the lease are 50,000 times that factor 5.6, we're going to debit at least property 280,000 credit lease liability, 280,000.

They wanted the balance in the liability. The answer is a, and then for the real estate taxes every year, you're going to debit real estate tax expense, 2000 and credit cash. 2000. That's like annual execratory costs. These annual costs, annual maintenance, annual execratory costs in this case and your real estate taxes.

The point is they're not payments on the lease. They're not capitalized. They're annual all expenses every year and they should be expensed every year. I'd like you to try seven and eight and then come back.

Welcome back in number seven. They want to know again, the balance in the lease liability. And of course the first question is in number seven, how do we know is a capital lease? Will they say it? They do say it's a capital lease that ends the issue. Not only that we know there's a bop, so we know it is a capital lease.

Let me ask you this in this problem, is it an ordinary annuity or an annuity due to an annuity due? Because they said payments begin immediately. They begin immediately. It is an annuity and advance on annuity. Do here's another issue in this problem when it comes to the interest rate? Should I use Robbins?

The lessee? Should I use Robbins? Incremental borrowing rate of 14% or the less oars rate 1212, because I use the less auras rate, the rate implicit in the lease when it's both lower and known and the less or rate 12% is lower than the lessee's rate 14. And they must know about it because the lease specifies the rate.

So we're going to use 12%. Let's get our factor. We want present value of an annuity due 12%, 10 periods factors, three, 6.3 to eight. I'm going to take that factor 6.3 to eight times the equal payments in the least 10,000, that discounts to 60 3002 80, but we can't stop there because there's a Bob's get capitalized.

They said at the end of the lease the assets going to have a fair market value of 20,000. But Robbins has the option to purchase the asset at a bargain price, 10,000. As we said earlier in this FAR CPA Exam Review course, in the exam, you'll have to assume that's such a bargain. That's such a good deal. That theoretically that's another 10,000 cash that flows out at the end of the lease.

That's another cash outflow, but now we want present value of a single dollar, 10 periods of 12% 0.3 to two. I'm going to take that factor. Point three to two. Times the $10,000 bop that discounts to 3000 to 20, add it all up. The discounted present value of all the cash. Outflows will be 66 five. So if your Robin's the lessee, you're going to debit lease property 66, five and credit what they wanted.

The lease liability 66 five. And the answer is C just remember bops, get capitalized. And let me mention this too. If they said in a lease that the lessee was guaranteeing a residual value. Do you ever see that in a problem that the lessee is guaranteeing a residual value? You treat that like a bop, a guaranteed residual value is the lessee is guaranteeing.

The asset will have a certain value at the end of the lease that guaranteed residual value. You capitalize that a bop it's treated just like a bop number eight.

Once again, they're asking whether or not this is a capital lease. We don't know. We don't know it is a capital lease. All we know is at the bottom. They want to know what East would record as a capitalized asset. There's no zero for an answer, so it must be a capital lease. But how do you know for sure it's a capital lease because the term of the lease 10 years.

Over the remaining life of the asset, 12 years is about 83%. Notice the term of the lease is equal to, or greater than 75% of the remaining life of the assets, actually 83%. So we know what is a capital lease in number eight? Are we dealing with an ordinary annuity or an annuity and advance? If you circle the word beginning, it's an annuity in advance payments made at the beginning of each lease a year.

So we'll get our factor. Present value of an annuity and advanced 10 periods at 14%, the factor is 5.95. You're going to take that factor 5.95 times equal payments in the least 40,000, that discounts the 238,000. Is there a bop? They say that East has the option to purchase the app. The asset, the machine on may one year 16 by paying 50,000, which approximates it's expected.

Fair value on that date. That's not a bop. A bop is you have the option to purchase the asset at a bargain price. No, this option is that at the end of the lease, you have the option to purchase the asset at its fair value. That's a terrific deal. The point is you can't assume they'll take advantage of that option.

They may or may not take advantage of that option. Maybe at that point, they'd rather have a new asset. My point is this only capitalize a purchase option. If it's a bargain purchase option, it has to be a bargain price. When it's a bargain price, we assume that the lessee would take advantage of it, but not just any option to buy.

You only have the option to purchase the asset at its fair value. You can't assume they'll take advantage of that. So the answer is big. They're going to debit a capitalized asset. For 238,000 credit lease liability, 238,000. Answer B. They wanted the value of the capitalized asset. But as I say, you don't just capitalize any purchase option.

It has to be a bargain price, a bargain purchase, option a bop, please do nine and 10 and then come back.

Welcome back. And number nine, they want to know what the depreciation expense would be for the year. And I'm sure you noticed there's a zero for an answer right on top. If none of the criteria are met, it's not a capital lease. It would be an operating lease and an operating lease. There wouldn't be any depreciation expense, and the answer would be zero.

So here's my question. How do you know this is a capital lease? I hope you noticed it. They said title passes. Notice. They said title passes to the lessee. There is a transfer of ownership. It is a capital lease. It is. Now what they capitalize for the asset was 108,000. That must've been the discounted present value of all the cash outflows 108,000.

But here's my question. If I'm going to do depreciation, would I do appreciate that asset over the eight year term of the lease or the 12 year life of the asset? 12, because of the two of the bopper, Matt. If the two of the bopper mat depreciate over the life of the asset, if the 75 and 90 criteria is met depreciate over the term of the lease here what's met is a transfer of ownership.

The Tio is met. We would appreciate it over the life of the asset, which is 12 years. So I take what they capitalize for the asset, 108,000 divided by 12 straight line years. The answer is B 900 of depreciation expense in number 10. Once again, they want to know. The depreciation expense for the year. Now here, we know it's a capital asset because they say it is, there's no zero for an answer anyway, but we know it's capital.

We know it's capital asset. Excuse me. We know it's a capital. Yeah. And there's a bop also. So there's no question. It's a capital lease. Now what they capitalized for the asset was $240,000. And if you read it carefully, that 240,000 included the bop as it should. Bob's get capitalized. If you take that 240,000, should I appreciate that?

Over the eight year life of the asset or the five-year term and the Leafs eight year life of the asset, the two of the bopper meant depreciate over the life of the asset. And there's a Bob. If you take that 240,000, the cost of the asset divided by eight straight line years, you get answers C and answer C is wrong.

But it's tempting. If you pick C I hope you see what you missed salvage value. They said nor estimates that the equipment spare value will be 20,000 at the end of its eight year life. That's salvage value and straight line does back out salvage. So we're going to take what the capitalized for the asset.

240,000 back out the salvage 20,000 that's 220,000. Over eight straight line years. And the answer is D so be careful straight line backs out salvage, and that's really the first time it's come up, please do 11, 12, and 13, and then come back.

welcome back. Let's do these questions together in number 11, if you go to the bottom, they want to know the balance in the lease liability at December 31 year two. And I know that you noticed that answer D is a zero. So you had to think, are we sure it's a capital lease because it all comes back to two bops, 75 90.

And if none of the criteria are met, it's not operating lease. There is no lease liability. The answer wouldn't be D. So that's my question to you. How do you know it's a capital lease? Because in the first sentence they said the term of the lease is for the entire nine year life of the asset. Obviously if the term of the lease is for the entire life of the asset, that's equal to a greater than 75%.

So we know it is a capital lease. We know that. So it's not answered to now another thing you had to think about. Always with a capital lease. Is this an ordinary annuity or annuity and advance? We'll notice in the first sentence they said the $50,000 lease payments are made at the start of the lease term.

They made it immediately, right? The start of the lease December 31 year one, when they signed the lease, they made a $50,000 payment. So obviously if the payments were made at the beginning of every yearly period, right at the start, it is an annuity in advance. It's an annuity due. Another thing I want to ask you.

If we have to work out the balance and the lease liability, December 31 year two. What was your starting point? What was the balance in the liability when you began December 31 year one, was it 316,500 or two 98, five. You got two choices there be three 16, five. Wouldn't it? Because we use the less oars rate, the rate implicit in the lease.

If it's both lower and known and notice that the less, or is rate 12%, excuse me, the less his rate, 10% is both lower than the less ease rate. And Oaks rate is 12. The less or his rate implicit in the lease is 10. It is lower and they say, Oak knows about it. They do know about it. It's both lower and known.

We're going to use the less stores rate 10%. So that means that the liability started December 31 year one. At 316,500. And because it's an annuity in advance, didn't they make their first $50,000 payment immediately on that same day. And if they made it on that same day, it would all be principal. They'd be no interest, no time has passed.

So right away that knocked the liability down to two 66, five, but they want the balance and the liability a year later, December 31 year two, what happens on December 31 year two, they make another $50,000 lease payment, but some of that would be interest. The balance. And that was outstanding in the liability all three year to two 66, five times the interest rate, 10%, 26,006, 50 26,006 50 of that payment would be interest the rest of the $50,000 payment.

20 3003 50 would be a pay down of principal. So we would pay down the liability from two 66, five down 20 3003 50 D to answer bait two 43, one 50. Make sure you're good and comfortable. With manipulating that liability. I basically think of leases as a liability area, even though there are obviously other accounts involved assets and depreciation, other things were involved as well.

But fundamentally I think of capital leases as a liability area because it's so essential that you're comfortable with manipulating that liability. In number 12, they say on January one year, one frost entered into a two year lease. With any company to lease 10 new computers. The term of the lease is two years.

The annual lease payments are 8,000 present value. The lease payments 13,000, which of the following circumstances would require frost to classify this as a capital lease. Again, it's two Bob's 75 90. That's what you're looking for about answer a what if the economic life of the computers is three years?

Well determined at least two years over three, the life of the computers, that's just two thirds, 66 and two thirds percent. It's not the terminal lease is not equal to a greater than 75% of the remaining life of the asset. Just two thirds, 66 and two thirds percent. So that wouldn't do it. What of, how about B?

What if the fair value of the computers on the day you signed? The lease was 14,000. What's 90% of 14,000. 12,600 notice the present value of the lease payments 13,000. They gave you that is greater. It's equal to, or greater here. It's greater

than 90% of the fair value of the asset that would make it automatically a capital lease at the present value. The lease payments 13,000 is equal to a greater than 90% of the fair value of the asset. 90% of. 14,000 is there is 12, six. Yeah. The present value of these payments 13,000 is equal to, or greater than 90% of the fair value of the asset answer.

Be what automatically make it a capital. So the answer is B C said, there's no bargain purchase option. No bop that wouldn't do it. Of course, D ownership is not transfer that. Wouldn't do it. Answer B would do it. And the answer of course is B in number 13. It says on December 31 year six row leased a machine from Colt for five-year period, equal payments under the lease are 105,000, but that included $5,000 in annual execratory costs, annual maintenance.

The payments are due December 30, one of each year. I noticed the first payment was due right away, December 31 year six. It's an annuity and advance on annuity due. They said that the present value of all the lease payments on the day they signed the lease 417,000. Let's do a couple of entries. We know the day they sign the lease, December 31 year six, they would have debit at least property for the discounted present value, at least payments 417,000 and credit at least liability for the discounted present value.

The lease payments 417,000 now, because this is an annuity in advance. They made the first payment right away. So on that same day, December 31 year six, they would have credited cash, 105,000. They would have debit it executor the cost and expense 5,000 and debit lease liability a hundred thousand. So they paid down a hundred thousand, a principal on the first day, right away that brought the lease liability down to 317,000 right away.

Cause it's an annuity in advance. And notice, again, those execratory costs, those annual execratory costs. Those aren't really aren't payments on the lease annual maintenance and your real estate taxes. Things like that are not expensive. Excuse me. Things like that are not capitalized. They're not payments on the lease.

They're expensed every year. So that's why I created the cash 105,000. Debit execratory costs and expense for 5,000 and debit the liability for just a hundred thousand. But my point is now the liability going forward is down to 317,000. We go ahead a year. It's now December 31 year seven, which is what they're asking about.

Didn't they have a balance outstanding in their liability all through year seven of 317,000 times. The interest rate, 10%. They're going to debit interest expense 31,700 credit cash, a hundred thousand. That's the payment on the lease. And debit lease liability 68,300. That's the pay down the principal for that year.

And then they would debit execratory cost 5,000 credit cash, 5,000. That would be expensed every year. Those are all the entries they ask us at the bottom, December 31 year seven. What's the liability now? It was 317,000. We just paid off 68,300 a principal. So the liability is down to answer D two 48, seven.

Now, you may have noticed that up until this point. All we've discussed are leases from the lessee side. Now let's go to the less sore side, because as I mentioned at the beginning of class, sometimes the FAR CPA Exam ask questions on the last or side. Now let's go back to the beginning of class. Remember we said at the beginning of class, if I'm a less or, and I signed a lease, if I'm using that lease to just rent out my property, if I'm just renting out my property, we call that an operating lease.

But if I'm the last sore and I signed a lease and I'm using that lease in substance to sell my property. If in substance, the lease is a sale. Then there are two possibilities for the less, or it could be a sales type lease, or it could be a direct financing type lease. Those are the possibilities for the less are either a sales type lease or a direct financing type lease.

Here's the first thing that you could see in the exam. You're in the exam. How do you know if the less are, has a sale? Here we go. The, or has a sale if it meets all this criteria. First, the two bop, 75 90 criteria has to be met from the Les aura's perspective. So that's number one, the two Bob's 75 90 criteria, which you know, so well must be met from the less oars perspective and collectability of the lease payments, collectability of the MLP minimum lease payments.

Must be reasonably assured. So the two bops 75 90 criteria must be met from the  perspective and collectability of the MLP. The minimum lease payments must be reasonably assured and one more, and there are no material uncertainties regarding any future costs. That's the final piece. There can't be any material uncertainties regarding any future costs.

If the lessor meets all of that criteria in substance, the less, or has a sale in substance, the lease was away for the less sell the property. And then as I said, if in substance it's a sale, then there are two possibilities for the less, or could be a sales type lease, could be a direct financing type lease.

Let's start with a sales type lease. And I want to go back to the problem we did earlier, because we sorta know the numbers. We're going to go back to that illustrator problem. Number one, and you remember the basic facts. The lease was signed January one, year one. It is a five-year lease. The lease payments are 10,000 every year.

It was an ordinary annuity payments made at the end of every year. Now, just to refresh your memory, remember what the lessee did. This we've already covered. The lessee said present value of an ordinary annuity, five periods of 10%. The factor is 3.79. What the lessee did was take that factor 3.79 times the $10,000 of equal payments in the lease and what the lessee did was debit leased property 37,900 and credit lease liability 37,009.

That's what the law that's what the lessee did. Debit leased property 37,900 credit lease liability 37,900 for the discounted present value of all the lease payments. Now let's take the same problem. Since we know the numbers, but let's go to the other side. Now let's say run the less sore side and let's say it is a sales type lease.

So now we're on the less sore side. It is a sales type lease. And also let's assume that the asset has a cost to the less or of $30,000. Those are my assumptions. Same problem. Now with the less sore side, it is a sales type lease. And let's assume that the asset has a cost of the lesser of 30,000. Let me show you the entries that the lessor would make in the same problem.

If I'm the less or in this problem, I know that I'm going to collect five payments of 10,000 each. So I'm going to debit gross, lease receivable 50,000. Again, if I'm the lesser, I know that I'm going to collect five payments of 10,000 each. So I'm going to debit gross, lease receivable 50,000 and notice this.

In a sales type lease. I credit sales, I'm going to credit sales in this case, the 37,900, the discounted present value the payments, or sometimes in the exam. They'll just give you the sales price. So I'm going to say it again. If you're in a sales type lease, you're going to credit sales for the discounted present value, the payments, or sometimes the exam.

We'll just give you the sales price, the cash selling price. We don't know the cash selling price here. So I'm going to credit sales for the discounted present value. The payments 37 nine. But the big point is it's a sales type lease. So I credit sales. If I'm the less sore I'm going to treat this as if I went out and made a sale of 37,900, and I'm going to create a discount 12,100.

Now we're going to make another entry. We said that the asset has a cost to the lesser of 30,000. So now they make a second entry where they debit cost of goods sold 30,000 and credit the asset 30,000. That's the second entry debit cost of goods sold 30,000 credit, the asset 30,000. Those are the entries that you would make in a sales type lease.

So with those entries in mind, what could the FAR CPA Exam ask you? A couple of questions they could ask you in a sales type lease. What is the profit on sale? What's the profit on sale for the less or? If you look at the entries, it's pretty obvious they want the profit on sale. Just take the sales 37, nine minus the cost of goods sold 30,000.

Profit on sale would be 7,900. That's a question they could ask you, sales type place. What is the profit on sale? Just look at the entries. It's obvious. Take the sales 37 nine minus the cost of goods sold. 30,000 profit on sale would be 7,900. Now there's only one thing left that they could get into.

Let's go to that $12,100 discount. All that's left. Is that the less, or we'll take that discount. And amortize it to interest income over the term of the lease. See that's the nature of a sales type lease. There's a profit on sale. And then the less, it makes a little money on financing as they amortize the discount to interest revenue over the term of the lease.

Let's say a year goes by, let's say it's now December 31 year one. How do you work out the interest revenue while the important thing is to work with the net receivable, I'm going to take the grocery saveable, which was. 50,000 minus the discount. 12 one notice the net receivable is 37,900 times.

The interest rate, 10%. We're going to debit discount, 3007 90 and credit interest income, 3007 90. What we've now gone through that is the nature of a sales type lease. That's what happens to the less or. There's a profit on sale. And then they make some money on financing. As they amortize the discount to interest income over the term of the lease, there's a profit on sale.

They make some money on financing. There's a profit on sale. They make some money on financing. And as I say, when you're working out the amortization of the discount, the important thing is to work with the net receivable, taking the groceries. He will 50,000 minus that discount. While one, the net receivable would be 37, nine times the interest rate, 10% debit discount, 3007 90.

Credit interest revenue, 3007 90. I'd like you to try a problem. Please do number 14 and then come back.

Welcome back. And number 14, they say peg leased equipment from how July one year seven. For an eight year period expiring June 30th, year 15 equal payments under the lease 600,000. Every payment is due July one. And notice that the first payment is due July one year seven, the day you sign the lease. So obviously this is an annuity due, always important.

The rate of interest contemplated by pegging, how 10% the cash selling price of the equipment. 3,000,005 20, the cost of the equipment on house books, 2,000,008. They say the lease is appropriately recorded as a sales type lease. And when you're on the less or side, generally the FAR CPA Exam will tell you whether it's a sales type lease or it's a direct financing type lease.

That's one good thing about being on the lesser side. When the FAR CPA Exam has questions on the lesser side, they'll tell you whether it's a sales type lease or it's a direct financing type lease for the less, or here it is a sales type lease. What is the amount of profit on sale and what's the interest revenue that how the less sore would record for the year ended December 31 year seven?

Let's think about a couple of entries. Not that you had to do entries, but I'm hoping that the entries make this clearer on July one year seven. When peg and how enter into this lease, what entry would, how make. How was the less or if you're how you're going to look at this as if over the term of the lease, you're going to collect eight payments of 600,000 each.

So you're going to debit gross lease receivable for 4,000,008 and in a sales type lease, if you're how you're gonna credit sales in this case, but 3 million, five 20, the cash selling price. As I said before, in a sales type lease you credit sales. For either the discounted present value of the payments, or sometimes the FAR CPA Exam will give you the cash selling price here.

They gave you the cash selling price 3 million, five 20. But the important thing is that in a sales type, lease you credit sales in this case for the cash selling price 3 million, five 20, and you would credit discount 1 million, 280,000, and then how it would make a second entry where they debit cost of goods sold.

For the cost of the asset shipped. They said the cost of the asset on house books, 2,000,008. So they would debit cost of goods, sold 2,000,008 and credit the asset 2,000,008. Those are the entries that you make in a sales type lease. Now let's answer some questions in the first call and they want to know what's the profit on sale.

If you look at the entries, it's pretty obvious. Take the sales 3,000,005 20 minus the cost of goods sold 2,000,008. Let's agree that profit on sale would be 720,000. So it has to be a, or B has to be, but they also want the interest income, the interest revenue, because that's all that's it's left for the less or the less, or it takes that discount of one month, 1 million, two 80, and amortize it to interest revenue over the term of the lease.

Let's work it out together. What would happen on December 31 years, seven. Remember I said, the key to working out the interest revenue is to work with the net receivable, but what's a little tricky in this problem is that it is an annuity due on annuity and advance. So what is the net receivable?

The gross receivable when we started 4,000,008, but the lessee would have made a $600,000 payment immediately on the first day. It would all be principled. That'd be no interest. So right away that brought the gross receivable down from 4 million, eight to 4 million, two minus the discount, 1 million, two 80, the net receivable, which is what I have to work with is 2,000,009 20.

That's the net receivable. Now what's the interest rate. It's 10%, but that's for a full year. This is just a happy year. Notice that they signed the lease July one, and they want to know interest revenue, December 31. Just a half a year. So don't use 10% use 5% times 2 million, nine 20, the net receivable.

You're going to debit discount, 146,000 credit interest revenue, 146,000. And that's answer B, as I say, that is the essence of a sales type lease. There's a profit on sale and the less, or it makes a little money on financing as they amortize the discount to interest revenue over the term of the lease.

There's a prophet on sale. They make some money on financing. There's a profit on sale. They make some money on financing by amortizing that discount to interest revenue over the term of the lease.

Now, the second possibility for the less, or when in substance, the lease is a sale is a direct financing type lease. Let's go back to illustrator problem. Number one, once again, since we sorta know those numbers, we're comfortable with those numbers. Let's use those again. Let's assume we're back to illustrator problem.

Number one, we're on the lesser side, and now I'm going to assume for the less, or it is a direct financing type lease. Now listen carefully. There's one big thing to remember about a direct financing type lease. And that is that with a direct financing type lease. There's never, the word is never any gain or loss from the sale of the asset.

There's never with a direct financing type, lease a gain or loss from the sale of the asset. I promise you if illustrated problem. Number one had been a direct financing type lease. The asset would have had a cost to the lessor of 37 nine. Let me show you it's the entries for a direct financing type lease.

If I'm the less or in a direct financing type lease. I know I'm going to collect five lease payments of 55 lease payments of 10,000 each. So I'm going to debit gross, lease receivable 50,000 once again, because I know that I'm going to collect five lease payments of 10,000 each I'm going to debit gross, lease receivable 50,000, but notice this I don't credit sales, it's not a sales type lease.

I just credit the asset for its costs. 37 nine. As I say, if this has been a S if this has been a direct financing type lease, trust me, the asset would have had a cost to the lesser of 37 nine so that when I take the selling price, the discounted present value the payments 37 nine minus the cost of the asset, 37 nine.

There is no gain or loss on sale, but notice getting back to the entry that I don't credit sales, I just take the asset off the books, edit call edits costs 37 nine. And I credit discount 12,100. So you see my point. When you look at the selling price, the discounted present value, the payments 37 nine minus the cost of the asset, 37 nine.

There is no gain or loss on sale. My point is this a company like this makes all their money by amortizing, that discount to interest revenue over the term of the lease. They're a financing agent. They make all their money. By amortizing that discount to interest revenue over the term of the lease. And you know how to do that?

Let's go ahead a year. It's now December 31 year one. Remember you have to work with the net receivables. So I'll take the gross receivable 50,000 minus the discount 12 one. Then the net receivable is 37,900. That's the net receivable times the interest rate, 10%. We'll debit discount, 3007 90 credit interest revenue, 3,790 there a financing agent there's never any gain or loss from the sale of the asset.

They make all their money by amortizing that discount to interest revenue over the term of the lease. As I say, they're a financing agent, that's the whole point of a direct financing type lease. I'd like you to try 15, 16, and 17, and then come back.

Welcome back. And number 15, they tell us that current is the last door and this is a direct financing type lease. As I said earlier, that's one good thing about the exam. When they have problems on the left or side, generally, they'll tell you. If it's a sales type lease or a direct financing type lease for the less or so let's think about the entry that Kern would make current knows that they're going to collect six payments of 10,000 each.

So current is going to debit gross lease receivable for 60,000 and that's all they want to, the answer is say they wanted the balance in the gross lease receivable 60,000, but let's finish the entry in a direct financing type lease. You don't credit sales, you just credit the asset. For its cost, whatever it is in this case, 48,000 and credit discount, 12,000, the whole point of a direct financing type lease is to make the money on the financing, a company like this is going to make all their money by amortizing, that discount to interest revenue over the term of the lease.

They're a financing agent. There's never any gain or loss from the sale of the asset. It's not what they're interested in, but as I say, all they wanted here. Was the balance in the gross lease receivable. And that was answer a 60,000 and notice, I don't need those present value factors. We don't use those at all.

In this case, those were just there to slow you down. So you'd stare at them and go, what do I do with those? We don't need them at all. In number 16, once again, we're told that blade is a less or signs, a direct financing type lease. And what we're told is that. Glade wants to make 8% from the lease payments because that's how they make their money, their financing agent.

They want to make, they want to make a return from the lease. They don't care about any gain or loss on the sale of the asset. They want to make 8% on the lease payments. Now we're told that the present value of an annuity at 8% for five periods is 4.312, but I don't know. What the annual lease payments are going to be, but I know I want them, I want the discounted present value, at least payments to equal the cost of the asset three 23 four, because if the discounted present value of the lease payments equals three 23, four, that's the selling price, illegal the cost of the asset, and there'll be no gain or loss on sale.

That's not what I'm interested in. So I can set up my equation. I can take that factor 4.312 times X, the lease payments, whatever they're going to be. They have to equal the cost of the asset three 23 for now, what ever we do to one side of an equation we do to the other. So I'm going to divide both sides by 4.312 that tells me that the minimum lease payments on the lease have to be 75,000.

If I want to earn 8%. So now I can do the entry for Glade. If I'm Glade, I know that I'm going to collect five payments of 75,000 each. So I'm going to debit gross lease receivable for 375,000. I'm going to credit the asset for its cost three 23 for I just take the asset off the books and it's cost three 23 for I don't credit sales.

It's not a sales type lease. So credit the asset for 323,400 and credit discount, 51,600. And that's the interest revenue I will earn 51 six over the term of the lease. The answer is a cause that's th that's what they're asking. What's the total amount of interest revenue that Glade will earn over the lease.

51 six, the discount, because that's what they'll do. Amortize that discount to interest revenue over the term of the lease. That's the total interest revenue they'll learn, answer a and number 17, it starts off sounding like a problem for the less or on January one of the current year Tel leased equipment from S under a nine year sales type lease.

It is a sales type. The equipment had a cost of 400,000 to the, or, and an estimated useful life of 15 years, semi-annual lease payments of 44,000. Do every January one and every July one, the present value of all the lease payments at 12%, 505,000, which equals the sales price onto the straight line method.

What amount would tell us the less eight. What's the depreciation expense for Tel, what would they recognize the depreciation expense? Think about what Tel would do here. If it's a capital lease for tail and it must be because they want to know depreciation expense, and there's no zero for an answer.

When tell, sign that lease, wouldn't tell debit, lease property for the discounted present value of all the lease payments at 12%, 505,000 and credit lease liability 505,000. That's the entry Taylor would make. Now they want to know the depreciation expense for twin tip for tail. Then the question is that leased property, that's valued at 505,000.

What I do appreciate that over the nine year term of the lease or the 15 year life of the asset. And you may have noticed that if I take that cost of the asset, lease property 505,000 and I divide by nine straight line years determined lease there's no salvage mentioned. If I take that 505,000 divided by nine straight line years, the term of the lease, I get answer date.

But if I take that 505,000 divide by the life of the asset, which is 15 years, I get answer B, it's really going to come down to B versus D. So that's what I'm asking you. Should we depreciate over the term of the lease or the life of the asset? What's the rule? If the two of the bopper met.

Depreciate over the life of the asset. They don't say anything about a transfer of ownership. They don't say anything about a bargain purchase option. The two of the bop aren't met here now, not that we're told about the 75 criteria is the term of the lease equal to a greater than 75% of the remaining life of the asset.

The terminal lease is nine years remaining. Life of the asset is 15 years. That's 60%. No. The term of the lease is not equal to a greater than 75% of the remaining life of the assets. About 60%. It's exactly 60%. How about the 90 criteria is the present value of the lease payments that's 505,000 equal to, or greater than 90% of the fair value of the asset.

It is because they said that the present value, the lease payments equals the cell, the selling price. So the present value lease payment equals a hundred percent of the fair value of the asset. If that's the selling price, And equals a hundred percent of the fair value of the asset. So the two of the bop are not met.

The 90 criteria is met. So I'm going to depreciate over the nine year term of the lease. And the answer is D what I want to get into next is sale. Lease back. But let me say, before I do that, the FAR CPA Exam has a lot more questions on the lessee side for leases. They don't ask. The less sore side is often you can't ignore it.

I want to mention that to you. You can't ignore the less sore side they do test it, but I will say that the FAR CPA Exam tends to hit the lessee side heavier, which is why we've spent more of our class time on the lessee side. But as I started to say, we do have to cover one more thing about leases before we leave the area of leases and that is sale.

Lease back.

In a sale, lease back, a company sells an asset to somebody and then leases the same asset right back from the person that you sold it to. There's a sale, then there's a lease back. That's what's going on. A company sells an asset to somebody and then the company leases the same asset right back from the person.

They just sold it to let me give you an example. Let's say a company takes an asset that has a carrying value, a cost of 80,000, and they sell it to another company for a hundred thousand. So a company is taking an asset that has a cost to the company of 80,000. They sell it to another company for a hundred thousand and then.

They leased the same asset right back from the person. They just sold it to let's start with a sale. I always tell my students that in your mind, when you see, say a lease pack, always remember that there's two distinct transactions, there's a sale. Then there's a lease. There's a sale. Then there's a lease.

There's two separate transactions here. There's a sale. Then there's a lease. There's a sale. Then there's a lease let's deal with the sale. We know when they made the sale, they would debit cash for the selling price, a hundred thousand. Credit the asset for its carrying value 80,000. And obviously we need a $20,000 credit to balance the entry out.

That would be the gain on sale. And here's the point if by leasing the same asset right back from the person who just sold it to, if by leasing that same asset right back, the seller has retained a substantial economic interest in that property. If by leasing the asset back, the seller has retained a substantial economic interest in that property.

We're going to have to credit deferred gain. We can't put that gain on our income statement. If by leasing the asset back, the seller has retained a substantial economic interest in that property. We're not, we can't put that gain on our income statement. We're going to have to credit deferred gain, and I hope you see what's going on here.

Do you see why they did this? Because they think it's all a big sham. Just think about it. I sell you this table at a big game, put the gain on my income statement. And then I lease the same table right back from you. It never leaves the room. They just think it's a big sham. I leased the table to you.

Excuse me. I sell the table to you. Put a big gain on my income statement. Then I leased the same table right back from you. It never leaves the room. They just think it's a big sham. So if by leasing the asset back, The seller has retained a substantial economic interest in that property. They can't put that gain on their income statement.

They're going to have to credit deferred gain. I hope that makes sense to you now, here's the question. How do you know if the seller has retained a substantial economic interest in the property? There's some criteria first. If the term of the Leafs is a large percent of the remaining life of the asset.

If the term of the lease. Is a large percent of the remaining life of the asset. The seller has retained a substantial economic interest in that property. Does the term of the lease have to be equal to, or greater than 75% of the remaining life of the asset? No, that's capitalized criteria. No. All we're saying is determined.

Lease has to be a large percent of the remaining life of the asset. It's not equal to a greater than 75%. That's capitalized criteria. In other words, arguably 60% enough, you're supposed to use judgment, but at the term of the lease is a large percent of the remaining life of the asset. The seller has retained a substantial economic interest in that property or our old friend.

If the present value, the lease payments are equal to, or greater than 90%. If the present value, the lease payments are equal to, or greater than 90% of the fair value of the asset, the seller has retained. A substantial economic interest in that property. And as I said, if the seller has retained a substantial economic interest in that property, they can't put that gain on their income statement.

They're going to have to credit deferred gain. Now what happens to that deferred gain? It gets amortized. See, now there's two possibilities. They lease the debt, they lease the asset back. You're going to amortize that gain against rent expense. If they now set up an operating lease, right? There's two possibilities.

They lease the asset back. You're going to amortize that deferred gain against rent expense. If they set up an operating lease. In other words, every year, you're going to debit defer a gain credit rent, expense, debit, deferred gain credit rent, expense, debit, deferred gain credit rent expense, or you'll amortize that deferred gain against depreciation expense.

If they set up a capital lease. If they set up a capital lease, Daniel amortize that deferred gain against depreciation expense every year. You'll debit defer, gain credit depreciation, expense, debit, deferred gain, credit appreciation expense. So that's what happens. You advertise that deferred game against rent expense.

If they set up an operating lease, you'll amortize that deferred gain against depreciation expense. If they set up a capital lease, please do 18 and 19 and then come back.

Welcome back in number 18, they say in a sale leaseback transaction, the seller who becomes the lessee retains the right to substantially all of the remaining use of the equipment sold notice. They have retained a substantial economic interest in this asset that they've sold. So they say the profit on the sale should be deferred, which is true.

And subsequently advertised by the lessee when the lease is classified as a capital lease. Yes. You want yes. In that column because you'll amortize the deferred gain against depreciation expense and yes. Under operating lease also because you'll amortize the deferred gain to rent expense. Yes. Under both answer D.

19 in a sale leaseback transaction, a gain resulting from the sale should be deferred at the time of the sale. Lease back and advertised. When what statement number one says the seller who becomes a lessee has transferred substantially all of the risks of ownership. No. You would not defer the gain in that case, if the seller who now leases the asset back has transferred substantially all.

Of the risks of ownership. It's a sale. The gain should go right to your income statement. So that's not a true statement, but the second statement is true. If the seller who becomes the lessee retains the right to substantially, all of the remaining use of the property sold the gain should be deferred as and the answer is B I'd like you to try number 20 and come back.

Welcome back in number 20, we're dealing with the sale lease back of equipment. And as I mentioned earlier, anytime you see sale lease back in the exam, it's important to remember that there's a sale and then there's a lease split that in your mind, there's a sale and then there's lease. Let's deal with the sale.

We know when mega makes the sale, mega is going to debit cash for the selling price. 400,000 Meg will credit the equipment for its carrying value 300,000. And obviously we need a hundred thousand dollar credit to bounce the entry out, and that would represent the gain on sale. Now, you know the issue here, anytime you see sale, lease back in that exam, the issue will be, should we defer that gain?

We should, if by leasing the asset back, Mega has retained a substantial economic interest in this property. So that's my question to you. How do we know if Megan has retained a substantial economic interest in this property? If the term of the lease is a large percent of the remaining life of the asset, they've retained a substantial economic interest in this property.

In this problem. What's the term of the lease one year, what's the remaining life of the remaining life of the property 25 years. So no. The term of the lease is not a sub is not a large percent of the remaining life of the asset one over 25 years. No, but the other criteria is the present value lease payments.

They gave you that 36,900. Is that equal to, or greater than 90% of the fair value of the asset? The fair value of the asset is the selling price. 400,000 notice the discounted present value of the payments. The lease payments would be less than 10% of the fair value of the assets. So no. The present value of lease payments are not equal to, or greater than 90% of the fair value of the asset.

They represent less than 10%. So I hope we can agree. Megha did not retain a substantial economic interest in this property. So what's the answer. When they ask at the bottom, what is the deferred gain? It is zero. It is a, that entire gain can go to Megan's income statement. No part of that game would be deferred because they did not retain a substantial economic interest in that property.

Try number 21 and come back.

Welcome back in number 21, we're dealing with a sale. Lease back of an airplane. Let's deal with the sale when park is out and makes the sale park with debit cash. For the selling price, 600,000 park is going to credit the airplane for its carrying value. 100,000 and obviously we need a $500,000 credit to bounce the entry out.

That would be the gain on sale, but we know the issue because Parker now leases the asset back. Has Parker retained a substantial economic interest in this airplane? First of all, is the term of the lease, a large percent of the remaining life of the asset wellness problem. The term of the lease is three years.

The remaining life of the asset is 10 years. No, the term of the lease is not a large percent of the remaining life of the asset. It's not would the present value the lease payments be equal to, or greater than 90% of the fair value of the asset wellness problem. The present value at lease payments, they gave us one 95, 81 over 600,000.

The fair value of the airplane. It's about 32%. No, the present value of lease payments are not equal to a greater than 90% of the fair value of the assets about 32%. So I hope we can agree. Park has not retained a substantial economic interest in this airplane, but we're in a weird area here. What we would call this.

We agree that park has not retained a substantial economic interest. That's true, but what we would call this problem. Is that park has retained more than a minor interest, but less than a major interest. Now you're in this area any time you're more than 10%, less than 90. That's the right. It's a gray area when you're more than 10%, less than 90 now park has retained what we would call more than a minor interest, but less than a major interest.

And here's the point. If the seller who becomes a lessee. Retains more than a minor interest, but less than a major interest, they have to defer the gain up to the present value of the lease payments. They just have to defer the game up to the present value of lease payments. So let's do the entry again.

When Parker makes the sale, Parker's going to debit cash. 600,000. The selling price park is going to credit the airplane for its carrying value. 100,000 and notice I am going to credit defer a gain. One 95, 81. Notice I do defer the gain up to the present value of the lease payments. So I'm going to credit the, for a game one 95, 81.

That's why the answer was B. They wanted the defer a gain and it would be one 95 81. And then notice I just credit a regular game for three Oh nine four 19. The rest of that $500,000 game three Oh nine, four 19 can just go right to my income statement. I only have to defer the gain up to the present value, lease payments.

If I retain more than a minor interest, less than a major interest, that's not a heavily tested point, but with this far into leases, and I thought we should at least look at a problem like that, as I say, not heavily tested, but you should be aware that when you're in that more than 10, less than 90% range on the present value of lease payments.

You are talking about more than a minor interest, less than a major interest being retained. So you should defer the gain, but just up to the present value at lease payments. And as I say in this problem, the rest of the game three Oh nine four 19 three Oh nine, four 19 of the game can go right to your income statement.

We are done with accounting for leases, and now we're going to move on to accounting for pension.

When we're talking about the proper accounting for pensions, it's important to remember that there are two types of pension plans. There are defined contribution plans and there are defined benefit plans. That's what it boils down to. There are defined contribution plans and there are defined benefit plans.

We're going to begin with defined contribution plans. What you will come to think of as the easy one, let's get into it in a defined contribution plan. All that is defined, all that is defined is what the corporation, the employer is obligated to contribute to the plan each year. That's what we mean. By defined contribution plan, where all that is defined is what the company, the employer is obligated to contribute to the plan each year.

Let me give you an example. Let's say a corporation has a defined contribution plan, and let's say this year, the company is obligated to make an $850,000 contribution to the plan. If this year the company is obligated to make an $850,000 contribution to the plan. Then we're going to debit pension expense 850,000.

It really is that simple in a defined contribution plan. Your pension expense for any year will be what the company is obligated to contribute to the plan that year. So we know they're going to debit pension expense, 850,000. Now, assuming they did turn $850,000 cash over to the trustee that administered the fund.

Then we would simply credit cash, 850,000. And we would call that fully funded. Now same example company has a defined contribution plan. This year, the company is obligated to make an $850,000 contribution to the plant. So we know they're going to debit pension expense, 850,000. I'm not going to change that on you in a defined contribution plan, your pension expense in any year.

Is whatever the company is obligated to contribute to the plan that year. But now let's assume they turn only, not only $200,000 cash over to the trustee that administers the fund. So now they credit cash 200,000. Of course now they would be underfunded. It's not really a big deal. You would just credit an underfunded pension liability, credit underfunded pension liability for 650,000 same example.

Company has a defined contribution plan. This year, the company is obligated to make an $850,000 contribution to the plan. So we know they're going to debit pension expense for 850,000. That's not going to change in a defined contribution plan. Your pension expense in any year is whatever the company is obligated to contribute to the plan that year.

But now let's assume instead they turn 950,000 cash over to the trustee. That administers the fund. So now we credit cash 950,000. Of course, in this case, they would be overfunded. It's not a big deal. You would just debit for a hundred thousand, a prepaid pension or an overfunded pension asset for a hundred thousand.

That's the entry that you would make. Now. I want you to look at those three entries. This is very important. This is pension accounting. In a nutshell, I don't care. What kind of plan a company has. What pension accounting always comes down to is this first figure out the expense, get that first. And then in a defined contribution plan, that's easy.

It's whatever the company is obligated to contribute this year. But once you have the expense, you're always back to these three possibilities. Are they fully funded? Are they underfunded or are they overfunded? I just want you to know that you never get away from those three possibilities. So again, that's pension accounting in a nutshell.

Figure out the expense, but once you have that expense, you're always back to those three possibilities. Are they fully funded? Are they underfunded or are they overfunded? That is pension accounting. And when you look at a defined contribution plan, it's a 401k, this is how a corporation accounts for a 401k.

And it's what most of us have. And even though it is what most of us have as a pension plan, If we have one, the FAR CPA Exam does not test defined contribution plans very heavily, in fact, very lightly. So let's get right down to it. If the FAR CPA Exam is going to test you on pensions, what they'll probably hit you on is a defined benefit plan.

In a defined benefit plan. What is defined are the pension benefits that will be paid out at retirement? That is a defined benefit plan. Where what is defined are the pension benefits? The company will pay you at retirement. That is a defined benefit plan. Now in a defined benefit plan, there are six elements that make up your pension expense for the year.

Don't you miss a defined contribution plan already because in a defined benefit plan, there are six elements that make up your pension expense for the year. Let's go over the six elements. The first element is service costs. Service costs is the discounted present value of all the pension benefits earned by your employees.

This period that's service cost, the discounted present value of all the pension benefits earned by your employees. This period, not too bad. Now. Number two, the second element is the hardest one to understand you're going to find that of the six. Number two is a little difficult. It's a little difficult when you first start studying pensions to really get your mind around.

But I think you'll find that we keep working with it in this FAR CPA Review course. You'll just start to feel comfortable with it. You just thought, I didn't know what it is. You just, you work with it enough. It makes sense. Number two is interest on projected benefit obligation. Number two is interest. On projected benefit obligation.

Here's what's going on. What a company does is they do a projection notice. This is called projected benefit obligations. What a company does is they do a projection, they project out their total obligation for pension benefits into the future. And it's a difficult calculation because you have to project out retirement ages, years of service.

Future salary levels. It's a very complicated calculation because you're projecting out your total obligation for pension benefits into the future. And as I say, it's complicated because you have to project out future salary levels, retirement ages, project out years of service it's complex. What the company has done is they have discounted that obligation back to January one, but now it's December 31 and that obligation has grown.

Just a little bit, because a year has gone by interest on projected benefit obligations, interest on PBO. Now you're going to find, as we go through these, some of these are always a plus always in addition to your pension expense, some are a minus and of course that's a big, that's a big part of the exam.

So you want to remember that service cost, the present value of all the pension benefits earned by your employees, this period, always a plus. Always an addition to your pension expense for the year interest on PBO, always a plus always an addition to your pension expense for the year. Number three, third element is the actual return on plan assets.

What's going to happen every year. The company is going to turn cash over to the trustee that administered the fund. They make investments. And the point is the better those investments do. That's good for us. That lowers our pitch, our pension expense for the year. So that's a minus. So again, every year you turn cash over to a trustee that administers the fund.

They make investments the better those investments do that lowers your pension expense for the year. That's a minus the actual return on plan assets. Number four is amortization of prior service costs. Now just think for a minute, what is prior service costs? Let the words help. You should be able to figure it out.

Prior service cost is the discounted present value of all the pension benefits earned by your employees. In years before we had a plan notice prior service costs, Hey, that's the present value of all the pension benefits earned by our employees in years before we had a plan prior service costs. And what we're going to do is advertise.

Some of that prior service costs as one of our six elements. It's a plus it's an addition to your pension expense for the year. Number five is actuarial gain a loss. You bring an actuaries, you can have a gain, a loss because of actuarial changes. People are living longer. People are retiring later.

You can have a gain, a loss just because of actuarial changes. Now, you know that you don't have to be an actuary to take the CPA exam. The example I have to give you this, but what you have to remember is that if you've had an actuarial gain, that's good for you lowers your pension expense for the year.

If you've had an actuary loss, that's bad for you increases your pension expense for the year. And then finally, number six, transition asset transition obligation. The year you begin. A defined benefit plan. The year you start a defined benefit plan. If you're overfunded, if you're initially overfunded, we would call that a transition asset.

If you're initially underfunded, when you start to play it, we call that a transition obligation. That's bad for you. So if you have a transition obligation, That's bad for you. That's going to be a plus on addition to your pension expense for the year. If you have a transition asset, that's good for you.

It lowers your expense for the year. That's a minus, and those are the six elements that make up your pension expense in a defined benefit plan. Now, just to say the obvious you have to know those elements cold, you're not going to be able to do a multiple choice or any kind of problem. On a defined benefit plan.

If you don't know those six elements. So I'm going to give you a memory tool to remember the six elements. Just remember surpass S I R P a T. If you remember, sir, Pat, you've got the six elements, let's go over it. The S you know what that is? It's service costs, and you know what that is. Hey, that's the present value of all the pension benefits earned by my employees.

This. Period service costs always a plus always an addition to your pension expense for the year. I, as the hard one interest on PBO interest on projected benefit obligation, let's go through it again. The company does a projection. They project out their total obligation for pension benefits into the future.

What they did is discount that obligation back to January one, but now it's December 31 a year has passed. So that obligation would grow just a little bit because a year has gone by. See that obligation gets bigger and bigger. As people get closer and closer to retirement interest on PBO, always a plus always an addition to your pension expense for the year.

The R is return on plan assets. Every year you turn cash over to the trustee that administers the fund. They make investments the better those investments. Do that return on plan assets. That's a minus lowers your expense for the year. The P prior service cost amortization. You know what prior service cost is?

Hey, that's the present value of all the pension benefits earned by your employees in years before you had a plan prior service costs, we're going to give employees credit for those years. We're going to advertise some of that. Prior service cost is one of our six elements. It's a plus it's an addition to your pension expense for the year, a actuarial gain a loss.

You bring an actuary. If you've had an actuarial game, that's good for you. Lowers your expense for the year. Actuary loss is bad for you. Increases your pension expense for the year. And then finally the T transition asset transition obligation. When you start a defined benefit plan, if you're overfunded, if you're initially overfunded, we would call that a transition asset.

I transitioned assets. Good for you. Lowers your expense for the year. If you're initially underfunded. You'll have a transition obligation. That's bad for you increases your expense for the year. If sir, Pat, you've got the six elements and as you're going to see, that's a huge part of the battle.

Once you get those six elements down, this isn't really that bad at all. I think we're ready to try a problem. Let's go in your viewers guide and look at the illustrator problem on a defined benefit plan.

In the illustrated pension problem, we can see that they started the plan January 1st year one, and then they funded a million dollars cash over to the trustee, December 31 year one. They also tell us that the unrecognized or the unamortized prior service costs as of January, first of year, one was born in 80,000.

Now, you know what that prior service cost represents, Hey, that's the present value of all the pension benefits earned by our employees in years before we had a plan prior service costs. And we have a note here on where that Ford and 80,000 came from. We're assuming that. The average remaining service period for those employees 12 years.

And the way we got the four to 80,000, you'll notice we're expecting that we're going to have to pay those people $2 million worth of benefits. And we took a present value of a dollar at 12 years. Why 12 years? Because that's the average remaining service period for these employees at a 10% discount rate or settlement rate, the factor was 0.2, four.

So I took that factor time, point to four times the total benefits we're eventually going to have to pay these people in the future to a million. And that's where we got the Ford in 80,000. And let me show you the entry for that. The entry for the prior service costs would have been a debit to OCI 480,000 and a credit to underfunded pension liability, 480,000.

That's the first entry we would've made. Debit OCI 480,000 credit underfunded pension liability, 480,000. We're also told that the year one service costs 400 and $400,000. That's the present value pension benefits earned by our employees, this period 400,000. Now our job in this problem is to work out the pension expense for the year and to December 31 year one.

So dates are always important. That's where we are now. It's December 31 year one. How do we work out the pension expense for the year? The way I feel about it, anytime you have to work out the pension expense in the defined benefit plan, you're thinking S I R P a T, sir, Pat, let's go through the elements.

The S of course the service costs present value of all the pension benefits earned by our employees. This period, we know that's 400,000. Next the I it's the hard one interest on PDO interest on projected benefit obligation. Now I want you to listen to me carefully. Don't get confused here the day you start a pension plan.

Just think about this for a minute. The day you start a plan January 1st year one. What is your only obligation for benefits prior service cost? I want you to see that. That the day you start a plan, your only obligation for benefits is prior service costs. Nobody's earned anything else. So I'd like us to agree that the day you start a plan prior service costs and projected benefit obligation are one in the same hope that makes sense to you.

Cause the day we start the plan, our only obligation for benefits is prior service cost nobody's earned anything else. So the day you started planning prior service costs and projected benefit obligation are one in the same. All right. So think what happened here. We did a projection, right? We projected out our total obligation for benefits into the future.

And we're expecting in the future to pay these people $2 million worth of benefits. What we did is discount that obligation back to January one year one came out to Ford and 80,000, but now it's December 31 year, one a year has passed. And at a 10% discount rate, multiply that Ford and 80,000 by 10%, our obligation has increased 48,000 just because of the passage of time, just because a year has gone by interest on PBO, always a plus always on addition your pension expense for the year.

Now, the next element are. Return on plan assets. Didn't we give the trustee a million dollars cash, but that was not until December 31 year one at the end of the year. So there's been no return on plan assets. They haven't earned anything yet. So that's nothing. How about prior service costs amortization?

Our prior service cost is 480,000. We know that the average remaining service period for those employees is 12 years. So I'm going to take that forward and 80,000 over 12 straight line years, it's just a straight line calculation based on the average remaining service period for these employees.

And notice I put another 40,000, it's a plus in addition to my pension expense for the year amortization, the prior service caused a actuarial gain a loss. I'm going to assume there's none. And I will say that's something you have to get used to in the exam. You have to deal with the elements they give you.

Not all six elements have to be there. Apparently there is no actuarial gain or loss, transition, asset transition obligation. I'm assuming there's none. If you add it all up, it all adds up to 488,000. We're going to debit pension expense 488,000. See that's what surpass does for you. It gets you the pension expense in a defined benefit plan.

So we're going to debit pension expense, 488,000. We're going to credit cash a million. That's the funding. We turned a million dollars cash over to the trustee, December 31 year one. So we're going to credit cash for the funding. A million notice were overfunded. So what do we do? When we recorded it, our price, our prior service costs.

Didn't we debit OCI for an 80,000 credit underfunded pension liability, 480,000. Right now we had before this entry, an underfunded pension liability of 480,000. Now we funded it. So now I debit that underfunded pension liability, 480,000. It's now it's been funded and now I need a debit to balance the entry out.

That is my overfunded pension asset, 32,000. That's the entry that we would make. To record the pension expense for year one. Notice once again, that what sir Pat does for you is get you the expense, but then you're always back to the three possibilities we talked about earlier. Are they fully funded? Are they overfunded?

They underfunded here. They were overfunded. So we got rid of that underfunded pension liability and set up an overfunded pension asset, basically a prepaid pension of 32,000. Let's go ahead. Another year.

Let's go to the end of year two. It's now December 31 year two. Notice we funded another 475,800 to the trustee, December 31 year two. The tooth that the year two service costs 425,000. And we're going to assume that pension assets are earning 10%. We're just going to make an assumption that all my pension assets are earning 10%.

So where are we? It is now December 31 year two. We have to work out the pension expense for the year and the way I feel about this, anytime my students have to work out. The pension expense in a defined benefit plan. They're always thinking, sir, Pat S I R P a T. So we listed down and let's put a date over that.

What's the date on this? It's December 31 year two. That's where we are. We've got to work out the pension expense at December 31 year two. Now, before we do, sir, Pat, there's another calculation we have to do first. You'll notice that we have a little schedule there to work out the balance in PBO. Let's work out the balance.

In our projected benefit obligation. What was the balance in the projected benefit obligation? January one, year one, 480,000, because as we said, the day, you start a plan projected benefit obligation, and prior service cost are one and the same. So here's what you had to think about during year one. What increased that obligation?

Don't forget interest on PDL. Don't forget that obligation would have grown by 48,000, just because a year goes by. Also your service costs for year one, all the pension benefits earned by your employees in year one, 400,000. Didn't that increase your obligation. All the pension benefits earned by your employees in year one that would have increased your obligation.

So add that and then if they pay out any benefits, notice that would be a minus. If they pay out any benefits, there were none here. There were none, but at the payout, any benefits, that would be a minus. Why? Because they've met that obligation. They no longer have that obligation. If you add it up the balance in projected benefit obligation.

January 1st year two is 928,000. That's the balance in PBO January 1st year to 928,000. Now let's do surpass. I know you're getting used to it, the ass, you know what that is? That service costs. Hey, that's the present value of all the pension benefits earned by my employees, this period, they gave us that 425,000, always a plus, always.

In addition to your pension expense for the year, let me ask you a question.

Could the FAR CPA Exam asks you to calculate service costs or realistically, do they have to give it to you? It's got to be given. It's gotta be given. It takes experts to come up with that number. That's a complex number takes actuaries takes, takes experts to come up with that number. There's no way they could ask you to calculate it has to be given.

And we know it's always a plus always an addition, your pension expense for the year. I, as the hard one interest on projected benefit obligation interest on PBL, always a plus always on addition to your pension expense for the year. How do we work it out? Think what happened here, they did a projection didn't they projected out their total obligation for pension benefits into the future.

And what they did is discount that obligation back to January 1st year two came out to 928,000. We just worked it out, but now it's December 31 year to a year has grown a year, has gone by. So hasn't that obligation grown. By 10%, 92,800, just because a year goes by interest on PBO interest on projected benefit obligation, always a plus always.

In addition to your pension expense for the year, how about the, our return on plan assets? Didn't we give the trustee a million dollars cash at the end of year two, excuse me. At the end of year one. We gave the trustee a million dollars cash at the end of year one. Wasn't that invested all through year two.

And we're assuming that pension assets are earning 10%. So that's a minus 100,000. Remember the better those investments do, that's good for you that lowers your pension expense for the year? That's a minus a hundred thousand. Why didn't I worry about the. 475,800 cash. I gave to the trustee at the end of year two, because that hasn't earned anything yet.

That went to the trustee at December 31 year two. It hasn't heard anything yet, but the a hundred thousand, excuse me, the million cash we gave the trustee at the end of year, one was invested all three year to earn 10% a minus a hundred thousand. Now I should mention that it's a minus because we're assuming it's a return, an actual return on plan assets.

If the stock market plummets, if you have a loss on plant assets, which of course could happen. If you have, the stock market takes a huge tumble and you have a loss on plan assets, this would be a plus. Assuming you making a positive return, an actual return on your plant assets, it's good for you lowers your expense for the year.

But as I say, if you took a bath on your plant assets, which can happen. That also that all of a sudden becomes a plus that's bad for you, but here it is a 10% return minus a hundred thousand. How about the P in sir, Pat prior service cost amortization? That's just a straight line calculation. We're going to take the Ford in 80,000 price service costs divided by 12 straight line years.

The average remaining service period for those employees. It's another 40,000. It's a plus it's an addition to your pension expense for the year. A actuarial gain a loss. We're assuming there's none T transition asset transition obligation. We're assuming there's none. If you add it up, it adds up to 457,800.

We're going to debit pension expense, 457,800. As I said, that's what surpass does for you? It gives you the pension expense for the year in the defined benefit plan. What's the credit to cash? The funding. Was it credit to cash? A 475,800. That was the funding notice we are overfunded. So what did we do?

We debit an overfunded pension asset, 18,000. Notice the basic process here, sir. Pat, do an entry, sir. Pat, do an entry, sir. Pat, do an entry. That's how you handle the defined benefit plan. It's sir, Pat then do an entry. Let's do year three.

Notice we funded another $300,000 cash to the trustee at December 31 year three, the year three service costs 430,000. And we're still assuming. The pension assets earning 10% let's work out the pension expense for the year of year three. Any time you have to work out the pension expense in a defined benefit plan.

You're thinking S I R P a T. We know that we know the date on it. Dates are important. It's December 31 year three. Now, before we work out, sir, Pat, there's another calculation we have to do first. Let's work out the balance in PBL. What was the balance? And projected benefit obligation January 1st year to 928,000.

We had to work that out now, just stop and think during year two, what increased your obligation? Didn't that obligation increase by 92,800, just because a year goes by. Don't forget interest on PBO. What else increased your obligation? How about all the pension benefits earned by your employees in year two, 425,000 that increased your obligation?

And as I mentioned, if you pay out benefits, you've met that obligation. You no longer have that obligation. That would be a minus, but I'm assuming there's none. If you added up the balance in projected benefit obligation, January 1st year three, 1,445,800. That's the balance and PVO January 1st, year three.

1,445,800. And I want to make a point any time you're doing year to year information on pensions. You have to work out the balance in PBL, as we're doing here. That's why I'm showing you this schedule. I'm showing you the schedule on how you work out the balance of PBO, because that's what it comes into play any time.

You're doing year to year information. You have to work out the balance in PBO each year. They probably won't give it to you, but the good news is that's all they can eat. That's all they can test with PBL. That's pretty much it, but you've got to know that little schedule that we're going over, how to work out the balance and PBL year to year because they give you any kind of problem where you're doing year to year information.

It would be up to you to work out the balance and PBO each year. So that's why we're showing you that schedule. All right now. Let's do sir. Pat S I R P a T. And I know you getting used to it. The S service costs. Hey, that's the present value of all the pension benefits earned by my employees, this period for year three, it's 430,000, always a plus always.

In addition, your pension expense for the year eyes, the hard one interest on PBL. Let's think about it. They did a projection, right? They projected out their total obligation for pension benefits into the future. And what they did is discount that obligation back to January 1st year three came out to 1,445,800, but now it's December 31 year three a year has passed.

So that obligation would have grown by 144,005 80, just because a year goes by. Interest on PBO, always a plus always. In addition to your pension expense for the year, as we said earlier, that obligation gets bigger and bigger. As people get closer and closer to their retirement.

How about the, our return on plan assets? Didn't we give the trustee a million dollars cash at the end of year one. Wasn't that invested all through year two. And earn 10%. So didn't that grow to 1,000,001. And then didn't we give the trustee at the end of year to 475,800. So what we had invested all three year three is 1,575,800.

It earn 10%. So that's a minus one 57, five 80. Let me do that again. We gave the trustee a million dollars cash at the end of year one, it was invested all through year two and are in 10%. So that grew to 1,000,001. And then we gave the trustee another 457,800 at the end of year two. So we had invested all through year three is 1,575,800, which we're assuming the return is 10%.

That's a minus one 57, five 80, the P prior service costs amortization. That's just straight line take the Ford and 80,000 prior service costs. Divide by 12 straight line years, the average remaining service period for those employees at another 40,000. It's a plus an addition to your pension expense for the year.

Now I know that you listened to me carefully, at least I like to think you do. And I hope that you think that I try to choose my words carefully. And you may have noticed that when I get to prior service cost emiratisation I have not said it's always a plus. Always an addition, your pension expense for the year.

I can't say it's always, it could be a minus if there was some agreed upon reduction of benefits with the pension, it is possible that it could be a minus. He had some sort of a negotiated reduction in benefits. That could be a minus. I don't think the FAR CPA Exam is likely to get into that. It's usually price, service, cost amortization, a plus.

On addition to your pension expense for the year, a actuarial gain a loss, there was none T transition, asset, transition obligation, none, add it all up. It all adds up to 457,000. We're going to debit pension expense 457,000, as I say time. And again, that's what surpass it'll do for you. It'll give you your pension expense in a defined benefit plan.

What do I credit to cash? 300,000. That's the funding. That's the funding. You know what I'm going to ask? Am I overfunded or underfunded under? So what do I do? Be careful. Don't I have an overfunded pension asset on the balance sheet back in year one, we were overfunded. So I set up an overfunded pension asset of 32,000.

Then in year two, I was overfunded. I added another 18,000. To my overfunded pension asset. So don't, I have an overfunded pension asset on my balance sheet of 50,000. Now that I'm underfunded, I have to get rid of that. I'm no longer overfunded. I have to get rid of that overfunded pension assets. So I'm going to credit overfunded pension asset, 50,000 and credit an underfunded pension liability for 107,000 notice.

Sir, Pat, do an entry, sir. Pat, do an entry, sir. Pat, do an entry, sir. Pat do an entry works every time. That's how you handle a defined benefit plan. Let's try a problem. I'd like you to shut FAR CPA Review course down, do question number 22 and then come back.

Welcome back. Let's do number 22 together. And number 22 is a classic sort of multiple choice question they would have on a defined benefit plan. They say the following information pertains to. Ralph corporations defined benefit plan. And at the bottom they say, all right, what is the pension expense for the year?

You know what? I'm hoping. I'm always hoping that my students, anytime they get a question like this are thinking one way in one way. And one way only S I R P a T, sir, Pat, if you have to work out the pension expense in a defined benefit plan, that's always your thought process, sir, Pat. So you put it down, you fill it in the S is service costs.

In this problem, 300,000, always a plus always. In addition to your pension expense for the year interest on PVO, 164,000, always a plus always. In addition to the pension expense for the year, the return on plan assets, 80,000, that's a minus prior service cost amortization, the pay, apparently they don't have any, apparently they're not going to give people credit.

For years before they had a plan, there is no prior service cost. I mentioned earlier that students really have to get used to that, that you have to deal with the elements they give you. Not all six elements will necessarily have to be in a problem. They don't have any prior service cost amortization, a actuarial gain, a loss batch 30,000.

And because it's a loss it's bad for you. It's a plus in addition to your pension expense to the year, and then. Transition asset transition obligation. The amortization of the obligation is 70,000. And because it's a transition obligation, that's bad for you. A transition asset is good for you, the a minus, but this is a transition obligation.

It's bad for you increases your expense for the year. It's a plus. Add it all up. The pension expense for the year is answer B 484,000. You put down, sir, Pat, that'll always give you the pension expense. In a defined benefit plan, let's go to number 23. They say the following information pertains to say the company's pension plan.

We know their estimate of projected benefit obligation. January one, we know they use a discount rate of 10%. We know the service cost for year one. 18,000. And we'd also know that the benefits paid 15,000 and they say, okay, what is PBO? December 31 year one? Let's go through the calculation. We know that projected benefit obligations back on January one a year ago was 72,000.

And you really just have to stop and think during year one, what increased that obligation? First of all, don't forget interest on PBO. That obligation would have grown by 7,200, just because a year goes by interest on PBO. What else increased your obligation? All the pension benefits earned by your employees in year one, 18,000, that increased your obligation.

And as I mentioned earlier, if you pay out any benefits, which they did here, 15,000, that's a minus. Why? Because you've met that obligation. You no longer have that obligation. So back that out, the balance PBO December 31 year one is answered D 82,000 too odd. Now I want you to look at that calculation and remember what I mentioned before, any time you're doing year to year information, you have to work out the balance in PBO, just as we did in that multiple choice.

This is why I make you do the schedule with me a couple of times. And the good news is if you're desperate for some good news, the good news is that's all they can do with PBL. That's all they can do with it. They can't ask you for the 18,000 that takes experts. They can't ask you for the 72,000, the beginning balance.

It takes experts come up with that has to be given, but the one thing they could do with projected benefit obligation is have you work out the balance? From year to year in this case, from the beginning of the year, to the end of the year, if we give you the service cost for the year, we tell you the benefits that were paid, what's the balance and PBO at the end of the year.

And as I say, where this becomes critical is that anytime you're doing Yeti or information. So as I say, make sure you know that little schedule and how you work out the balance and PBL, but the good news is that's really all they can test with PBL. That's pretty much all they can do with it.

Now let's think about sir, Pat for a minute, the S service costs the present value of all the pension benefits earned by my employees. This period has to be given there's no idea. Exam could ask you to calculate that takes experts. I interest on PBO. You have now seen everything they can really do with PBL.

Let's go to the ROI, the return on plan assets. You might remember that in the illustrator problem that we just did together in the viewers guide. When we did those three years of information, I was assuming that plan assets were earning 10%. I just assumed every year plan assets were earning 10%. That's how I figured out the return on plan assets.

That's very easy. Isn't it? I mentioned this because once in a while on the exam, they'll ask you to really work out the actual return on plan assets. How do you work it out? If you have to work it out, we'll show you problem. Number 24 24 says the following information pertains to galley company's defined benefit plan.

We know the fair value plan assets, January one, the fair value plan assets, December 31, the employer contributions and the benefits paid. They say in computing, the pension expense for the year, what amount would galley use as the actual return on plan assets in a multiple choice like this? They're making you work it out.

I want to show you how it's done. And it's actually a fairly simple calculation. I think it'll make sense when you see it. If I want to work out the actual return on a plan assets, here's how I start. I look at the fair value plan assets at the end of the year in this case 525,000 minus. The fair value plan assets at the beginning of the year 350,000.

So the first thing I noticed is that in the last year plan assets have increased by 175,000. That's your starting point? I know in the last year plan assets have increased by 175,000 and notice that the answer is C, but we can't stop there. Why? Think about it for a minute. Did I make all that increase in the stock market?

No. Look at the employer, contributions, the employer put 110,000. And again, you can't say that entire increase of 175,000 occurred in the stock market because the employer put in one 10. So back out the employer contribution of one 10, that brings you down to 65,000. That's the answer a, that's not it either.

Cause I also paid out benefits of 85,000. Add back the benefits and that gives you answer B that's the actual return on plan assets. Every now and then they'll make you work it out and that's yeah. That's basically how you do it in practice, in practice you're like, Oh, plant acids, earning 15%.

No, you look at the fair value plan assets at the end of the year, minus the fair value plan assets at the beginning of the year, all they increased by this much back out what the employer put in, add back any benefits and that'll give you the actual return.

All right now, let's get back to surpass. So service costs has to be given. We've seen everything that can hit with interest on PBO. Now, you know how to calculate the return on plan assets. If you have to calculate it, the P prior service cost amortization. You've really seen what that is. It's a straight line calculation.

All that really is taking the prior service cost, which the FAR CPA Exam has to give you divide by the average remaining service period for the employee straight line. So there's really nothing complicated there let's go to the, a actuarial gain loss. Let's say that a company has a huge actuary loss. Let's say a company has.

But, a $4 million actuarial loss, do they just put 4 million in as the fifth element they saw that fifth element is a $4 million plus no, but there's a minimum amount that they have to take. So they don't have to take the whole actuarial loss, but there's a minimum they have to take. Let's go to problem.

Number 25, we're talking about in number 25 mercury company. They have a defined benefit plan. And here's what we know. We know the accumulated benefit obligation is 500,000. I'd like you to put a line through that. We'll talk about that in a bit. We also know the projected benefit obligations, 600,000 circle that we know the fair value plan assets.

We also know the market related value plan assets circle that six 50, the market-related value plan assets. Now the actuary loss is 80,000. And the average remaining service period for the employees is 10 years. And they ask at the bottom, the amount of actuarial loss that they would include in their calculation of pension expense for the year would be what?

Of course, a lot of students would sit in the FAR CPA Exam and go, Oh, I see it. I take the actual word of loss of 80,000 divide by 10 straight line years. The average remaining service period for the employees. And they say, Hey, I, hello, D I'm looking at your answer date. It's not D here's how you work this out.

You have to look at the two numbers that I had your circle. You have to look at the projected benefit obligation, 600,000 and the fair value, excuse me, D Margaret related value plan assets, 650,000. You look at those two numbers. Now you might be wondering. Bob, what's the difference between the fair value plan assets and the market related value plan assets?

The difference is that the fair value plan assets is that as of December 31, the market related value is a way that average for the year. That's the difference? Fair value plan assets is as of December 31, the market-related value plan assets is a weighted average for the year and. In this calculation, we have to use the market related value plan assets.

And what might make you feel a little better is the only time you worry about that distinction. The only time you worry about the difference between the fair value plan assets and the market related value plan assets is this calculation right here. It's really the only time you worry about it. All right.

So I look at those two numbers, projected benefit obligations, 600,000 Mark related value plan assets, 650,000. Take 10% of the larger number. Take 10%. Of whatever number is larger, why 10% is just a threshold. It's just a rule. So because the Margaret related value plan assets is larger. I'll take 10% of 650,000 that comes out to 65,000.

Notice that the actuarial loss 80,000 is 15,000 higher than that threshold. What they're going to do is take that $15,000 difference divide by 10 straight line years. The average remaining service period for the employees. And the answer is a, that's the minimum amount of actuary loss. They have to amortize as one of their six elements.

And I mentioned that because it's pretty much all they can do with actuarial gain actuarial loss, make sure that little calculation. And as I say, it's the only time we worry about the market related value plan assets.

All right now, the only element that's left is transition. Asset transition obligation. Let's go to number 26. If you go to number 26, we'll go right to the numbers. Notice the year we started the plan, our projected benefit obligations. 780,000. The fair value plan assets, 600,000. So the year we started the plan, our plan was underfunded.

PBL was underfunded by 180,000. We started with a transition obligation of 180,000. Let's read on it, says it December 31 year seven, all amounts accrued as net periodic pension costs. Have been contributed to the plan. Then they say the average remaining service period for the employees is 10 years. Then they go on to say some participants are going to work 20 years.

Some participants going to work 25. I hope you understand. We don't care about that in these calculations. What we're always looking at is the average remaining service period for the employee. And then again, they'll say some people going to work 15 years, some people going to work 35 years, we don't care.

What we always need in these calculations is the average remaining service period. They go on to say, to minimize the accrual for net periodic pension costs. What amount of transition obligation, where they advertise? Of course, people sit in the FAR CPA Exam and go, Oh, I see it. Take the transition obligation 180,000 divided by 10 straight line years.

The average remaining service period for the employees. Hello? D no, because there's a little rule here. Here's the rule. When you're amortizing transition, asset transition obligation. If the average remaining service period for these employees, if the average remaining service period is less than 15 years, They'll let you go up to 15.

If the average remaining service period is less than 15 years here, it's Ted. They'll let you go up to 15. So I'm going to take the 180,000 divided by 15 straight line years. What they would amortize is answers C 12,000. Just remember if the average meaning service rate for the employees is less than 15.

They'll let you go up to 15. What if the average meaning service period was 22 years? What would you use? 22 or 1522, right? At the average managed service period is 44 years. He was 44, but at the average managed service period is less than 15. They'll let you go up to 15. That way you minimize the accrual on the income statement, you minimize the hit on the income statement and they that's what they said they wanted to do, minimize the accrual.

So they'll let you do that. All right. Now, if you, with me on. And that's pretty much what they could hit with transition asset transition obligation. That's pretty much all there is do it. Let's go back to more typical type of questions they have on defined benefit plans. I'd like you to try 27 and 28 and then come back.

Welcome back in number 27. We're told that lock has a defined benefit plan. And we know that anytime you see a defined benefit plan, you're thinking surpass S I R P a T Sur, Pat do an entry. So let's work out surpass. We know that as the service costs, I is interest on PBO. And you'll notice that in this problem, they combined service costs and interest on PBO together adds up to a total of 620,000 plus and increased your pension expense for the year.

How about the ROI, the return on plan assets? We gave the trustee a million dollars cash. It has earned 10%. That was the actual return. That's a minus 100,000. Prior service cost amortization. They don't have any actuarial gain a loss. They don't have any transition asset transition obligation. They don't have any, as I keep saying, you've got to deal with the elements they give you, add it all up.

It adds up to 520,000. So we know. That lock is going to debit pension expense 520,000, because that's what sir Pat does for you. It gets you the pension expense for the year in any defined benefit plan. We know they're going to credit cash a million. That was the funding. So we know they're, over-funded, they're going to debit an overfunded pension asset 480,000.

The answer is C because that's what they wanted. They wanted the balance in the overfunded pension asset, and it is. 480,000 notice, sir, Pat do an entry, sir. Pat do an entry works every time. Let's try number 28. Once again, we're dealing with a defined benefit plan. So let's work out, sir. Pat, we know the service cost is 19,000.

That's a plus interest on PBO. 38,000 is a plus return on plan assets. 22 is a minus. Prior service cost amortization 52 thousands of plus apparently they don't have any actuarial gain loss or transition asset transition obligation. You add it up. It adds up to 87,000. So we know they're going to debit pension expense 87,000, because that's always what surf hat does for you.

Get you the expense in a defined benefit plan. Now the employer contribution was 40,000, so we know they're going to credit cash 40,000 aren't they. Underfunded. So what should I do? They have an overfunded pension asset on the balance sheet. Now that they're underfunded, you have to get rid of that.

So I'm going to credit overfunded pension asset 2000 and credit, an underfunded pension liability for 45,000. And the answer is a, they wanted the balance in the underfunded pension liability. Just remember, sir, Pat do an entry and you've got it.

When a corporation has a defined benefit plan, they have to report the funded status of that plan. Companies are required to report the funded status of any defined benefit plan. Let me show you how it's done. Let's say a corporation has a defined benefit plan. And when they get to December 31, their projected benefit obligation is 1 million, 200,000, but let's say the fair value plan assets at year end a million.

So at year end, December 31, the projected benefit obligation 1 million, 200,000, but the fair value plan assets at December 31 a million. So notice that year end. There PBO is underfunded by 200,000 listen carefully because their PDO is underfunded by 200,000. They're going to have to report a liability for the four pensions on the balance sheet of 200,000, because they are required to report the funded status of any defined benefit plan.

Their PBO is underfunded by 200,000 at year end. So they're going to have a liability for pensions on the balance sheet. Of 200,000. So what entry did they make? They would debit OCI 200,000 and credit underfunded pension liability, 200,000 because you are required to report the funded status of any defined benefit plan, same example.

What if at December 31, the balance in PBO 1 million, 200,000 fair value plan assets, a million. So once again, your end, their PBO is underfunded by 200,000. But the FAR CPA Exam mentions that they already have a pension liability on the balance sheet of 45,000. What would be your analysis? We know that we are required, I'd report the funded status of any defined benefit plan.

Since their PVO is underfunded by 200,000, we know they need a liability on the balance sheet for pensions of 200,000. Since they already have 45,000 on the balance sheet, we have to bring that up to 200,000. So we're going to debit OCI 155,000. Credit underfunded pension liability, 155,000 to bring the liability on the balance sheet from 45,000 up to 200,000, we have to report the funded stats.

And I mentioned that because the FAR CPA Exam could ask you what additional liability must be recorded in this case, 155,000. You have to read the problems carefully. They might ask what additional liability must be recorded. 155,000 to bring the liability on the balance sheet from 45,000 up to 200,000, because corporations are required to report the funded status of any defined benefit plan.

Let me ask you this. What if it, December 31 let's reverse the numbers. What if the balance and PVO was a million and the fair value plan assets, 1,000,002, let's just reverse the numbers. December 31. The balance of PBO a million, the fair value plan assets, 1,000,200 thousand. Notice that ERN PBO is overfunded by 200,000.

If PBO is overfunded by 200,000 at year end, what I debit overfunded pension asset 200,000 and credit OCI, 200,000. Yes. Yes. Because you are required to report the funded status, overfunded or underfunded of any defined benefit plan. So just remember that anytime a corporation has a defined benefit plan, they have to at year end report the funded status, either overfunded or underfunded of any defined benefit plan.

I'd like you to shut FAR CPA Review course down, do 29 and 30, and then come back.

Welcome back in number 29 at the bottom. They're saying, what is the amount of pension liability that would have to be on the December 31 year seven balance sheet will. I think, the analysis at December 31 year seven there projected benefit obligation. 5,000,007, but the fair value plan assets on December 31, 3,000,004 50.

Notice there PBO is underfunded by 2 million, two 50. They're going to have to debit OCI 2 million, two 50 and credit an underfunded pension liability of 2 million, two 50. And the answer is B because a corporation is required to report the funded status of any defined benefit plan. And I want you to notice that line accumulated benefit obligation ABO just put a line through that and you want to put in your notes.

That's not used for any calculation. And you'll find when you do your homework, that very often in pension questions, they'll mention the ABO the accumulated benefit obligation. And I know students sit in the FAR CPA Exam and go, what do I do with that? It's not used in any calculation. It's just there to get you down the wrong path.

So we're not going to use the AVO, the accumulate, a benefit of the accumulated benefit obligation for anything. So don't get caught up in that. It's just simply not used in any calculation. In number 30 at the bottom, they say what amount would pay in record as their additional pension liability?

December 31 year three. We'll think what happened here for year three, their net periodic pension costs. 90,000. So we know they debited pension expense 90,000. And of course, sir, pad is how they got that 90,000 it's made up of the six elements, but here they gave it to you. So we know they debit pension expense, 90,000, the employer contribution was 70.

So we know they credited cash 70,000 for the funding, they were underfunded. So they must have credited underfunded, pension liability. 20,000 when they booked their pension expense for the year, they ended up crediting underfunded pension liability for 20,000. Now, is that the liability for the balance sheet?

No, it's not. Because at year end, the PBO is 103,000. The fair value plan assets at year end 78,000. So notice there PVO is underfunded by 25,000. If their PBO is underfunded by 25,000 at year end. They have to have a liability for pensions on the balance sheet of 25,000, because corporations are required to report the funded staff of any defined benefit plan.

So since they already have a $20,000 underfunded pension liability on the balance sheet from when they booked the pension expense for the year, our job would be to bring that up to 25,000. So we're going to debit OCI 5,000 and credit underfunded, pension liability, 5,000. That brings are underfunded pension liability from 20,000, which they recorded when they recorded the pension expense for the year up to 25,000, because the ERN, their PBO is underfunded by 25,000.

So when they ask us what additional liability must be recorded, the answer is B 5,000 to bring that underfunded pension liability from 20,000 up to 25,000, because the ear ERN, their PBO was underfunded. By 25,000, they had to have a liability on the balance sheet for pensions of 25,000. So the additional liability that had to be recorded, their answer be 5,000.

Now I could be wrong, but I'm going to assume that you're in the mood to talk about post retirement benefits.

Let's talk about post retirement benefits. Now, when you see that phrase in the exam, post retirement benefits, what they're referring to is a defined benefit plan for fringe benefits. That's what we mean by post retirement benefits. It's a defined benefit plan for fringe benefits. In other words, we all are retired.

Employees, healthcare, dental care. It's almost always healthcare, but we are retired employees, fringe benefits, healthcare. That's what we mean by post retirement benefits. Now you'll be happy to know that there are six elements that make up. Your post retirement benefit expense for the year. And what will help?

Is it still surpass? That's why I have to show this to you. If sir, Pat, you've got the six elements of pension expense for defined benefit pension plan, but you've also got the elements for your post retirement benefits expense. Let's go over, sir. Pat, it's basically the same idea. The S is still service costs.

You know what that is, that would be the discounted present value of all the post retirement benefits earned by your employees. This period, always a plus always. In addition to your expense for the year, the eye is a little different, but it's the same idea. Now I is interest on APRB Oh, interest on accumulated post retirement benefit obligation.

Just think of it as interest on the obligation it's interest on AP RBO. Interest on accumulated post retirement benefit obligation, but it's always a plus always. In addition to your expense for the year, the ROI is return on plan assets, same idea. Every year you turn cash over to the trustee. They make investments the better those investments do.

That's good for you. That would be a minus that lowers your expense, the pay, you know what that is. Prior service cost amortization. And, prior service cost is, Hey, that's the present value of all the post retirement benefits earned by your employees before you had a plan we're going to give credit for those years and amortize.

Some of that private service costs as one of our six elements. It's a plus an addition to your expense for the year a is actuarial gain a loss event, an actuarial gain. That's good for you. Lowers your expense. Actuary loss is bad for you. Increase your expense and then T transition asset transition obligation.

When you started the post retirement benefit plan. If you were overfunded, you had a transition asset. That's good for you. Lowers your expense. If you're underfunded, when you started the plan, you have a transition obligation, that's bad for you increases your expense. So I want to show you that if sir, Pat, you've got the six elements.

Now I know you know this, but I want to say it. Remember, sir, Pat just gives you the expense for the year and then you're always back to, are they fully funded? Are they overfunded? Are they underfunded? You might want to put in your notes. Entries are the same. I'm not going to make us do them, but the entrance would be the same surpass would get me the expense.

And then wait, are they overfunded under funded, fully funded. It's still, sir. Pat, do an entry, sir. Pack do an entry. We'll still work. Another point. It's a little picky point, but you have to know it. Remember when we did a defined benefit plan for pensions and we got to transition asset transition obligation.

Remember we said that if the average remaining service period for the employees was less than 15 years to minimize the hit on the income statement, they'll let you go up to 15 years. I know you remember that, right? For transition asset transition obligation. For defined benefit pension plan. If the average remaining service period for the employees is less than 15 years to minimize the hit on the income statement, they'll let you go up to 15.

For post retirement benefits, they'll let you go up to 20. That's a picky point, but you gotta be careful. They could ask that. So for transition asset transition obligation, with a post retirement benefit plan to minimize the hit on the income statement, you can go up to 20 years. If the average mimic service period for the employees is less than 20 years to minimize the hit on the income statement, you can go up to 20 years.

Another point a corporation is required to report the funded status of any post retirement benefit plan. You also have to report the funded status of any post retirement benefit payment plan. Let me give you an example. Let's say we get to December 31, the balancing APR beyond. The accumulated poster time and benefit obligation is 4 million at year end, but let's say the fair value plan assets at year end 2,000,006.

That would mean that their APR BPO, their accumulated post-trauma benefit obligation is underfunded by a million for well, they would have to have a liability on the balance sheet for, to drive the benefits of 1,000,004. So they'd have to debit OCI, a million, four, and credit. Underfunded poster time at benefit obligation 1,000,004, because corporations are required to report the funded status, either overfunded or underfunded of any defined benefit plan.

Even a post retirement benefit plan, same concept.

That concludes our discussion on leases and pensions and from all of us at bisque review, we want to wish you the best of luck on the exam. Study heart.

Yeah.

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Hello, and welcome to the bisque review for the financial accounting and reporting section of the CPA exam. My name is Bob Monette, and I'll be your instructor in this FAR CPA Exam Review course. And in this FAR CPA Exam Review course, we're going to be covering several important topics. We're going to look at the type of questions that come up in the FAR CPA Exam for stockholders' equity ratio analysis.

Partnership accounting and also foreign operations. Now, before we dive into the material, I just want to take a moment to give you some advice about the way to get the most out of this class. The important thing is to avoid just sitting back passively and watching this class. The important thing is to be an active participant take good notes, treat this like any other class later in the class, when we do problems, the important thing will be to shut FAR CPA Review course down.

Do the problems yourself, come up with your answers before you come back and we go through the problems together. And I think if you do these simple things, you'll get much more out of this class. And obviously that's, we both want,

let's do our first topic. Let's get into stockholders' equity. Now you certainly know. That formal classified, published balance sheet corporations report their capital structure under the heading stockholders' equity. And I want to begin by going over the different components that make up stockholders' equity, starting with common stock notice.

In my example, on the screen. There are 60,000 common shares issued and outstanding at $10 par value per share. So the total par value for all the common shares issued and outstanding is 600,000. And by the way, that is a requirement, corporations are required to publish on their balance sheet, the total par value or the total stated value.

Of all the common shares issued and outstanding. And let me just quickly say that in the CPA exam, you can treat par and stated value as being exactly the same thing, but corporations are required to report the total par or stated value for all the common shares issued and outstanding. And since corporations are required to report this, what is it?

What is par value? I think we should talk about it for a minute. If you're in the FAR CPA Exam and they ask you anything about the concept of par value, you remember one key phrase, the phrase is legal capital. Remember that the par value of a corporation is that corporation's legal capital, theoretically. It is there to provide creditors of the corporation.

With some minimum basic protection. So that's what it represents. It is the legal capital of the corporation. And as I say, theoretically, it is there to provide the creditors of a corporation with some minimum basic protection. What do I mean by protection for creditors? In most States, now this does depend on the laws of the state of incorporation, but in most States, Corporations are not allowed to pay any dividends out of par value.

Why? Because they're the legal capital of the corporation. And theoretically, that par value that legal capital is there to provide some minimum basic protection for creditors. As I say, in most States, corporations are not allowed to pay a dividend out of par value. Next we have additional paid-in capital or API C, and I think, for the most part, what that million dollars represents.

Is what shareholders were willing to pay. Over par or stated value over legal capital to acquire shares. That is additional paid-in capital, which shareholders were willing to pay over legal capital to acquire shares. Then we have retained earnings and you know what that is retained earnings. Is the cumulative net income of the corporation from the date of incorporation after you've deducted dividends, essentially retained earnings is the cumulative net income of the corporation from the date of incorporation after you've deducted dividends.

But always remember there is still one more element in stockholders' equity notice, accumulated other comprehensive income items. And I think, you know what that $500,000 represents there are gains and losses. That are simply not on the income statement. There are gains and losses that are not on the income statement.

These gains and losses flow directly to stockholders' equity as items of other comprehensive income items of OCI. So now down in stockholders' equity, we have accumulated, Oh, see, I notice these gains and losses accumulate. I think, you know exactly what that represents. That's like having a retained earnings account down in stockholders' equity for all these gains and losses.

That are not on the income statement. They accumulate, accumulated other comprehensive income items. Now, with those elements in mind, let's get into what the FAR CPA Exam tests on stockholder's equity. And let me just say that the primary thing that the CPA exam tests with stockholders' equity is dividends.

Now, just to get us into this, let's start with a simple cash dividend. Let's say that this corporation that we just looked at on the screen, let's say this corporation declares. A $200,000 cash dividend. I think, if this corporation declares a simple $200,000 cash dividend, they're going to debit retained earnings 200,000.

Always remember that dividends come directly out of retained earnings. They're not on the income statement in any way, dividends come directly out of retained earnings. So they would be a debit to retain earnings 200,000 and a credit to dividends payable, 200,000. That is the entry for a simple cash dividend.

All right, now let's try to complicate it. Let's say that $200,000 dividend never happened. Forget that's a simple cash dividend. It's too simple. Let's say instead this same corporation declares a dividend of 1,750,000. I think you see the complication. If this same corporation declared a dividend of 1,750,000, they're going to credit dividends payable, 1,750,000.

But notice they're going to debit retained earnings, but just 1,000,005, you see what's happened in this problem. They've declared a dividend greater than their accumulated earnings. And here's the point. If a corporation declares a dividend greater than their accumulated earnings? Then the argument would be that at that point, they are no longer distributing earnings.

They are distributing capital. So the other 250,000 would be a debit to additional paid-in capital. That's the basic argument. If a corporation declares a dividend greater than their accumulated earnings then at that point, they are no longer distributing earnings. They are distributing capital. So the other 250,000 would be a debit to additional paid-in capital.

And I want you to know. But that debit to additional paid-in capital for 250,000, that's what the CPA exam would mean by a liquidating dividend. You have now the FAR CPA Exam talks and that 250,000 that we debit to additional paid-in capital. That's what the FAR CPA Exam would mean by a liquidating dividend. I'd like you to try a couple of questions.

And as I said earlier, when we get to questions like this, the best thing to do is shut FAR CPA Review course down. Do the questions, get your answers and come back. You learn a lot more that way. So I'd like you to do questions one and two and then come back.

Let's do these questions together. Number one says old corporation declared and paid a liquidating dividend of a hundred thousand dollars. This distribution resulted in a decrease of old corporations. What? We know that liquidating dividends by definition are a distribution of capital. So there would be a decrease to additional paid in capital.

So you want yes. Underpaid in capital, because again, liquidating dividends by definition are a distribution of capital API. C would have to decrease. How about retained earnings? No. Liquidating dividends are a distribution of capital. API. C would go down retained earnings. As far as we know wouldn't be touched.

And the answer is D and you might be thinking about Bob wouldn't. I have to go to retained earnings first. How do you know this corporation ever had earnings? You don't know that. You can be careful. You can't make assumptions. All I know in this question is that there's been a liquidating dividend.

That's all I know. And I know that liquidating dividends are a distribution of capital. I know API C would go down, but I can't assume that this corporation ever had earnings. You can't make assumptions. Be very careful. And just to drive this point home, look at number two. Number two says a corporation declared a dividend, a portion of which.

Was liquidated was liquidating. How would this declaration affect each of the following? The portion that's liquidating would decrease additional paid-in capital. The portion that's non liquidating with lower retained earnings. Now you want decrease under boat. Now the answer is B so hope you see the difference in those questions, because if a portion of the dividend is liquidating, that's a little different.

The portion that's liquidating of course, would lower, additional paid in capital and the portion that's non liquidating with lower retain earnings. So now you'd want decrease under bolt.

Now we're going to stay on dividends. And what I want to get into next is how you would allocate dividends to common and preferred stockholders. It's a basic type of problem. But I have to be sure that you're comfortable with this kind of problem. So if you look in your viewers guide, you'll see the same stockholders' equity section that we started with, but now we've added some preferred stock noticing the stockholders' equity section.

Now there are 4,000 shares of preferred stock, outstanding at a hundred dollars par per share. So the total par value for all the preferred shares outstanding 400,000. And we're also given some information about the preferred. The preferred is 9%. It is cumulative. It is fully participating. Preferred stock dividends are eight years in arrears, not including the current year.

And if you look at what we're told here, the board of directors have declared a $380,000 dividends. So the question is how much of that 380,000 would go to preferred stock holders. How much would go to common stockholders. So we'll set up a column for preferred a column for common and let's work it through now.

I'm sure you know that the minute you see the word cumulative, you know that before common stock holders can get a dime of dividends, the dividends in arrears have to be settled. First. Those are the demands of the cumulative feature. Remember the whole idea behind preferred stock. Is that you, as a shareholder, you give up your voting rights.

That's what they want. You give up your voice and management. You give up your voting rights and in return you get privileges, preferential treatment that other shareholders don't receive. And the most basic preferential treatment you receive is of course, in terms of dividends, preferred stockholders are preferred as to dividends.

And when preferred stock is cumulative, which it most often is when preferred stock is cumulative. It means before common stock holders can get a dime of dividends, and arrears have to be settled first. So let's start with the dividends in rears. I'm sure you remember that with preferred stock, the annual dividend is a fixed rate on par value.

So we're going to take the fixed dividend rate for preferred, which is 9% times the par 400,000. Let's agree. That the annual preferred dividend here is $36,000 because we preferred stock. The annual dividend is a fixed rate on par value. So take that fixed dividend rate 9% times the par 400,000. I know we agree that the annual preferred dividend is 36,000.

And since it's eight years in arrears, take 36,000 times eight. Let's agree that the first 288,000 of the $380,000 dividend has to go to preferred stock holders. And we have no choice. Those are the demands of the cumulative feature. Now what comes next? That's right. Don't forget. The current year, the problem said that the dividends were eight years in arrears, not including the current year.

And don't forget in the current year, preferred stockholders are going to step forward and demand to be paid first. That is the most basic privilege you give up your voting rights. You get privileges that other shareholders don't receive. And as I say, the most basic privilege, You as a preferred shareholder receive by giving up your voting rights is your preferred as to dividends and in the current year that wouldn't go away.

So they're going to demand the current year's dividend before Carmen can get to anything. So add another 36,000 for the current year. So if he added up, let's agree that the first 324,000 of the $380,000 dividend has to go to preferred stockholders. And you have no choice. Now I want to ask you a question.

I'd like you to think about this. If I told you. That the preferred stock was non-participating. Now I know it is. We'll get to that, but I'd like you to think of this first. If I were to tell you the preferred stock was, non-participating what I worked down to the 324,000. Exactly the same way. And just give the rest to common.

Is that what that means? If I tell you that preferred stock is participating. Would we work down to the 324,000? Exactly the same way we just did. And then just give the rest to common. Yes. Yes. It's a much easier problem. If they tell us that preferred stock is participating, we're basically done. We give the first 324,000, the preferred stockholders give the rest of common and you're out.

I'd like you to see this the way I do when preferred stock is participating, what that does, it puts a limit. It puts a ceiling on what I can give common stockholders at this point. See, that's what participation does to you when you see participation it means there's a limit a ceiling to what common stockholders can receive at this point.

All common stockholders can receive at this point is a dividend at the same rate at the same rate as preferred stockholders. So now common can get up to 9% of their par 9% of 600,000 or the next 54,000. So you see what participation does to you? It puts a limit, a ceiling on what common stockholders can get at this point.

All can come. All common stockholders can receive at this point is a dividend at the same rate at the same rate as preferred stockholders. So now common can get up to 9% of their par or the next 54,000. Now let me set, let me summarize didn't we give the first 324,000 to preferred stock holders. Then the next.

54,000 to common stock holders. Add it up, add up three 24 plus 54. Haven't we allocated 378,000 of dividends. But the problem is the dividend. This year is 380,000. That still leaves an additional 2000 of dividend to be distributed this year. That is your participation amount. So hope you see how we got that participation amount.

We gave the first 324,000 to preferred the next 54,000. The common we've allocated 378,000 of the dividend, but the dividend is 380,000. There's still another 2000 of dividend to be paid out this year. That is your participation amount. So we're down to one final question. How do you work out that participation?

How do you allocate that final $2,000 of participation? And from my experience, this is what a lot of students forget. A lot of students remember pretty well down to here, but from my experience, a lot of students forget how to work out the final 2000. So it's good that we go over it. Remember the way you work out participation is always based on relative par values.

Again, the way you work on participation is based on relative par values. So let's work it out. We know in this problem, the total par value for common stock holders is 600,000 to total par value for preferred stock holders, 400,000. Add it up, add up 600,000 plus 400,000. Notice the total par value in the corporation is a million.

Now you strike a ratio. You say since preferred stockholders make up 400,000 over 1000040%. Of the total part in the corporation preferred stockholders would get 40% of that remaining $2,000 or. $800 of participation. I'll do that again. Since preferred stock holders make a 400,000 over a million, 40% of the total part in the corporation preferred would get 40% of that remaining $2,000 or $800 of participation since common makes up 600,000 over a million.

60% of the total par value in the corporation, common would get 60% of that remaining 2000 or 1,200 of participation. And that gives us our final distribution. The final distribution of that dividend would be 324,800 to preferred stock holders, 55,200 to common stockholders. There's no way when that exam and not know how to allocate dividends between common and preferred stockholders.

As I said, it's a basic type of problem, but. You want to make sure you're comfortable with it? Let's try multiple choice on this. I'd like you to do multiple choice number three, and then come back.

welcome back. Let's do number three together. In this question, we have a $44,000 dividend to distribute. And of course, the question is how much of that 44,000 would go to preferred stock holders. How much would go to common stock holder. So we'll set up a call and for preferred, we'll set up a column for common and we'll work it through.

And you certainly know that the minute you see that word cumulative before common stock holders can get a dime of dividends. The dividends and arrears have to be settled. First. Those are the demands of the cumulative feature. So they said that dividends were in arrears on the preferred and amount of $12,000.

So the first 12,000. Of that 44,000 has to go to preferred stockholders. We have no choice. As I say, those are the demands of the cumulative feature. What comes next? You don't forget. The current year in the current year, preferred stockholders are going to demand to be paid first. That's the most basic preference.

So let's deal with the current year's dividend. We know with preferred stock, the annual dividend is a fixed rate on par value. So I'm going to take the fixed dividend rate 6% times the power a hundred. The annual for a dividend is $6 a share times 4,000 preferred shares. Outstanding. I think we can agree that the current year's preferred dividend is 24,000.

If you add up the 12,000 and the 24,000, I know we agree that the first 36,000 of the dividend has to go to preferred stock holders because they are after all preferred as to dividends. And because there's no participation to worry about, just give the rest of common. And the answer is B. And let me just quickly say you would never assume participation.

I hope that's clear if preferred stock is participating, it has to be stated you would never assume participation. So notice since they said nothing, I assume there is no participation. I just give the rest of the $44,000 dividend to common the other 8,000 and. That's why the answer is B. So you'd never assume participation.

Would you assume cumulative? That's a more difficult question. I don't think the FAR CPA Exam would put you in that position. Preferred stock is almost always cumulative to me. the FAR CPA Exam would have to say they'd have to state non cumulative, and I think they'd be pretty good about that. I don't think they'd be silent.

I'm just giving you my opinion because that's a more difficult question if they were where they were, if they were silent, what I assume cumulative. Mo, most of the time preferred stock is cumulative. It usually is. But again, I'm not trying to give you something to worry about that you don't have to worry about.

I don't think the FAR CPA Exam would ever be silent if preferred stock was non cumulative, they would state it. And as I say, participation has to be stated.

All right now, we're going to move on to something else. And what I want to get into next is stock dividends and stock splits. Let me start with a couple of definitions, a stock dividend. It's simply a dividend that's declared in the form of shares. In other words, a corporation declares a dividend, but rather than send you cash as a dividend, the corporation sends you additional shares of stock in the corporation as dividend.

That is a stock dividend. It's a dividend that's declared in the form of shares. Now a stock split is really just a very large stock dividend. So a stock split is just a huge, a very large stock dividend. Now, the first thing that could come up in the FAR CPA Exam is this how large is large, how large would a stock dividend have to be before you would consider it a split.

I'm gonna give you a little guideline that you can always trust. Just remember if a corporation increases their shares outstanding by 25% or more 25% or more, you treat it as a split under 25%. Treat it as a dividend, you're safe with that guideline. If a corporation increases their shares outstanding by 25% or more 25% or more treated as a split under 25%, treat it as a dividend, you should be safe with that guideline.

And every now and then in the exam, they'll try to slip that by you. So just be aware that guideline now let's get to the most important part of this, the most important part of this. Is when you go in the exam, make sure you know how to record a stock dividend. You know how to record a stock split.

That's the most important thing. If you look in the viewers guide, you'll see the same stockholders' equity section that we started with in this FAR CPA Exam Review course. This quarter, right? 60,000 common shares, outstanding at $10 apart per share total par for all the common shares, outstanding 600,000 additional paid-in capital, a million.

Retained earnings, 1,000,005 accumulated other comprehensive income items, 500,000. So as we start the total value of stockholders' equity, the total book value of the corporation is 3 million, 600,000. Now let's start with a stock dividend. Let's assume that this corporation declared a 10% stock dividend notice when the fair market value of the stock.

It's $50. So that's what's happened. This corporation has declared a 10% stock dividend. When the fair market value of the stock is $50 a share. And I want to say something about this, that $50 listen carefully. That's what the stock is trading for on the day of declaration, I've got to warn you on this in the exam.

They love to give you different market prices. They'll tell you what the stock is trading for on the day. Oh, stockholders of record. They'll tell you what the stock is trading for on the day they send out the shares. All you care about is what the stock is trading for on the day of declaration in any dividend problem.

That's the important date, the date of declaration. All right. So what is the entry to book a stock dividend? I always like to start with basics. How many shares are going out? I know, this, if you declare a 10% stock dividend. You are literally increasing your shares outstanding by 10%.

You're sending out another 10%. You're sending out another 6,000 shares, 10% of 60,000. That's how you read that problem. If you declare a 10% stock dividend, you are literally increasing your shares outstanding. By 10%, you're sending out another 10%. You're sending out another 6,000 shares. Now with a stock dividend, you're going to take those 6,000 additional shares times $50.

The fair market value of the stock on the date of declaration. And we're going to debit retained earnings 300,000. We're going to credit common stock for legal capital. We're going to credit common stock for 6,000 shares at par 10 60,000. And we're going to credit additional paid-in capital for the rest 240,000.

That is the entry to book a stock dividend. And you have to know it now, before I leave that entry, I want to bring up a couple of points and I know they're basics, but you've got to be aware of this. Notice something. Notice that the total value of stockholder's equity, the total book value of the corporation before the stock dividend 3,000,006.

Now think about this. What's the total value of stockholder's equity. What's the total book value of the corporation after the stock dividend 3,000,006. If you look at that entry notice, we're not doing anything in that entry that affects total stockholders' equity. All we're doing is taking money out of retained earnings.

And putting it into other capital accounts and there's a term you should know what you've done in this entry is you have capitalized a portion of your retained earnings. You should know that term. So what you've done in the century is you have capitalized a portion of your retained earnings. And please remember that stock dividends or splits, we'll get to splits in a moment, but stock dividends or splits never effect.

Total stockholders' equity. They never affect the total book value of the corporation. All right. Now let's say that 10% stock dividend never happened. Okay. Wipe it from even your memory banks. Let's say instead, let's say the same corporation. See this way we can use the same stockholders' equity section.

Let's say the same corporation declares a 100% stock dividend or what they could call a two for one split. So the same corporation now declares a 100% stock dividend or a two for one split. Now, again, let's start with basics. How many shares are going out? If you declare a hundred percent stock dividend, you are literally increasing your shares outstanding by a hundred percent, you're sending out another 60,000 shares.

Now you have to be careful because there are two acceptable ways of handling a split one way of handling a split. You just make a memorandum entry. Notice there's no journal entry. We're not going to book anything. We just make a memorandum entry to the effect that the number of shares outstanding have doubled from 60,000 to 120,000.

And the par is cut in half, goes from $10, a share to $5 a share. So take $5 times 120,000 shares. Outstanding notice we'd still have 600,000 of legal capital. That is a perfectly acceptable way of handling that split. You just make a memorandum entry, there's no journal entry. You don't book anything, just a memo that says, Hey, the shares outstanding have doubled from 60,000 to 120,000.

And the par is cut in half from 10 to five. Now notice something before I get into the second approach before we get into the second way, you can handle a split. Notice that if we handle a split with a memorandum entry, par per share has to go down. I want you to know that anytime you handle a split with a memorandum entry, par per share has to go down, like in my example, shares outstanding of doubled power is cut in half from 10 to five.

And the problem is that in practice, you may not be able to do that. You can in practice, you could run into a legal restriction. It could be that the laws of the state you're incorporated in won't allow that. You know that $10 per share par value is sacred, or it could be your, your bylaws, your articles of incorporation say you can't do that.

That $10 per share par value is sacred. All right. So here's the second way you can handle a split in a split. If the corporation wants to maintain that tender dollar per share par value. And as I say, it's probably in practice a legal requirement. That's what you run into a legal barrier and with a split.

If a corporation wants to maintain that $10 per share par value. Now they will book an entry. They'll capitalize retained earnings for the par value of the shares. They send out not the fair value. So we know they sent out another 60,000 shares times par 10, we're going to debit retained earnings, 600,000.

We're going to credit common stock, 600,000. That's the second way you can handle a split. If the corporation wants to maintain that $10 per share par value with a split. And as I say, it's probably a legal requirement. Now they will book an entry. They will capitalize retain earnings for the par value of the shares.

They send out not the fair value. So I took the 60,000 shares that they're sending out as a dividend. Times the par 10 and I debit retained earnings, 600,000. I credit common stock, 600,000. So now what does my balance sheet look like? I've got 120,000 shares, outstanding times, par 10. I kept the par 10. I now have 1 million, 200,000 of legal capital.

So those are the two ways you can handle the split. Either make a memorandum entry. Hey, shares outstanding. Have doubled parts cut in half. Or if the corporation in a split wants to maintain that $10 per share par value. They will book an entry where they capitalize retained earnings for the par value of the shares they send out.

I'd like you to try some questions. I'd like you to do questions four through seven, and then come back.

Welcome back. Let's do this group of questions together in number four. They say on May 18th of the current year Saul's board of directors declared a 10% stock dividend, the market price of solves 3000 outstanding shares of $2 par stock was $9 a share on that date. And that's the only date we care about.

Date of declaration. They go on to say the stock was trading for $10 a share on July 21st, the day they actually send out the shares. But as I say, all we care about with the dividend is the date of declaration. Let's think about the entry that would be made here. We know that if you declare a 10% stock dividend, you are literally increasing your shares outstanding.

By 10%, you're sending out another 10%. You're sending out another 300 shares, 10% of 3000. We're going to take those 300 additional shares, times $9. What the stock is trading for on the day of declaration, and we're going to debit retained earnings 2,700. We're going to credit common stock for legal capital 300 shares times.

Par two or 600 and you would credit additional paid-in capital for the rest 2,100. That's the entry to book a stock dividend. So when they ask at the bottom, what am I would solve credit to API C because of the stock dividend. You know what to answer a 2,100 now five and six are a set. Five says how would a hundred percent stock dividend effect additional paid in capital and retained earnings?

I have a question for you. In a split and we know a hundred percent stock dividend that's big enough be a split in a split. Would it be possible to have no change to API C no change to retained earnings? Would it be possible to have no change? Both columns? Yes. How, if we did a memorandum entry, remember if we do a memorandum entry?

There is no journal entry. We don't book anything. It's just a memorandum entry. So with a memorandum entry, there'd be no change to additional paid in capital, no change to retain earnings. But did you notice that's not an answer choice. If that's not an answer choice we had to infer, they must have done the second approach where they would capitalize retain earnings for the par value of the shares they sent out.

Now, how many shares are they sending out? Notice as we start here. The stock has a par of a dollar. There must be 90,000 shares. Outstanding because common stock has a balance of 90,000. And if we declare a hundred percent stock dividend, we're sending out another 90,000 shares. And if we want to maintain the par per share, we'll take those 90,000 shares.

They're sending out times par a dollar we'll debit, retained earnings, 90,000 credit common stock, 90,000. So the answer is D. Retained earnings would go down. And in this example, 90,000 API would not be touched. They must have capitalized retained earnings for the par value of the shares. They sent out.

It's a split. So retained earnings would go down, but API would API C wouldn't be touched. And the answer is D in number six, they say, how would a 5% stock dividend affect API C and retained earnings? So now it's a small one. Right now it's a small, a 5% dividend. If it's a 5% dividend, instead, we're going to debit retained earnings for the fair value of the shares, whatever that is.

We were not told the fair value, the shares, but in a stock dividend, not a split, we would debit retained earnings for the fair value of the shares. Credit common stock for power, dollar and credit API C for the rest. And we know that would be API because they did say at all times the stock was selling more than par.

They did say that at all times the stock was selling for more than par. So there would be API C so on a small stock dividend. In this case, 5%, we would debit retained earnings for the fair value of the shares. So retained earnings would go down. We'd credit, common stock for legal capital and API C would go up and the answer is a.

Number seven

following stock dividends were declared and distributed by Saul and they want to know the aggregate debit to retain earnings. Remember I said, basic guideline you can always lean on is 25% or more split under 25% dividend. Just good to know that. That's good guideline. You can lean on it 25% or more split under 25% dividend.

And if you remember that, you know that the 10% distribution is a stock dividend. So you would debit retained earnings for the fair value of the shares fair value. So I would circle that 15,000. Now the 28% distribution is a split. So you would debit retained earnings for the par value of the shares. So I would circle the 30,800.

So when they ask us at the bottom, what is the aggregate debit to retained earnings? It's 15,000 plus 30,800. Answer B 45,800.

Now, one thing I worry about with my students. Don't be one of those students who confuses a stock dividend with a property dividend. They're really very different. Let me make sure you see the difference. That if I own a thousand shares of Microsoft stock and Microsoft sends me 25 shares of Microsoft stock as a dividend, we know that's a stock dividend.

We know that, but how about this? What if I own a thousand shares of Microsoft stock? And Microsoft sends me 32 shares of AOL stock as a dividend. That's a property dividend. They're very different. So if I own a thousand shares of Microsoft and Microsoft know sends me 15 shares of AOL stock as a dividend, that is a property dividend.

Now, before we look at a problem, the big thing to remember about property dividends is that property dividends are always recorded at their fair market value. Always use the fair market value of the property. On the day of declaration, always with dividends. That's the date. We care about date of declaration and with property dividends, it's always the fair market value of the property.

On the date of declaration, let's go to a problem. Look at number eight, eight says on December one, NILAH declared a property dividends. So notice the FAR CPA Exam makes it very clear. This is a property dividend. NILAH declared a property dividend of marketable securities to be distributed on December 31 to shareholders of record December 15th.

So you notice very often in the exam, they give you all these dates. But as the only date we care about is date of declaration. They go on to say on December one, the date of declaration, the marketable securities had a carrying amount of 60,000 and a fair value of 78,000. What is the effect of this property dividend on retained earnings?

Let me show you the entry that you make for a property dividend. When nihilo declares this property dividend, they're going to debit retained earnings. For the fair value of that property on the date of declaration in this case, 78,000, as I said, the key to property dividends is to use the fair market value of the property on the date of declaration.

So nihilo in this problem. We'll debit retained earnings for 78,000 they'll credit, investment in AOL and investment in Tandy company, whatever it is credit the investment for its original cost 60,000. And the important thing is you'll credit gain 18,000. Nyla will have to report. And he gained a loss on the property and here it is a gain of 18,000.

Now there's a nasty little point here. They said, what is the effect of this property dividend on retained earnings. Now you think it's answer D but be careful because they said after all the nominal accounts have been closed. Now, I don't know if you've seen that term before. What are nominal accounts?

Nominal accounts are income statement accounts, revenues, expenses, temporary accounts. These are nominal accounts. And if you look at our entry where I debit retained earnings for the fair value of the property, 78,000 credit, the investment for its original cost 60,000 credit gain on investments, 18,000.

What is the nominal account in that entry? The gain is an income statement account. It's a nominal account. That's been closed. That game was close to retain earnings. We're all game and losses ultimately end up. So think what's happened here. Retained earnings went down by 78,000 because of the declaration.

But if all the nominal accounts have been closed, that game would have gone to retained earnings and retained earnings would have gone up 18,000. So the net effect on retained earnings is 78 minus 18 60,000 answers seats nasty. After the nominal accounts have been closed. After that game has been closed to retained earnings, the net effect on retained earnings would only be 60,000 answers.

C make sure you remember that entry to record a property dividend. Because you might see that.

Now what I want to get into next is stock options. More precisely stock options that are meant to be salaries and wages, stock options that are meant to be compensation. Let me say this right away. If you're in the FAR CPA Exam and stock options that are meant to be salaries and wages, they're meant to be compensation right away.

There are two big issues issue. Number one, when do we measure the compensation? That's issue. Number one, when do we measure the compensation and issue? Number two, how do we measure the compensation? Those really are the issues. When do we measure the compensation? How do we measure the compensation?

When do we measure the compensation? How do we measure the compensation? The answer to when you measure the compensation is on the day of the grant. Remember that we measure the compensation when, on the day of the grant now, how do we measure the compensation? In terms of how we measure the compensation, all corporations now have to use what they call the fair value based method.

The fair value based method to value the stock options as compensation. And the point is that the real way to measure the compensation is to ask yourself, what are those options were on the day of the grant? What would somebody be willing to pay you for those options? What's the fair value. Those options are the day of the grant.

That's the best way to measure the compensation. So here's what it comes down to. How do we estimate what options are worth? How do we estimate the fair value of options? They recommended the black Sholes binomial pricing model in terms of how you measure what the options are worth. The fair value of the options on the day of the grant, they've recommended what they call the black Shoals binomial pricing model.

Now listen carefully in the black Sholes model. We have to look at six factors on the day of the grant. We look at six factors to try to estimate. What the options are worth. And I think going into the exam, you've got to know the six factors and just a fast way to remember the six factors. Remember the word devils, D E V I L S.

If you just remember the word devils, you've got all six factors, let's go through them. The D stands for dividends. What are the expected dividends from the stock? Are they high? Low non-existent? I is exercise price. What's the exercise price. What's the option price on the stock. We look at that.

It's important. Isn't it? The V is volatility. How volatile is the stock? Is this a boring, old utility or an internet startup? It matters. Doesn't it? How volatile the stock is. Look at volatility. I is interest rates on the day of the grant, our interest rates high, low, it matters in terms of how you discount it.

Doesn't it high, low interest rates. So I is interest rates. L is the life of the option. Why do we look at that? Because, if I have an option to buy a million shares of Microsoft stock and I have to exercise those options within 24 hours, they're not nearly as valuable are they as if I had 10 years to exercise the options, right?

The life of the options matters a lot. I have to, if I have to exercise the options within the next 15 minutes, they're not worth very much, but if Microsoft gives me 15 years to exercise the options. They're worth a great deal. So you look at the life of the option and then S what's the underlying stock price.

What's the underlying stock price. If you can remember devils, it gives you all six factors.

Let's do a little problem. If you look at your viewers guide. You'll see a problem on January 1st, 2011, a company grants, an option to a we're going to assume that a is the president of the corporation. So company grants and option a and the president a can use this option to purchase up to 10,000 shares of stock.

The stock has a par of 10. And the option price is $25 a share. That's the option price. That's the exercise price. In other words, the president can buy up to 10,000 shares at that fixed price. It's called the exercise price or the option price $25 a share. Now, one more thing, these options are to compensate the president for four years of service.

All right. So these options are meant to compensate the president before years of service. All right. So you're in the exam. You see this problem, that. There's two big issues right off the bat. When do we measure the compensation? How do we measure the compensation? As the answer to when you measure the compensation is on January 1st, 2011, the date of the grant.

So you're going to measure the compensation on January 1st, 2011. That's the date of the grant now? How do you measure the compensation? All corporations have to use the fair value based method. So they've recommended the black Shoals binomial pricing model. So let's say we use the black Sholes model.

And we look at the expected dividends from the stock, the exercise price, and the option, how volatile the stock is, interest rates, the life of the option, the underlying stock price. We evaluate all those six factors. And based on those six factors, we estimate the options of worth on the day of the grant, $160,000.

All right. So by analyzing those six factors, we've estimated that on the day of the grant, those options are worth $160,000. By the way, I really believe the FAR CPA Exam would have to give you that number. In my opinion, there's no way the FAR CPA Exam could give you the six factors. Have you evaluate the six factors and come up with a number?

So don't get nervous about that. That's beyond the scope of the FAR CPA Exam that takes experts. So don't get nervous about that. I believe the FAR CPA Exam would have to give you a number. Because as I say to have you evaluate the six factors and come up with a number that's just beyond the scope of the exam, it takes experts to come up with that.

All right. So we've analyzed the six factors and based on those six factors, we estimate those options of worth $160,000. Me let's do some entries. What's the entry that they would make on the day of the grant. Listen carefully on January 1st, 2011 on the day of the grant, we're going to debit deferred compensation.

160,000 and we're going to credit stock options, outstanding, 160,000. That would be the entry that would be made on the day of the grant. We would debit deferred compensation, 160,000, and we would credit stock options, outstanding, 160,000, like you to think about a couple of things. What kind of account is stock options?

Outstanding. Is it an asset, a liability? No, it is a stockholder's equity account. That's why we're covering this with stockholders' equity because that account stock options outstanding. That is a stockholder's equity account. And in fact, that account is going to stay down in stockholders' equity until when, till the options come in until they're exercised.

That is a stockholder's equity account. What kind of account is deferred compensation? Contra equity. That's a contract equity account. So that's a debit and stockholders' equity. That is a reduction of stockholders' equity. It is a Contra equity item. So right now in the balance sheet, this all washes out, but that would be the entry on the day of the grant.

Now, listen carefully. Don't forget that your job in that exam is to allocate the compensation over the periods of service. A lot of students forget that. But that's really your job in the FAR CPA Exam to allocate the compensation over the periods of service. Weren't we told that these options were meant to compensate the president before years of service.

So let's say a year goes by it's now December 31. It's now December 31, 2011. What's my thinking since one of the four years have passed, right? These options were meant to compensate the president for four years of service. So at December 31, 2011, we're going to thank well since one of the four years have passed.

Presumably what one quarter of the services have been performed. So we're going to debit compensation expense for one quarter of 160,000, 40,000. And we're going to credit. Deferred compensation, 40,000. Notice my entry, debit compensation, expense salaries, and wages. This goes to my income statement as an expense, we allocate the compensation over the periods of service.

So we're going to debit compensation and expense 40,000. We're going to credit deferred compensation, 40,000. And there'd be an entry just like that. On December 31st, 2012, December 31st, 2013, December 31st, 2014. We allocate the compensation over the periods of service. Now, one more thing. What happens when the options are exercised?

Let's say the president AE decides to exercise all the options. Let's go through the entry. If the president decides to exercise all the options, how many shares can the president buy? 10,000? Does the president have to pay any cash? Yes. $25 a share number. The stock's not free. The president can buy up to 10,000 shares at a fixed price.

Called the option price or the exercise price $25 a share. So if the president buys exercises, all the options buys 10,000 shares at $25 a share won't the corporation debit cash 250,000 because the president after all just bought 10,000 shares at $25 a share. So the corporation's going to debit cash 250,000.

And now because the options have come in. They're going to debit stock options, outstanding, 160,000. That account comes out of stockholders' equity. We're going to credit common stock. We issue 10,000 shares at par 10. So we're going to credit common stock for legal capital, always a hundred thousand. And we're going to credit additional paid-in capital for 310,000.

That's the entry that's made when the options are exercised. And I want to make sure you understand that entry could be made 12 years from now. They could say the president has up to 12 years to excise the options. That's very generous, but it doesn't alter the fact that we allocate the compensation over the periods of service watch out for those time periods.

Again, they could say in a problem, the co the president a has up to 25 years to excise the options. That's incredibly generous, but it doesn't alter the fact that we allocate the compensation over the four years of service watch out for those time periods. I'd like you to try a couple of questions, please do nine and 10.

And then

welcome back. Let's look at these questions together. Number nine says January 2nd of the current year K company, granted Morgan, the president. Compensatory stock options to buy up to a thousand shares of K stock. The stock has a power of 10 and there's a call price of $20 a share. So that's the exercise price.

That's the option price. The president can buy up to a thousand shares at that fixed price, $20 a share. And then it says the options are valued at $35,000 on the date of the grant. Now we know that when we see compensatory stock options, we know there's two issues. First. When do we measure the compensation on the day of the grant?

How do we measure the compensation? Fair value? What's the fair value of the options on the day of the grant notice they gave it to you 35,000. They must've evaluated the six factors. In the black Sholes model, the dividends, the exercise price, how vulnerable stock is interest rates, the life of the option, the underlying stock price.

They look at, they looked at devils and analyzing those six factors. They thought the options were worth $35,000 on the day of the grant. And as I said before, I think realistically, the FAR CPA Exam has to give you that number. They can't make you come up with a number. I don't believe so. Just beyond the scope of the exam.

All right. So what entry did. This company make on the day of the grant on the day of the grant, January 2nd, they would have debited deferred compensation, 35,000, and they would have credited stock options outstanding, 35,000. That's the entry on the day of the grant. And then they say on December 31, Morgan exercised all the options.

So let's go through that entry. If Morgan exercises, all the options, December 31, we know that Morgan can buy a thousand shares at that fixed price. $20 a share. So the company is going to debit cash 20,000, and now that the options have come in they'll debit stock options outstanding. 35,000 they'll credit, common stock for legal capital, a thousand shares at par 10, 10,000 and credit API C for the rest 45,000.

That's the entry that would be made. So when they ask at the bottom, by what net amount. Would stockholders' equity increase as a result of the grant and exercise of the options. We'll look at our entries. Didn't we credit common stock, 10,000 didn't we credit API 45,000 haven't. We credited capital accounts for a combined 55,000, but deferred compensation is Contra equity.

So total stockholders' equity went up 55,000. Minus 35,000 cause deferred compensation is contract equity. Total stockholders' equity went up answer a 20,000. Number 10 says in a compensatory stock option plan for which the grant measurement and exercise date are all different. The stock options outstanding account would be reduced on what day?

When do we debit stock options? Outstanding. When the options are exercised and the answer is D when the options are exercise, we debit cash, whatever that whatever's paid, debit stock options. Outstanding. It is reduced on the exercise date, answer day, and then we credit common stock, but legal capital and API C for the rest.

Let's talk about treasury stock. I think you know that when a corporation acquires shares of its own stock, that's what we're going to look at here. When a corporation acquires. Shares of its own stock B shares immediately when the treasury and it's what we mean by the phrase restock now, right off the bat.

I think there are three main points that you always want to remember about treasury stock. Let's go over them. Point number one, remember that when shares are in the treasury, they're still considered authorized. They're still considered issued, but they're no longer considered outstanding shares. Always keep that mind when shares are in the treasury, they're still considered authorized.

They're still considered issued, but they are no longer considered outstanding shares. In fact, what does outstanding mean? Remember outstanding means in the hands of shareholders for shares to be outstanding, those shares have to be in the hands of shareholders. And of course these shares are not in the hands of shareholders during the treasury.

So when she has her in the treasury, they are, they're still authorized. They're still issued, but they are no longer considered outstanding shares. Point number two. Remember that treasury stock gets reported in the balance sheet as a Contra equity item, treasury stock is a debit and stockholders' equity.

It is a reduction of stockholders' equity. It always gets reported as a contract equity item and point number three, the cost of the shares in the treasury also place a restriction upon retained earnings itself. So you should also remember that when shares are in the treasury, the cost of the shares in the treasury.

Place a restriction upon retained earnings itself. In other words, when you have shares in the treasury, you have to have a footnote for creditors, shareholders of interested parties that theoretically corporation could distribute all of their retained earnings as a dividend, except the cost of the shares and the treasury see the cost of the shares and the treasury place, a restriction upon retained earnings itself.

So when you have shares in the treasury, you basically have to have a footnote that says. Theoretically, the company could distribute all their retained earnings as a dividend, except the cost of treasury shares. So keep that in mind as well. Now, the most important thing about treasury stock, the most heavily tested part of treasury stock is how to account for treasury stock.

And as you may know, there are two acceptable methods of accounting for treasury stock. There is the cost method and there is the par value method. So that's what you're up against. There are two acceptable methods of accounting for treasury stock. There's the cost method, and there is the par value method.

Now we're going to start with the cost method. And let me just say that I think the best way to study this. If, the journal entries for each approach, you should be able to break down any problem. the FAR CPA Exam comes up with. So let's start with the cost method is a problem. If you look in your viewers guide, let's say originally a corporation issued a thousand shares of $10 par stock at $15 a share.

That's what originally happened. Originally corporation issued a thousand shares of $10 par stock at $15 a share. So we know what entry the corporation originally made. The corporation would have debit and cash for what they collected a thousand shares at 15, 15,000, they would credit common stock for legal capital.

They would credit common stock for a thousand shares at par 10 or 10,000, and they would credit API C for the rest 5,000. That's what originally happened. Now we're going to assume that some time goes by and the company has bought back 200 shares of their own stock. And paid $18 a share. So they've bought back 200 shares of their own stock, paid $18 a share and notice they've decided to account for that treasury stock under the cost method.

Let's go through the entries under the cost method. First of all, remember under the cost method, we always debit the treasury stock account, but the cost of the treasury shares. That's why they call it the cost method. So we're going to start by debiting treasury stock for 200 shares at 1830 600. And credit cash 3,600, because under the cost method, we always debit the treasury stock account for the cost of the treasury shares.

All right. Now let's assume some time goes by and now the company sells a hundred chairs out of the treasury for $20 a share. What are you going to do? If they sell a hundred chairs out of the treasury for $20 a share, they're going to debit cash for what they collected a hundred shares at 20 or $2,000.

What do they credit the treasury stock? They're going to credit treasury stock for its costs for its carrying value. And that would be a hundred shares at 18 1800. And you'll notice what we have here. A gain on sale treasury stock. Notice we need a $200 credit to balance the entry out. What we have here is a gain on sale of treasury stock.

Now, you know what I'm going to ask you. Should I credit gain on sale treasury stock 200 never listened carefully. Treasury stock transactions. Never affect income statement accounts. Remember that treasury stock transactions only affect balance sheet accounts, and I'll give you another absolute, anytime there's a gain indicated in any type of treasury stock situation, anytime there's a gain indicated in any type of treasury stock situation, what do you always credit API?

See, now you notice. I'm going to be a little bit picky here. I'm going to credit additional paid-in capital from treasury stock. I'm going to credit API from treasury stock, but again, anytime there's a gain indicated in any type of treasury stock situation, you would always credit additional paid-in capital or in this case, API from treasury stock.

And I don't want you to misunderstand that account API, see from treasury stock that account's not published in a published balance sheet. You only publish one API C account, but in your subsidiary accounts, you keep track of API by source, but that's not why I'm using that account name. I'm using that account name API C from treasury stock, because you'll see that in the exam.

Sometimes the FAR CPA Exam draws that distinction, but in your balance sheet, it's just all going to show up as API C. All right. Now let's assume some more time goes by and now they sell the other a hundred chairs out of the treasury for $12 a share. What are we going to do? If they sell. The other a hundred years out of the treasury for $12 a share, we know they're going to debit cash for what they collect a hundred shares at 12 or 1200.

We know they're going to credit treasury stock for its cost. Its carrying value. That's a hundred shares at 18 1800. And notice now we have a loss from the sale of treasury stock notice. Now I need a debit of $600 to balance the entry out. Should I debit loss on sale of treasury stock? 600. No, we've already talked about that.

Treasury stock transactions never affect income statement accounts. Here's what I really want to ask you. Should I debit API C 600? You can't you. Can't why? Because there's a rule. There's a rule you have to know here, and it is just a rule. You know what the rule is when you sell treasury shares at a loss.

If there's a loss on treasury stock, you can only debit API C. To the extent there have been gains on prior treasury stock transactions. I'll say that again. When there's a loss on sale of treasury stock, you can only debit API. You can only debit API C to the extent there have been gains on prior treasury stock transactions.

In other words, you can only debit API C from treasury stock. So I'm going to debit a pic from treasury stock for 200. The other 400 would be a debit to retained earnings notice only balance sheet account. Only balance sheet accounts, never income statement accounts. All right. So if you, with me down to there, that's what you want to study under the cost method.

You want to know how to buy the shares, sell them at a gain, selling at a loss.

Let's now do the par value method. Let's start the same way. Let's say originally the company issued a thousand shares of $10 par stock at $15 a share. So we know the original entry they made. If they issued a thousand shares of $10 per stock at 15. We know they would have debited cash for what they collected a thousand shares at 15 or 15,000.

We know they would credit common stock for a thousand shares at par 10 or 10,000. And we know they'd credit API for 5,000. That's the original entry they would've made. And we're going to assume again, that some time goes by and now they've bought back 200 shares of their own stock and paid $18 a share.

So you'll notice this is exactly the same problem we did a moment ago, but now we're going to assume. They decided to account for the treasury stock under the par value method. Here we go. Under the par value method, we always debit the treasury stock account for the par value of the treasury shares. So I'm going to debit treasury stock for 200 shares at par 10, 2000.

I'm still going to credit cash for what I paid 200 shares at 1830 600, but that's why they call it the par value method because under the par value method, we always debit the treasury stock account for the par value of the treasury shares. So debit treasury stock for 200 shares times par 10 or 2000 credit cash for what you paid 200 shares, times 18 or 3,600.

Now I want you to know that the CPA exam always calls this the par value method always. And that does help because we know in the par value method, we always debit the treasury stock account for the par value. The treasury shares. It makes perfect sense, but I want you to know when I was a student, I never thought of this as the par value method.

I always thought of this as the retirement method. And if you look at old textbooks used to call this the retirement method, the CPA exam never does CPA exam calls it the par value method, but I'll tell you why. I liked it. The reason why some textbooks call this the retirement method is that the key to this method is to remember in the opening entry, we have to constructively retire the shares in the opening entry.

We have to constructively retire the shares. What does that mean? It means we have to debit API. As if we've retired, the shares, we have to debit API C for the original API. See on every share. Now, what is the original API see on every share $5, right? Because originally didn't, they issue a thousand shares of $10 par stock at 15.

So don't, we know this $5 of original API on every share times 200 chairs. We're going to debit that original API for thousands. And we're going to debit retained earnings for 600 only balance sheet accounts. Of course. But that's why old textbooks used to call this the retirement method, because that's the key to the method.

To remember in the opening entry, you'll have to constructively retire the shares. You've got a debit API as if you've retired, the shaders, you've got a debit API C for the original API C on every Sharon isn't that $5 because originally they issued a thousand shares of $10 par stock at 15. So I know this $5 of original API C on every share times 200 chairs.

We're going to debit that original API C for a thousand and debit retained earnings for the rest. 600, as I say, only balance sheet accounts. And I want you to say, once you get that entry down, that entry is a little tricky, but once you get that entry down, it's not bad. For example, let's say some time goes by and they sell the 200 chairs out of the treasury for $14 a share.

What are you going to do? If they sell the 200 chairs out of the treasury for $14 a share, they're going to debit cash for 200 shares at 14 or 2,800. That's what they collected. They're going to credit treasury stock for par. Remember what's in that treasury stock account. It's par value, not cost.

So we're going to credit treasury stock for 200 shares times par 10, 2000. And we know anytime there's a gain indicated in any type of treasury stock situation, we credit API say, or API C from treasury stock in this case 800. And if you look at that entry, Isn't it like a normal issuance of stock. Look at that entry.

It's just like a normal issuance of stock. We debit cash. What we collected credit treasury stock for par and the rest is API. See, I don't think that I don't think that entry bothers people, but the first entry you've got to get used to it. That in that opening entry, we constructively retire the shares.

I'd like you to try some questions. I'd like you to do 11, 12, and 13, and then come back.

Welcome back. Let's do this group of questions together in number 11, they give us a lot of information and they just say, what is total stockholders' equity at December 31? So in the area of stockholders' equity, you may get a question like this, where they just. Ask for total stockholders' equity. So basically what you have to do in a question like this is organize it.

You're going to pick up the common stock of 600,000. You're going to pick up the additional paid-in capital of 800,000. Now the retained earnings, they told you that there was retained earnings, appropriated of 150,000 and retained earnings. Unappropriated of 200,000. It really makes no difference.

Total retained earnings here. Would be 350,000 when you appropriate retained earnings like that 150,000. You're just telling shareholders, look, this part of retained earnings won't be available for dividends. They're setting it aside for some projects. Maybe like plant expansion, something like that, but it's really just informational to tell shareholders that, Hey, this part of retained earnings is appropriated.

It won't be available for dividends, but it doesn't alter the fact that your total retained earnings would be one 50 plus 200,000, 350,000. And then they also had an unrealized loss on available for sale securities of 20,000. Now we have to assume this must be their first year of operation. This must be the only one they have.

So if that's true, accumulated OCI down in stockholders' equity would be a $20,000 deficit and then treasury stock. We know that 50,000, the cost of the shares and the treasury would be reported on the balance sheet as a Contra equity item. It's a debit and stockholders' equity. It's a reduction of stockholders' equity.

So back that out, add it all up. Total stockholders' equity is answer a 1 million. 680,000. Now on number 12, we're talking about, say corporation, say the corporation goes out and buy 6,000 shares of their own stock at $36 a share say that does use the cost method. So we know in the cost method, we always debit the treasury stock account for the cost of the treasury shares.

So say it is going to debit treasury stock for 6,000 shares at 36 or 216,000 credit cash. 216,000. That's the first entry that would be made. And then some time goes by and now say to sells off 3000 shares out of the treasury. She sells 3000 shares out of the treasury for $50 a share. So what will you do?

We'll say to sales, 3000 chairs out of the treasury for $50 a share, that CEDA is going to debit cash for what's collected 3000 shares at 50, 150,000. Say there's going to credit treasury stock for its cost, its carrying value. That would be 3000 shares at 36 or 108,000. And we know anytime there's a gain indicated in any type of treasury stock situation, we're going to credit API or API C from treasury stock in this case 42,000.

So when they ask us the bottom, what accounts and amounts would say to credit to record the issuance of the 3000 chairs? We know the answer is C. Say to would credit treasury stock 108,000 say to would credit API see 42,000. Say they wouldn't touch retained earnings, say to wouldn't touch common stock.

So the answer is C and then ask the company on January 5th. ASP goes out and buys.

Let's start on J let's start January 5th. ASP issues, 20,000 shares of their own stock at $15 a share. So we know the original entry that was made, right. ASP issues, 20,000 shares at 15 originally. So ask what have debited cash for what was collected 20,000 shares at 15 or. 300,000 credit common stock for legal capital 20,000 shares at par 10 to hundred thousand and credit API for the rest a hundred thousand.

That's the original entry that was made. And now some time goes by then on July 14th, ASP buys back 5,000 shares of their own stock at $17 a share. Now ASP uses the par value method to account for treasury stock. So let's go through it. We know in the par value method, we always debit the treasury stock account.

For the par value that treasury shares. So on July 14th, this company is going to debit treasury stock for 5,000 shares at par 10 or 50,000 in the par value method. We always debit the treasury stock account for the par value. The treasury shares. We know the company is going to credit cash for what was paid 5,000 shares at 17 or 85,000.

And remember. Another way to think of this method is to think of it as the retirement method. Because in the opening entry, you have to constructively retire the shares. You have to debit API as if you're retiring the shares. You've got a debit API for the original API CEO on every share. And wouldn't that be again, $5, because originally back on January 5th, they issued 20,000 shares of $10 par stock at 15.

So we know this $5 of original API C on every share. Times 5,000 shares. We're going to debit that original API twenty-five thousand and debit retained earnings for the rest 10,000 only balance sheet accounts. Then on December 27th, the company now sells the 5,000 shares out of the treasury for $20 a share.

So what are you going to do? You're going to debit cash for what you collect 5,000 shares at 20 or a hundred thousand. You're going to credit treasury stock for par that's what's in that account. 5,000 shares at par 10 or 50,000. And any time there's a gain indicated in any type of treasury stock situation, you're going to credit API say, or API C from treasury stock.

In this case 50,000, those are the entries that would be made here. So when they ask at the bottom in the December 31 balance sheet, what amount would the company report for additional paid-in capital? Think about it back on January 5th. A pic was 100,000. Then on July 14th, API C went down 25,000, but then on December 27th, API C went up 50,000.

So it was a hundred thousand down, 25, then up 50. Now the balance in API I see is answer B 125,000. Now that concludes our discussion on stockholders' equity. And now I'd like to move on to another topic. What we're going to get into next is how to account for partnerships.

Now in the area of partnership accounting, there are several things the FAR CPA Exam can get into first. They could ask you, how do you allocate profits and losses between partners? That's a question that could come up in the exam. How do you allocate profits and losses between partners? The answer really is that you would allocate profits and losses to partners.

However, they agree to allocate the profits and losses in the partnership agreement. That's really the answer you're going to allocate profits and losses to partners. However, they agree to allocate profits and losses in their partnership agreement. What if the FAR CPA Exam is silent? If the FAR CPA Exam is silent, you would have no choice.

But to assume that profits and losses are allocated equally to all the partners, right? If the FAR CPA Exam is silent, you'd have no choice, but to assume profits and losses are allocated equally to the partners. I want you to understand my thinking here. Do you think the FAR CPA Exam is going to be silent? No, because that lets everybody off the hook.

If they're silent, we assume it's equal. They're not going to be silent. Then it's too easy. If they're silent, it's equal. That's much too easy. You trust me on this. If the FAR CPA Exam is going to give you a problem on how you allocate profits and losses to partners, you trust me, the method of allocation will be in that problem.

You have to read it carefully because as I say, if they're silent, it's just equal. That's too easy. So if they ask you a problem on how to allocate profits and losses between partners, the method of allocation will be in the problem. You just have to read it carefully. Some of the ones they like. They may give you, they may give you an, a problem, a profit loss sharing ratio.

In other words, 60% to you, 40% to me. So they may give you a profit loss sharing ratio. Now the one they like they could have partners, allocate profits and losses based on their average capital balances and their favorite example. They may have the partners take, like a monthly salary, some sort of bonus, and then any remaining profits and losses would be allocated.

In some profit loss sharing ratio. I'd like you to try one of these. I'd like you to try number 14 and then come back.

Welcome back. Let's look at this question. Number 14. They're asking at the bottom, what amount of these earnings would be credited to each partner's capital account. So we'll set up a column for red to call them for white. And you'll notice that each take a salary. Red takes a $55,000 salary. White takes a $45,000 salary, to live.

They have to live. And the problem is that the partnership profit for the year was 80,000. So when you back out the salaries, they took. 45,000 plus 55,000, a hundred thousand that throws the partnership into a $20,000 loss position. And red would get 60% of that loss or 12,000 white would get 40% of that loss or 8,000.

And that'll give you the final distribution. The final distribution to red would be the 55,000 that red took as a salary minus their share of the loss. 12,000. The distribution to red will be 43,000. White that the $45,000 salary minus their last distribution of 8,000, what will be credited to White's account would be 37,000.

And the answer is B. So it's not too bad. As I say, anytime, the FAR CPA Exam is going to ask you how to allocate profits and losses to partners. The method of allocation has to really be laid out in the problem one way or another, because if they're silent, it's equal. And I just don't think they would do that.

The problem with partnership accounting. Is I think, that there are other things they can get into. For example, they could ask you questions about the formation of a partnership, formation. They could ask you questions about how you would admit a new partner to a partnership. They could ask you questions on how you handle the retirement or the withdrawal of an old partner for the partnership.

And of course, everybody's favorite. They could ask you. How to liquidate a partnership,

let's start with formation and I want to go right to a problem. Let's go right to number 15, 15 says. Abel and car formed. I would circle the word form. This is a question on formation Ablin car formed a partnership and agreed to divide initial capital equally. I want you to underline divide initial capital equally.

That's important, even though a contributes, a hundred thousand and C contributes, 84,000 in identifiable assets under the bonus approach. I want you to circle bonus approach under the bonus approach. To adjust the capital accounts, what his cars on identifiable asset. And I'd like you to write underneath on identifiable assets, the word Goodwill.

I don't know if you recall this from school, but remember Goodwill technically is an unidentifiable and tangible. The point is it's not an identifiable asset that you can buy and sell. I can't sell you Goodwill. I paid for you. Can't sell me. Goodwill. You paid for Goodwill is what they call technically an unidentifiable intangible.

I could sell you my copyright. I could sell you my patent. Those are identifiable intangibles, but Goodwill is an unidentifiable and tangible. So when they ask for cars, unidentifiable asset, they mean what would be the Goodwill? Let me show you the entry. They said they use the bonus approach. Here's the entry that the partnership would make under the bonus approach.

They said that a contributes a hundred thousand in assets C contributes 84,000 in assets. So the partnership will debit assets 184,000. So the partnership will bring the assets on the books, debit assets, 184,000. And because they said they agreed to divide initial capital equally. Not only will we credit a capital 92,000 we'll credit C capital 92,000.

The way to look at this in the bonus approach, really a is giving see an $8,000 bonus because they said they agreed to divide initial capital equally. Not only would I credit a capital 92,000, I would also credit C capital 92,000. And as I say, the way we really look at this is really giving see an $8,000 bonus.

All right. That's the entry that you would make in the bonus method? What's the answer. What is cars on identifiable asset? What's the Goodwill it's answer D there is no Goodwill. There's no Goodwill in the bonus approach. There's only Goodwill in the Goodwill approach. So I hope you see why the answer is D there is no Goodwill in the bonus method.

There's only Goodwill in the Goodwill method. Let me show you the Goodwill method. Same problem. If I did this problem under the Goodwill method. Again, they said a contributes a hundred thousand in assets C contributes to 84,000 and assets. So the partnership will debit assets 184,000. But because they said they would divide initial capital equally.

Not only what I credit a capital, a hundred thousand, I'd also credit seek capital a hundred thousand and I would recognize. That C must be bringing in 16,000 of Goodwill. And I would debit Goodwill 16,000. And now the answer is B. If I were you for my studying, I would write next to answer B Goodwill method.

If this had been the Goodwill method, the answer would be B, but because it's the bonus method, it's answer D because there's no Goodwill in the bonus method, there's only Goodwill in the Goodwill method. So I hope you with me on that's really everything the FAR CPA Exam could ask on the formation of the part of a partnership.

Yeah, just make sure you study those two entries, make sure the bonus of method and make sure the Goodwill method.

All right. Now let's get into how you admit a new partner to a partnership. How do we handle the admission of a new partner? To a partnership. Let's go to question. Number 16, 16 says Blau and Ruby are partners who share profits and losses in the ratio of 60, 40 E respectively on may. One of the current year, their respective capital counts were as follows.

So notice as we start Blough capital is 60,000 Ruby. Capital's 50,000. I want you to bracket those two numbers together. And I want you to show they add up to 110,000 because as we start, Blau capital is 60,000 Ruby capitalist, 50,000. So you bracket those two numbers together and just show for your own information that as we start total contributed, capital is 110,000.

Then they say, On that date, Linde was admitted as a partner with a one-third interest in capital and profits for an investment. I'd like you to underline the word investment. We'll talk about it in a bit for an investment of 40,000. All right. Now, listen carefully. This is really subtle. This is really subtle.

Then they say the new partnership began with total capital of 150,000. Now this thing for a minute, what was total capital before Linda came in? 60 plus 50, 110,000. How much is Lynn bringing in 40 does not add up doesn't that add up to 150,000, and because they said the new partnership began with total capital of just that 150,000 that tells me they're not going to record any Goodwill.

This is going to be the bonus method. I'll grant you. That's very subtle. Again, total capital invested before I started 110,000. Lynn brings in 40. And because they said the new partnership began with total capital of one 50, that tells me they're not going to record any Goodwill. This is the bonus method.

Now let me show you the bonus method. Here's the entry that the partnership would make under the bonus method of admitting Lynn brings in 40,000 into the partnership. So the partnership is going to debit cash 40,000. Now didn't they say that Lynn. Is going to get a one-third interest in capital and profits.

Total capital now is 150,000. So I'm going to credit Lind capital for one third of 150,000 or 50,000. They said Len was going to get a one third interest in capital and profits. So since total capital is now 150,000, I'm going to credit Lyn capital for one third of one 50 or 50,000. See the way we look at this in the bonus methods.

The old partners are giving lend a $10,000 bonus because all Lynn contributed was 40,000. And yet Lynn's going to get a capital account of one-third of one 50, 50,000. So the way you look at this in the bonus method is that the old partners are giving Lynn a $10,000 bonus. And we're going to take that bonus out of the old partners accounts.

In their profit and loss sharing ratios. So I'm going to debit lend, excuse me, I'm going to debit Blau capital for 60% of the bonus or 6,000. I'm going to debit Ruby capital for 40% of the bonus or 4,000. That's the entry that you'd make in the bonus method. So when they asked me at the bottom, I immediately after Lynn's admission, what is Bao capital?

Blau capital before I started was 60,000. Now look at your entry. Hasn't blocked capital, gone down. 60% of the bonus for 6,000 now, black Blau capital is 54,000 answer be Bao capital before I started 60,000. When you bring Linden Blough capital went down 6,000 to 54,000. All right. Now I think, the answer there is B, but I can't leave it there because there's also the Goodwill method.

That's the bonus method. Now let's do the same problem, but going to change, I'm going to change a couple of things here. Now. Let's assume that Linde. Invests $40,000 for a 20% interest in capital and profits. It's going to change it a little bit, same basic problem. But now let's assume that Lin invests $40,000 for a 20% interest in capital and profits.

But now it's the Goodwill method. Now listen carefully. Anytime you see Goodwill method, thank formula. You really get used to it. Oh, it's Goodwill method. I have to set up a formula. Here's the formula don't we know that 20% of X. The implied value of the whole business. The implied value of the whole partnership must be worth 40,000, 20% of X, meaning the implied value of the whole partnership must be worth 40,000.

Now we know that whatever we do to one side of an equation, we do to the other side of the equation, we're going to divide both sides by 20%. What I end up with is that the implied value, the whole business. The implied value of the whole partnership would be that 40,000 divided by 20%. If you take 40,000 divided by 20%, the implied value of the whole partnership, the implied value of the whole business is 200,000.

I hope you see how we got the implied value. The whole business, 200,000 right now what's been invested. What's been invested. What was invested before Lynn came in 60 plus 50, 110,000. How much did Lynn bring? In 40,000? What's been invested is 150,000. So the implied Goodwill in the partnership is 50,000.

Again, if I know the implied value of the whole business is 200,000, but all of it's been invested is 60 plus 50 plus 41 50. The implied Goodwill here is 40,000. Now I record that Goodwill. I, excuse me. The implied Goodwill is 50,000. Again, if the implied value, the whole business is 200,000 and all of it's been invested is 60 plus 50 plus 41 50, the implied Goodwill.

Here's 50,000. Now I'm going to record that Goodwill. I'm going to debit Goodwill 50,000. I'm going to credit Blau capital for 60% of the Goodwill or 30,000. I'm going to credit Ruby capital for 40% of the Goodwill or 20,000. Remember the old partners built up the Goodwill. Linde had nothing to do with that Goodwill.

The old partners built up the Goodwill in the business. So 60% goes to Blauer or 30040% goes to Ruby or 20,000. And now you just bring Linde in debit cash, 40,000. And credit lend capital 40,000. That's the Goodwill method. Now I have a question for you and I don't hate me for this, but I have to ask you this in this problem, did Lenz $40,000 come into the partnership or did it go to the individual partners outside the partnership you ever see what I'm asking here?

Did Lynn's $40,000 come into the partnership? Or did lends 40,000 go to the individual partners outside the partnership. Noah came into the partnership. How do I know that? Because they said it was invested. So I had to underline that word that told me when I see that word invested, it tells me the 40,000 came into the partnership.

I'm going to change it. Now, what if they said this? What if they said that Lynn pays the individual partners outside the partnership $40,000? For a 20% interest in capital and profits. You see the difference. What if Lynn paid the individual partners outside the partnership, $40,000 for 20% interest in capital and profits.

Now the money's going to the individual partners outside the partnership. Let me show you the bonus method. The bonus methods, really not bad in the bonus method, you would simply debit Blough capital for 20% of their capital balance. 20% of 60,000 or 12,000. I would debit Ruby capital. For 20% of their capital, 20% of 50,000 or 10,000 and credit Lin capital 22,000, just bring Lind in.

So the bonus methods not bad there that's. If the 40,000 goes to the individual partners outside the partnership, I'll just debit Blau capital, but 20% of their capital at 12,000 I'll debit, Ruby capital, but 20% of their capital at 10,000 and credit Lin capital 22,000. Now, I can't leave it there.

What if it's the Goodwill method? When you see Goodwill method formula, let's set up the formula. Don't we know that 20% of X, 20% of X, the implied value, the whole partnership must be worth 40,000. So I divide both sides by 20%. What I end up with is that the implied value of the whole business, the implied value, the whole partnership must be that 40,000 divided by 20% or 200,000.

Now I know the implied value of the whole business. Is that 40,000 divided by 20% or 200,000. Now be careful what's been invested. What's been invested one 50 or one 10, one 10, because the 40,000 went to the individual partners outside the partnerships. See the difference what's been invested. It's still the original one 10 in the partnership because Lynn's 40,000 went to the individual partners outside the partnership.

So now the implied Goodwill is 90,000. You see the difference. Because all of it's been invested in the partnership is still the original 60 plus 51, 10 Lynn's 40,000 went to the individual partners outside the partnership. So now the implied Goodwill would be 200 minus one, 10 or 90,000. We're going to record that Goodwill.

We're going to debit Goodwill 90,000. I'm going to credit Blau capital for 60% or 54,000. I'm going to credit Ruby capital for 40% or 36,000. Remember the old partners built up the Goodwill lend, had nothing to do with that Goodwill. The old partners built up the Goodwill in the business. So I credit Blough capital for 60% of the Goodwill or 54,000 credit Ruby capital, the 40% of the Goodwill or 36,000.

All right. Now stay with me after I record the Goodwill. What's the balance in Blough capital? Blowout capital. When I started with 60,000 hasn't Blau capital gone up. 54,000 to 114,000. Now I debit Blau capital for 20% of 114,000 or 22 eight. What's the balance in Ruby capital? Before I started Ruby capital was 50,000 Ruby.

Capital's gone up 36,000 because of the Goodwill. Now Ruby capital is 86,000. I'm going to debit Ruby capital for 20% of 86,000 or 17 to, and I'll credit Lin, capital 40,000. That's if the 40,000 goes to the individual partners outside the partnership and it's the Goodwill method. See, that's the problem with partnerships.

There's so many variations. And I know when you first started to study this, you have to get it straight in your mind, but I'll tell you what you'll end up with on this, where you end up with you're in the exam. You'll go. Okay, wait a minute. Is the money coming into the partnership or outside the partnership?

Oh, inside. Is it bonus method, Goodwill method, formula. That's where you are on it. I'll do that again. That's  your mindset. When you see partnership questions, you go, wait a minute. Is the money coming into the partnership or outside the partnership? Oh, outside is a bonus method.

A Goodwill method. Oh, it's bonus. So I don't worry. I don't have to do a formula. I just bring the part in the rent. Oh, it's Goodwill method. Formula work with a little bit. You get used to it. I'd like you to try one. I'd like, what's going on? We're going to go to a set. Which is 17 and 18. All I'd like you to do is number 17.

We're going to do 18 together. Shut FAR CPA Review course down, just do number 17, come back. We'll do it together. And then we'll do 18 together.

Welcome back. Let's look at number 17 and 18 in 17. They say on June 30th of the current year, the condensed balance sheet of the partnership of Eddie Fox and grim together where they respective. Profit and loss sharing percentages are as follows. And in 17 they say ham is admitted as a new partner with a 25% interest in the cap, but it'll have a new partnership.

So notice in this case, the money's going to come into a new partnership. So in this case, the money's not going to the individual partners outside the partnership. No Ham's money is going to come into a new partnership. Ham is going to make a cash payment of 140,000 into a new partnership. So the money is coming into the partnership.

Total Goodwill I'd circle that Goodwill. It is the Goodwill method. Total Goodwill implicit in the transaction is to be recorded immediately after the admission of ham. What is Eddie's capital account? I think, anytime you see Goodwill method, you think formula let's cut right to the chase.

Don't we know that the implied value of the whole business. Must be that 140,000 divided by 25%, you can take 140,000 divided by 25%. Let's agree that the implied value of the whole partnership, the whole business must be 560,000. Now, once we know that we can figure out the Goodwill, if the implied value, the whole business is 560,001 40 divided by 25% what's been invested.

What was invested beforehand came in. Was Eddie's one 60 foxes, 96, grim 64. What was invested beforehand came in was 320,000 ham brings in one 40. So what's been invested is 460,000. So if the implied value, the whole business is 560,000. What's been invested is 460,000 that tells us the implied Goodwill is a hundred thousand.

Now we record that Goodwill. We're going to debit Goodwill a hundred thousand. We're going to credit Eddie capital for 50% of the Goodwill or 50,000 credit Fox capital for 30 bucks instead of the Goodwill or 30,000 credit grim capital for 20% of the Goodwill or 20,000. Remember the old partners built up the Goodwill ham had nothing to do with that Goodwill.

And now after you've recorded the Goodwill, you just bring him in debit cash, 140,000 credit ham capital, 140,000. So when they ask us at the bottom immediately after admission of ham, what is Eddie's capital account? His capital account before I started was 160,000 Eddy capital has gone up 50,000 because of Eddie share of Goodwill.

Now Eddie capital is 210,000, which is answer B. I hope you got that. Now there's also number 18, 18 says assume instead, that ham is not admitted as a new partner, but Eddie decides to retire from the partnership. So now we're getting into how you handle the withdrawal or the retirement of an old partner from a partnership.

And by mutual agreement is to be paid 180,000 out of partnership funds for his interest, total Goodwill. I circled that word. It is the Goodwill method, total Goodwill implicit in the. Agreement is to be recorded after Eddie's retirement. What are the capital balances for the other partners? I want to show you the bonus method first.

We'll get to the Goodwill method in a moment. Let me show you the bonus method. If Eddie retires under the bonus method. You're going to debit Eddy capital for the balance. Eddie capital right now has a balance of 160,000 and he's gone. So we're going to debit Eddie capital 160,000, and he's gone. We're going to credit cash 180,000. Because by mutual agreement, they agreed to give Eddie 180,000 cash out of partnership funds. So you'd credit cash, 180,000. The way you look at it and the bonus method, the old partners, Fox and grim are giving Eddie a $20,000 bonus. Now this is, what's a little tricky.

You're going to take that $20,000 bonus out of the surviving partners accounts. In their surviving ratios. Again, you're going to take that $20,000 bonus out of the surviving partners accounts in their surviving ratios. What do I mean by their surviving ratios? Fox gets 30% of profits and losses.

Grim gets 20% 30 plus 20 is 50. So Fox would get 30 over 53 fifths of the bonus or 12,000 grim would get 20 or 52 fifths of the bonus. Or 8,000. So debit Fox capital for 30, over 53 fifths of the bonus or 12,000 debit grim capital for 20, over 52 fifths of the bonus or 8,000. That would be the entry. Now notice something they said after Eddie's retirement, what are the capital balances for the other partners?

Look at answer a. Look at our entry. Hasn't Fox gone from 96,000 down 12 to 84,000. Hasn't grim gone from 64,000 down eight to 56,000. I think if I were you just for my own studying, I would write next to answer a bonus method. If this has been the bonus method, which they could ask you, the answer would be, Hey, now we're not doing a bonus method in this problem.

They want the Goodwill method. Anytime you see Goodwill method, what do you think? Formula? We're going to have to set up a formula. Here's how you set up the formula. Don't we know that the balance in Eddy capital, when I start is 160,000, how much cash did they agree to give Eddie 180,000? When you do the Goodwill method, you have to assume that extra 20,000 cash that they're giving Eddie.

Must be Eddie share of Goodwill again, in the Goodwill method, you have to assume that extra $20,000 cash to giving Eddie must be Eddie, sheriff Goodwill. And because Eddie gets 50, the percent of profits and losses, now we can set up our formula. 50% of X, 50% of X. The total Goodwill in the partnership must be worth 20,000.

I'm going to divide both sides by 50%. What I end up with is that the total Goodwill and the partnership must be worth that 20,000 divided by 50%. Or 40,000 now I'm going to record that Goodwill. I'm going to debit Goodwill 40,000. I'm going to credit Eddie capital for 50% of it, or 20,000 credit Fox capital for 30% of the Goodwill or 12,000.

I'm going to credit grim capital for 20% of the Goodwill or 8,000. The old partners built up the Goodwill. So we give the Goodwill to the partners' capital accounts. Now, after I make that entry to record the Goodwill, what's the balance Nettie capital. Now 180,000. And now I just let Eddie retire, debit, Edie capital 180,000 credit cash.

180,000. Now we just let Eddie retire. And when they say at the bottom, after Eddie's retirement, what are the capital balances? The other partners look at answers. See hasn't Fox gone from 96, up 12 to one Oh eight. Hasn't grim gone from 64 up eight to 72,000. The answer now is C. So there's the bonus method of handling the retirement of a partner or the withdrawal of a partner.

And there's also the Goodwill method.

Now, the last thing we're going to look at in partnerships is how to liquidate a partnership. You have to know how to do this. Number 19 says. On January one of the current year, the partners of Bob Davis and Eddie who share profits and losses in the ratio of 50, 30, 20 respectively, decide to liquidate the partnership.

Now, what they give us is the partnership balance sheet. The partnership balance sheet is showing cash of 50,000 other assets with a book value of two 50 liabilities. Of 60,000. The balance in C capital is 80,000 D capital is 90,000. eCapital is 70,000. Then they say on January 15th of the current year, the first cash sale of other assets with a carrying amount of 150,000 realized only 120,000 safe installment payments to the partners were made on the same date, how much cash should be distributed to each partner.

All right now to really understand this. We're going to set up a little spreadsheet here and I'm just going to pull this information right out of this balance sheet. We know, as we start the balance sheet is showing cash of 50,000 other assets with a book value of 250,000 liabilities of 60,000. And the balance in C capital is 80,000 D capital 90,000.

eCapital 70,000. And we also know the profit and loss sharing ratio. See gets 50% of profits and losses do. He gets 30% and he gets 20%. So we set up our little spreadsheet and now let's work it through step-by-step. They said on January 15th of the current year, the first cash sale of other assets with a carrying amount of 150,000 realized just 120 thousands.

Let's put that in don't we know that the cash would go up by 120,000 up to 170,000 other assets. Would drop by the book value 150,000. And of course the point is there was a 30,000 all loss on sale. Again, cash would go up by 120,000 up to 170,000 other assets would drop by book value of 150,000. And of course there was a $30,000 loss on sale.

So we have to allocate that loss, see would get 50% of that loss or 15,000. D would get 30% of that loss or 9,000. He would get 20% of that loss or 6,000. All right. So we now have, after that cash sale of assets, we now have 170,000 of cash. What do I have to do first with that cash? I'll bet. Pay off the liabilities.

You can't distribute any cash to partners yet. You've got to pay off the liabilities. So I'm going to take 60,000 of that cash pay off the liability. So that's going to drop the cash. From 170,000 down 60 to 110,000 in liabilities would drop to zero pay off the liability. So after I pay off the liabilities, I still have 110,000 cash to distribute.

Where a lot of students make a mistake. Listen, very carefully. A lot of students in the exam, get it down to this point and go, Oh, I see it. There's 110,000 cash to distribute. C would get 50% or 55,000. D you would get 30% or 33,000. He would get 20% or 22,000 and they go, hell lo, see, a lot of students do that.

Hey, there's 110,000 cash remaining. Why can't I, why can't I get 50% to S to see 30% to D 20% to eight. I'm looking at your answer. See wrong. Why doesn't that work? Very tempting. Why doesn't that work? Because we're not allocating profits and losses. You can't use the profit loss sharing ratios because we're not allocating profits and losses.

We're allocating capital and you always allocate capital based on what's left in the capital accounts. Hope that makes sense to you. We're not allocating profits and losses. So we can't use the profit loss sharing ratios. We're allocating capital and you always allocate capital based on what's left in the capital accounts.

Now, do we know what's left in the capital accounts? Not yet. There's still another little problem here. Look at the other assets. When we started other assets had a book value of 250,000. We sold other assets that had a book value of 150,000. Doesn't the partnership still have other assets with a book value of a hundred thousands still on the books.

What's the worst that could happen. This is the thinking. What's the worst that could happen. It's conservatism. The worst that could happen. Is there a total loss? What if we get zero for all the remaining assets? What if that a hundred thousand of remaining assets sells for zero? It's a total loss.

They call this maximum possible loss, M P L maximum possible loss. If the a hundred thousand of other assets are now a total loss, C would get 50% of that loss or 50,000 D would get 30% of that loss or 30,000. He would get 20% of that loss or 20,000. So what's left in the partner's capital accounts.

After maximum possible loss would be 15,000 left in seed capital 50, 1000 left in D capital 44,000 left in the capital. And the answer is a that's how we would allocate the remaining capital. We're not allocating profits and losses. We're allocating capital, and you always allocate capital based on what's left in the partner's capital accounts after maximum.

Possible loss. So be careful. Now there's a couple of things you might see that are not in this particular problem, but they could put them in. What if one of the partners went into deficit now that wasn't in this problem, but I just want to make sure you're on top of it. For example, what if in this problem C went into deficit?

If see, you went into deficit, you cannot allocate any capital till you allocate that deficit to the surviving partners. In their surviving ratios. Let me say that again. If one of the partners goes into deficit see, you can't allocate any cash until you allocate that deficit to the surviving partners in their surviving ratios.

And I think, you know what I mean by surviving ratios D gets 30% of profits and losses. He gets 20% of profits and losses. 30 plus 20 is 50. So D would get 30 over 53 fifths of CS deficit. He would get 20 over 52 fifths. Of seize deficit, then you could allocate the cash. So be careful any partner goes into deficit.

You can't allocate any cash till you allocate the deficit to the surviving partners in their surviving ratios. So be careful another point. What if I were doing a partnership liquidation and I looked on the balance sheet and I saw loans receivable from partners or loans, payable to partners. That'll mess people up.

But just quickly illustrate what if I looked on this balance sheet and I saw a $5,000 loan payable to D you know what I would do before I started, I would debit that payable five, wipe it out credit D capital 5,000. In other words, I'd make D capital 95,000 before I start, what if I looked on the balance sheet and I saw a $2,000 loan payable to eat.

What would I do? Before I start, I would debit that payable 2000, wipe it out and credit. eCapital 2000. I'd make eCapital 72,000 before I started, what if I looked on the balance sheet and I saw a $5,000 loan receivable from see what if there's a $5,000 loan receivable from C? Before I start, I would credit that receivable 5,000, wipe it out, debit C capital 5,000.

In other words, I would make C capital 75,000 before I begin. Then I would just proceed as I just did proceed as normal. So if there's any loans receivable from partners or loans payable to partners, you wipe those out first combine those loans with the partner's capital accounts before you start just in case that was thrown into the balance sheet.

That concludes our discussion of partnership accounting. And what we're going to get into next is foreign operations.

In the area of foreign operations. There's a couple of things. the FAR CPA Exam likes to get into first. They might ask you how to convert a foreign subsidiaries financial statements back to U S dollars. That's one of the topics they'll get into. How do you convert a foreign subsidiaries financial statements back to us dollars?

There are two approaches. There are two methods. There is the remeasure method and there is the translation method. So that's what you're up against. It's either going to be the remeasured method or the translation method. Now listen carefully, which method you use. Depends. On what currency, the sub functions in now listen carefully.

If the sub really functions in us dollars, most of their transactions are in us dollars. They get all their financing from us banks, a lot of transactions with the U S parent. If the sub really functions in us dollars, again, most of their transactions are in us dollars. They get their financing from us banks.

A lot of transactions with the U S parent, if the sub really functions in us dollars, you have to use the remeasure method. But if the sub functions in their local currency and you know what that means, most of their transactions are in their local currency. They get their financing from local banks, very few transactions with the U S parent, if the sub functions in their local currency.

Then you have to use the translation method and you really have to have an idea of what these methods are all about. Let's start with the remeasure method. Now, when you look at the remeasure method, you have to remember that the way a balance sheet breaks down there are basically monetary items and there are non-monetary items.

Now, remember monetary items are items whose amounts are fixed in terms of a currency. By contract or otherwise again, monetary items are items whose amounts are fixed in terms of a currency by contract or otherwise. So obviously we're talking about cash accounts, receivable, notes, receivable, accounts, payable, notes payable, don't forget bonds payable.

Held to maturity securities. These are monetary items whose amounts are fixed in terms of a currency by contract or otherwise now under the remeasure method. And remember when you use the remeasure method, the Saab really functions in us dollars. Under the remeasure method, all monetary items are converted at the current exchange rate, the rate of exchange on the balance sheet date.

December 31, all monetary items get converted at the current exchange rate, the rate of exchange on the balance sheet date, usually December 31. Now there are also non-monetary items. Non-monetary items are items whose amounts are not fixed in terms of a currency. But their values change with changing prices.

Again, non-monetary items are items whose amounts are not fixed in terms of a currency, but they're values change with changing prices. So we're talking about land, property, plant, and equipment in tangible don't forget trading securities available for sale securities. These are non-monetary items. These items are not fixed in terms of a currency.

Their values change. We're changing prices all under the re measurement method. All non-monetary items are converted at the historical rate. The rate of exchange when you bought the land, the rate of exchange, when you bought the equipment, all non-monetary items are converted at the historical rate.

So you got to remember that all monetary items, you know what those are. You hopefully know what those are. Get converted at the current exchange rate, all non-monetary items. Get converted at the historical rate, the rate of exchange on the day you bought the equipment. Now how about the income statement?

The revenues and expenses on the income statement get converted at the weighted average exchange rate for the period. Again, on the income statement, the revenues and expenses get converted at the weighted average exchange rate for the period, but there are exceptions, not depreciation expense would be based on historical rate.

The rate of exchange, the day you bought the equipment, not cost of goods sold, that would be the historical rate. That would be the rate of exchange. The day you bought the inventory, right? That's non-monetary, that's a non-monetary item. So as I say, the revenues and expenses get converted at the weighted average exchange rate for the period, but not depreciation.

That would be the historical rate of exchange. On the day you bought the machine, not cost a good soul, that would be the historical rate, the rate of exchange on the day you bought the inventory. How about retained earnings? Remember there's no exchange rate for retained earnings. You just convert the revenues and expenses the way we've said and retained earnings builds over time, you back into it.

So there's no exchange rate for retained earnings. You just convert the revenue and expenses the way we've stated and retained earnings builds over time. You're back into it. How about common stock? Additional paid-in capital historical rates. The rate of exchange on the date that you issued, the shares dividends, always the rate of exchange.

I know, you know it on the date of declaration. All right, now we do all these conversions, right? We do all these conversions. And what we end up with is a remeasure moment, gain a loss, and you've got to remember that a remeasure meant gain a loss, belongs on the income statement it's included in earnings.

So I remeasure that gain or loss, as I say, after you've done all these conversions. You end up with a remeasure gain, a loss and a remeasure gain or loss does belong on the income statement it's included in earnings. All right. And how about the translation method? Now, remember, we're going to use the translation method when the sub really functions in the local currency.

Now, what do we mean by the translation method? It's actually easier under the translation method, all assets, all liabilities get converted at the current exchange rate. The rate of exchange on December 31 balance sheet date. All assets, all liabilities get converted at the current exchange rate on the income statement.

All revenues, all expenses get converted at the weighted average exchange rate for the period. No exceptions. So on the income statement, all revenues, all expenses get converted at the weighted average exchange rate for the period. How about retained earnings? Here again, there's no exchange rate for retained earnings.

You just convert all the revenues and expenses. The way we've stated, and then retained earnings builds over time. You back into it, common stock, additional paid-in capital historical rate of exchange on the day you that issued the shares dividends always rate of exchange on the day of declaration, but here's the point we do all these conversions.

And what we end up with is a translation gain a loss, and remember a translation gain. A loss does not go to the income statement. A translation gain. A loss goes directly to stockholders equity as an item of other comprehensive income on item of O C. I so remember a remeasure meant gain a loss belongs on the income statement, not a remeasure meant gain a loss.

A remeasure meant gain a loss does not go to the income statement, goes directly to stockholders equity as an item of OCI, an item of other comprehensive income. I'd like you to do 2021 and 22.

Welcome back. Let's do these questions together. Number 20 says a foreign subsidiaries functional currency. Is it's local currency. Now, the minute that if the stop is really functioning in their local currency, you have to use the translation method, not the right measurement method. They go on to say that the local currency has not experienced significant inflation.

The reason they mentioned that is because when there's hyperinflation, if the local currency has experienced hyperinflation, and that is inflation, greater than a hundred percent. In the three previous years, when you get into hyperinflation like that, you have to use the re measurement method.

So if the local currency has, is experiencing hyperinflation a hundred percent of more inflation for the three previous years, then you have to use the re measurement method, but there hasn't been significant inflation. So it would be the translation method. The weighted average exchange rate for the current year would be the appropriate exchange rate for what sales to customers.

Yes. Wage expense. Yes. Answer B because onto the translation method, all revenues, all expenses get converted at the weighted average exchange rate for the period. No exceptions. So the answer is B number 21 gains resulting from the process of translating. So we're talking about the translation method, translating a foreign entities, financial statements from the functional currency.

They've not experienced significant inflation. So it would be the translation method. Where would these games end up? If it's the translation method, the game wouldn't go to the income statement. It would go directly to stockholders equity as an item of other comprehensive income answer, a 22. They say the subs functional currency is the currency of the country in which it is located.

If they're functioning in the local currency, you have to use the translation method. So remember under the translation methods, all assets, all liabilities get converted at the current exchange rate. So just go to the current column, add it up 475,000. The answer is C because in the translation method, all assets, all liabilities on the balance sheet, get converted at the current exchange rate.

So you just had to go to the current exchange rate column, take the total. And the answer is C. Now just take a look at this for a second. Stay on number 22. What would be the answer in the remeasure method just to make you think about it? If this were the remeasure method, the monetary items, the note receivable and the prepaid rent would be converted at the current exchange rate to 40 plus 85, but the non-monetary item, the patent.

Would be converted at the historical rate one 70. Now the answer would be D you might want to just for your own study, right next to answer D remeasure method answer would be D in the re measurement method, because this is the translation method. The answer is C. Now there's one more thing. the FAR CPA Exam likes to get into with foreign operations.

And that is how do we handle transactions that are denominated in a foreign currency. Let's go to a problem. Number 23. 23 says on September 22nd year for Umi corporation purchased merchandise from an unaffiliated foreign company for 10,000 units of the foreign companies, local currency on that date, the spot rate was 55 cents.

Let's say the euros just to have a name for all right. So let's do some entries. What entry would the company have made on September 22nd year four? If you go out, you purchase merchandise from a foreign company. And you've got to buy the merchandise for 10,000 euros. And on that date, the euros are trading for 55 cents.

Each. You'll got to debit purchases for 10,000 euros, times 55 cents, $5,500. And you're going to credit accounts payable, $5,500. Then it says Yumi paid the bill in full March 20th year five. When the spot rate was 65 cents per Euro. The spot rate was 70 cents per Euro on December 31 year. For what amount would you report as a foreign currency transaction loss on their income statement for year four?

Let's go to December 31 year four. You see what happens when you get to December 31 year for what a Euro's trading for 70 cents each, when you get to December 31 year for aren't Euro's 15 cents more expensive.  Have to adjust my payable. I have to take that 15 cent increase in euros. Times 10,000 euros, I'm going to credit accounts payable, 1500, and I'm going to debit our transaction loss of 1500.

And the answer is D that loss would go to my income statement. So I would debit a transaction loss of 1500 and credit accounts payable, 1500. That brings my payable from 5,500 up to 7,000. I had to adjust my payable right now. I pay let's carry it through. I pay the bill on March 20th, year five. All right.

So on March 20th, year five, when I pay the bill, I'm going to debit what accounts payable. What's the balance of my accounts payable? It was originally 5,500, but at year end, I adjusted it by 1500. Now the balance in accounts payable is 7,000. So at December 31, I would debit accounts payable, 7,000.

What would I credit to cash? Now euros are just 65 cents each. So I would credit cash for 10,000 euros time. 65 cents. 6,500 and notice in year five, I have a transaction gain of 500 and that gain would go to my income statement in year five, but it's not answer B because that gain goes to my income statement in year five.

They wanted the transaction loss on the income statement in year four. And that is answer D 1500. And you know what? I worry about a little bit as your teacher, I worry about this. Notice something. Transaction gains and losses belong on the income statement, not translation gains and losses. Watch out for that distinction.

Again, transaction gains and losses do belong on the income statement, but not translation gains and losses, translation gains and losses go directly to stockholders' equity as an item of other comprehensive income. So just be careful with that terminology. So that's pretty much what the FAR CPA Exam hits. With foreign operations.

And now I want to move on to another topic. Let's get into ratio analysis

in terms of ratio analysis. There are of course, a lot of ratios that have been in the exam. And if you look at our book, In our book, we cover every ratio that's ever been in that exam. And I think it's critically important that you go to our book and expose yourself to all the ratios that have been in the exam.

But I think you know that with ratio questions, you really have to know a formula. Now, I don't think you have to memorize all the formulas that are in the book because there's a lot of them. But as I say, I think you do have to expose yourself to all the ratios, but I think there are seven ratio. That you absolutely have to know cold because these seven are what I think of as the big seven, the seven that are tested most often.

So you can't go in the FAR CPA Exam and not know the seven ratios, absolutely cold. You want to memorize these formulas. So let's go over the big seven and you'll see that some of them are easy. Some of them are a little bit more difficult, but you got to know these big seven let's go over the big seven.

The first one, it's an easy one is the current ratio. If you're going to calculate the current ratio in the numerator, you want total current assets and in the divisor you want total current liabilities. It's an easy one, but it's asked a lot in the exam. The second one you have to know cold is the acid test ratio.

Sometimes they call it the quick ratio. Now, when you do the acid test ratio or the quick ratio in the numerator, you want your most liquid asset. Cash plus marketable securities plus receivables. That's what goes into the numerator, your most liquid assets cash plus marketable securities plus receivables.

And you divide by current liabilities. Number three, the FAR CPA Exam loves, and that is the accounts receivable turnover. Now, if you're going to calculate the accounts receivable turnover in the numerator, you want net credit sales. That's what goes in the numerator net credit sales and you divide by average receivables.

Now be careful of the divisor. What do I mean by average receivables it's beginning receivables plus ending receivables divided by two. Sometimes people will mess up that divisor number. You're dividing by average receivables, which again would be beginning receivables plus ending receivables divided by two.

Number four is inventory turnover. It's in the FAR CPA Exam a lot. If you're going to calculate the inventory turnover in the numerator, you want cost of goods sold. And in the divisor, you want average inventory and I know you're ahead of me. Average inventory would be beginning inventory plus ending inventory divided by two.

Number five is the price earnings ratio. You've got to know it. When you calculate the price earnings ratio in the numerator, you want the market price of the stock. And you divide by earnings per share. So obviously what can make this one a little bit more difficult is that you may have to calculate earnings per share first because that's how you get the price earnings ratio.

It's the micro price of the stock divided by EPS divided by earnings per share. Number six is book value per share. Now listen carefully. If the FAR CPA Exam wants book value per share in the numerator. You want total stockholders' equity. And if you think about it, total stockholders' equity does represent the book value of a corporation because after all the book value of a corporation is assets minus liabilities or the total value of stockholders' equity.

So in the numerator you put total stockholders' equity and you divide by the number of shares. Outstanding. Always be careful with book value per share calculations. Don't divide by authorized shares. Don't divide by issue chairs. You always divide. By the number of shares outstanding. Now the seventh ratio is the most heavily tested of all the ratios and the most complex of all the ratios.

The seventh ratio is earnings per share. And we'll get to that in a little bit. Let's do a problem on book value per share. Let's go to number 24.

24 says white corporations, current balance sheet reports, the following stockholder's equity section. And if you look at it, notice there are common shares, outstanding, and there are preferred shares. Outstanding. And I want you to know that when you see a book value per share problem, And this common end preferred stock.

Outstanding. You have to be able to calculate a book value per common share and book value per preferred share. That's. That's what you have to be ready for. Calculate a book value per common share, calculate a book value per preferred share. Now, what do they want here? If you go to the bottom, they want book value per common share.

That's what they're asking for here. Book value for common share. All right. So you're in the exam. Hopefully you've memorized the formula and, That when you do book value per share in the numerator, you want total stockholders' equity and they gave you that total stockholders' equity adds up to 1,000,020 5,000.

And of course that is the book value of the corporation. Now I'm going to divide by the number of shares outstanding, but I want you to listen carefully when this common end preferred stock outstanding. I don't care whether they ask you for book value per common share book value per preferred share the fastest way to do a problem like this.

Is to do a quick calculation on what legal claims preferred stockholders have on that million 25. That's really the way to do this. You want to do a quick calculation on what legal claims preferred stockholders have on that million 25,000? Because once I know that once I know what legal claims preferred stockholders have on that million 25 common gets the rest.

So you can always plug the common equity and that saves time. So let's work out preferred stockholders legal claim. When you work out preferred stockholders, legal claims, you watch out for three things. Number one, preferred stock holders are entitled to their par value. So let's put down the par 250,000.

I see what you're doing is looking at theoretically what this corporation would do if it ever were to liquidate. And the point we're making is if this corporation were to ever liquidate, stockholders would go to a bankruptcy court, demand that 250,000 and they'd get it. That's a legal claim they have in liquidation, their par value.

Old textbooks used to call this liquidation value per share. Now the CPA exam never does. They always call it book value per share, but it's not wrong to call it liquidation value per share because it's a theoretical calculation on what each class of stockholder would receive in liquidation.

And I'm saying if this corporation were to ever liquidate preferred stock holders would demand their par value and they'd get it. Another legal claim they have is dividends in arrears. If preferred stock is cumulative, if preferred stock is cumulative, they're also entitled to dividends in arrears and noticing this problem preferred stock is cumulative and they said, dividends are going to rears and amount of 25,000.

We're going to pick that up also. I'm saying if this corporation were to ever liquidate preferred stock holders would go to a bankruptcy court, demand that 25,000 and they get it. That is a legal claim. They haven't liquidation. Now there's one more thing to be careful about. Always watch out for liquidation premium or a redemption premium.

He said, if Lloyd has ever liquidated preferred stock holders, get their par plus a premium of 20 premium of 50,000, they get that. Also let's put that in our list. We're saying if this corporation were to ever liquidate preferred stock holders would demand that 50,000 that premium and they'd get it. And the reason they get that is bankruptcy courts see that as a contractual claim.

When we bought the preferred stock, the corporation said in the unlikely event we ever liquidate, you get a $50,000 premium. Bankruptcy courts would honor that as a contractual claim. So you pick that up as well. All right. So if you added up what a preferred stock holders, legal claims, the par of 250,000, the dividends in arrears of 25,000, the liquidation premium of 50,000 preferred equity adds up to 325,000.

And now we can solve it if the total book value of the corporation, which has given. Is 1,000,020 5,000. And we just proved that preferred stock holders have a legal claim on 325,000 of that. What is common yet? The rest, the common equity must be 700,000. That's my point. You can plug the common equity and that saves time.

So now we can solve it. If I take the common equity 700,000 divided by the 100,000 common shares, outstanding book value per common share would be answered D. $7. You've gotta be ready for that same problem. They wanted book value per preferred share. Cause they could ask you for that. If they want book value for preferred share, you'd start the same way.

Work out preferred stockholders legal claims. They add up to 325,000. So take the preferred equity 325,000 divided by the 2,500 preferred shares. Outstanding and book value per preferred share comes out to $130. You've got to be ready to do both book value per common share. Book value per preferred share.

I'd like you to try some questions. I'd like you to shut FAR CPA Review course down, do 25 to 28, 25 to 28 and then come back.

Welcome back. 25, 26 and 27 are a set. In number 25, they want it, they say the accounts receivable turnover was five times. What was net credit sales? As we've already said with ratio questions, you really have to memorize the formula. And hopefully by the time the FAR CPA Exam comes, you've memorized the formula for accounts receivable, turnover.

What is it in the numerator? We want net credit sales and in the divisor, we want average receivable. All right now, what is it we know here? We know the accounts receivable turnover is five. We know that we can also figure out average receivables. Average receivables would be the beginning receivables 20,000 plus the ending receivables 22,000 divided by two.

Let's agree that average receivables comes out to 21,000. All right. So I know the divisor 21,000. I know the accounts we will turn over is five times. What I don't know is credit net credit sales. So let's back into it. Five times 21 net credit sales. Must've been 105,000 answer a so notice, the FAR CPA Exam is unlikely to give you something just straightforward here.

If you knew the formula, you could figure out the divisor 21,000 average receivables. You knew the accounts we will turn over is five. So net credit sales had to be five times 21, 105,000, but it does as always come down to knowing that formula, same thing with number 26. They want to know inventory turnover.

You start by the fact that you've memorized the formula in the numerator. I want cost of goods sold. They gave us that cost of goods sold is 18,000. I divided by average inventory. Average inventory is beginning inventory. That's 6,000. They gave us that plus ending inventory divided by two, but I don't know, ending inventory.

That's what's missing. And I always tell my students, anytime something is missing from cost of goods sold, you want to go right to your scrap paper and put the skeleton down of cost of goods. Sold use what cost of goods sold is beginning inventory. Plus purchases equals goods available for sale minus ending inventory equals cost of goods sold.

You know that it's in your head. So you go to the scrap paper, write it down and then let's fill it in. Do we know beginning inventory? Yes. It's given 6,000. Do we know purchases? Yes. Given. 24,000. So we know goods available for sale 30,000. Now we don't know ending inventory, but we know cost of goods sold is 18,000.

So now you can plug it. What from 30,000 gives you 18,000 ending inventory had to have a value of 12,000. Because we knew goods available added up to 30,000 cost of goods. Sold was 18,000 ending inventory had to have a value of 12,000. So now we can solve it. If I take the cost of goods sold in the numerator 18,000 divided by average inventory, what's average inventory, the beginning of the beginning inventory 6,000 plus the ending inventory 12,000 that's 18,000 divided by two is 9,000 divided, 9,000 into 18,000 inventory turnover two times.

And the answer is C. Now number 27 is a ratio that you may not have memorized, but you can figure it out. Here's one they could ask for, they say a number 27, what would be the formula to determine the average day sales and inventory to work out the average day sales in inventory. It'll make sense when you see it in the numerator.

You want the number of days in a year, 365, and you divide by inventory turnover. Answer be. If you take the number of days in a year, 365 divided by the inventory turnover, which in this problem is two times, on average they have 180 days sales, 182 and a half day sales in inventory.

What that tells you is they must be selling some really big ticket item. If on average, they've got 182 and a half day sales in inventory, they might sell cabin cruisers, some big items, probably what they sell. Now a number 28, we have another book value per share problem, but notice what they want is book value per preferred share.

So you know what to do. If you want to work out book value per preferred share. First, you have to add up preferred stockholders legal claims. What legal claims to preferred stock holders have? They're entitled to their par a hundred thousand. They're also entitled to dividends in arrears. If the preferred stock is cumulative and this preferred stock is cumulative.

Notice that. The corporation was just organized January 2nd. They say no dividends have been declared well, if the corporation was organized January 2nd, and we're now at December 31, according to the problem, and no dividends have been declared than the current year's preferred dividend is in arrears. So let's work that out.

Take the fixed dividend rate for preferred 10% times the par a hundred thousand. The preferred dividend for the current year is 10,000. That's in arrears and that's a legal claim they have in liquidation. So pick up that 10,000 in dividends in arrears. Now, the last thing you always look for is a liquidation premium or a redemption premium because that's a law, another legal claim that they have in liquidation.

And did you notice? They said that the preferred stock has a par of a hundred, but a liquidation value of one Oh five. That's their way of telling you there's a $5 per share liquidation premium. So I'm going to take that $5. If the power is five and the liquidation value is one Oh five that they're telling you that there's another $5 per share liquidation premium, and that's another legal claim they have in liquidation.

So I'm going to take that $5 times the thousand preferred shares outstanding at another 5,000. To the preferred stock holders, legal claims. So what a preferred stock holders, legal claims the power a hundred thousand dividends in arrears, 10,000 liquidation premium 5,115,000 would be the preferred equity divided by the 1000 preferred shares.

Outstanding and book value per preferred share would be answered D $115.

Now the seventh and final ratio of what I call the big seven is the most heavily tested of the ratios by far and the most complicated ratio by far. And what I'm talking about. Is earnings per share. And I want you to know that when we start talking about earnings per share, I know to some extent you're already ahead of me.

I know you're probably thinking, I know where Bob is going to go with this basic and diluted earnings per share. And of course you're right. But my first piece of advice is not to go too fast. The secret to earnings per share. If there is one is to slow down and master basic earnings per share, if you think the FAR CPA Exam ever asks for basic earnings per share.

Yes. A lot. So don't think they don't test basic earnings per share. They don't always ask for diluted. A lot of times all the FAR CPA Exam wants is basic earnings per share. So that's my first piece of advice on this, slow down. Don't go too fast. You want to start by mastering basic earnings per share.

So let me give you the formula. For basic earnings per share. Now be careful when you calculate basic earnings per share in the numerator. You don't just want the company's net income. No. In the numerator you want net income applicable to common stockholders. Now let me define that. What is net income applicable to common stockholders?

It's the corporation's net income minus the current year's preferred dividend. That's how we define net income applicable to common stockholders. It's the corporation's net income minus the current years, but for a dividend and listen carefully, if preferred stock is cumulative and no doubt, it would be if preferred stock is cumulative, you'll going to back out that current years for a dividend, whether its declared or not remember that if preferred stock is cumulative, you're going to back out that current year's preferred dividend, whether it's declared or not.

All right. So in the numerator we want net income applicable to common stockholders. And be careful you don't just divide by the number of common shares. Outstanding. A lot of students do that. Don't just divide by the number of common shares. Outstanding. No, you divide by the weighted average common shares.

Outstanding for the period. Don't forget in the divisor, we divide by the weighted average common shares outstanding for the period. So you have to remember in the divisor, you have to weight the shares by how many months they've been outstanding. And that's what I want to show you next. What I want to show you next.

Is how to weight shares. Let's go to question number 29 29 says Rand had 20,000 shares of common outstanding January one year six on may, one year six, they issued another 10,500 shares. Of common outstanding all year we're 10,000 shares of non-convertible preferred on what your dividend of $4 a share was paid in December of year six, the net income for your six 96 seven.

And what is earnings per share? Notice they're not asking for a diluted, they just want basic earnings per share, which I'm suggesting is not that basic. You've got to be careful. All right. So together let's work out. Basic earnings per share for rant. We know in the numerator we want net income applicable to common stockholders.

So we're going to take Rand's net income for year six 96,700 and subtract the current years preferred dividend. The current year's preferred dividend was $4 a share times 10,000 preferred shares outstanding. The current years before a dividend was 40,000. So back that out, let's agree that net income applicable to common stockholders would be 56,700.

Now, how about the divisor we divide by the weighted average common shares outstanding for the period. How do we wait the shares? Let me just say that in terms of weighting shares, there's a long approach and there's a shortcut. It's going to show you the shortcut, which I think which is the fastest way to do this.

Here's the quick way to wait chairs. Don't we know that in this problem, they had 20,000 shares of common outstanding, January one, year six. My thinking is those 20,000 shares were outstanding. For all of your six, they were outstanding for the full year. They're outstanding for the one full year.

So give them a full weight of one that's 20,000 weighted shares again, because those 20,000 chairs route standing for all 12 months of year six, we give them a full weight of one. They were outstanding for the complete year. Give those a full weight of one that's 20,000 way to chairs. Now they also issued another 10,500 common chairs.

On May 1st, how many months have they been outstanding? May June, July, August. Don't be ashamed to use your fingers. I do may June, July, August, September, October, November, December. They've been outstanding for eight months. So give them a weight of eight twelfths. That's another 7,000 weighted shares.

You have to weight the shares by how many months they've been outstanding. Since those 10,500 chairs have been outstanding for. Eight months, we give them a weight of eight twelfths or two thirds. That's another 7,000 weighted shares. So what's the way that average common shares outstanding for the period 27,000.

If you take the net income applicable to common stockholders, 56,700 divided by the 27,000 weighted average common shares outstanding for the period. Basic earnings per share comes out to answer a $2 and 10 cents. You have to be able to do that. Let's go to number 30. In number 30 notice Fe corporations, capital structure.

They had 200,000 common shares outstanding January one. Then they also have 50,000 shares of non-convertible preferred on October one, they should have 10% stock dividend on the common paid a hundred thousand cash dividend on the preferred net income for the year 960,000. And they want, again, just basic earnings per share.

They don't want diluted just basic earnings per share. So let's work it out. We know when we calculate basic earnings per share in the numerator, we want net income applicable to common stockholders. So we're going to take Faye's net income, 960,000 minus the current year's preferred dividend, a hundred thousand.

Let's agree that net income applicable to common stockholders would be 860,000. Now we divide by way to chairs. Now, since they had 200,000 common shares outstanding for the entire year, give those a full weight of one that is 200,000 weighted shares. Now, you know why we're doing this problem because of the stock dividend on October one, they issue a 10% stock dividend.

And you know what that means. If you wish to issue a 10% stock dividend, it means you have literally increased your shares outstanding. By 10%, you've sent out another 10%. You've sent out another 20,000 shares. How many months they've been outstanding? That was October one. So haven't those years been outstanding for October, November, December three months, give them a weight of three twelfths or one quarter that's another 5,000 way to chairs.

And if you take the net income applicable to common stockholders, 860,000 divided by the 205,000 way to chairs, there's no answer there for you. There is no answer for that because there's a little trick here and they love it. And you have to remember it, please remember, and you're doing basic. Or diluted earnings per share when you're doing basic or diluted earnings per share stock dividends and stock splits are retro actively weighted again, when you're doing basic or diluted earnings per share stock dividends and stock splits are retroactively weighted.

Here's my point. You will always bring a stock dividend or split. Back to the beginning of the year. And you'll be fine if you always bring a stock dividend or split back to the beginning of the year, usually January one, you'll be fine. So the way we're supposed to look at this it's as if we're going to look at this as if what they had 220,000 shares outstanding for the entire year, just bring the stock dividend or split right back to the beginning of the year.

So we're going to look at this just as if they had 220,000 shares outstanding for the entire year. Give them a weight of one, a full weight of one. So if you take the net income applicable to common stockholders, 860,000 divided by 220,000 way to chairs, the answer is a basic earnings per share comes out to $3 and 91 cents a share answer a I'd like you to try a couple of questions, 31 and 32, and then come back.

Welcome back. Let's do these questions together. And number 31, we have to work out the weighted average common shares for the period. While we know they had a hundred thousand shares outstanding for the entire year, they're going to get a full weight of one. And you've also got this stock dividend. But we know when we do basic or diluted earnings per share stock dividends, stock splits are retroactively weighted.

It doesn't matter that the dividend was on March 31st. We're going to bring it back to the beginning of the year. In other words, the way we're going to look at this, it's just as if they had 124,000 shares outstanding for the entire year, give those 124,000 shares, a full weight of one that's 124,000 way to chairs.

And then they have the 5,000 shares. They issued on June 30th. They've been outstanding for a half a year, six months, give those a weight of a half. That's 2,500 weighted shares. And the answer is C 126,500 weighted average common shares, outstanding for the period. And one small point I want to make, if they had just said on March 31st, there was a 10% stock dividend.

No he had, they gave you the number of shares. So you really, it was harder to mess up here. They gave you the number of shares 24,000. And you just brought those back to January one. But if they had said on March 31st, there was a 10% stock dividend. Will I still bring it back to January one? That's true.

But the 10% stock dividend wouldn't have been on the 5,000 shares because those 5,000 shares issued on June 30th. After the dividend, you gotta be careful of dates. If shares are issued after stock dividend or after stock split the dividend or split, wouldn't be on those shares. So yes, you always bring a stock dividend or split back to the beginning of the year, but be careful as I say, if they just said there was a 10% stock dividend, the 10% stock dividend would be on the a hundred thousand shares.

Outstanding January one. So it'd be like you had 110,000 shares outstanding for the entire year, but the 10% stock dividend wouldn't be on the 5,000 shares because they were issued after the stock dividend. I'm just making the point that you have to be careful about dates, but in this case they just gave us the number of shares.

So it was a little easier to say, then it's as if I had 124,000 shares weighted at one and 5,000 shares waited at a half, giving me answer C in number 32. Again, notice. They don't want diluted earnings per share. They just want basic earnings per share. And you've memorized the formula, in the numerator you want net income applicable to common stockholders.

So you're going to take the company's net income 500,000 back out that current years, but for a dividend 16,000. So net income applicable to common stockholders would be 484,000. And you divide by way to chairs since they had 200,000 shares outstanding for the entire year. Give those a full weight of one.

And if you take. 484,000 divided by 200,000 way to chairs. That gives you answer a and answer a is wrong, but it's tempting. A lot of people would pick answer a and I don't know if you picked answer a or not. I know a lot of students do, and this is a lesson you really have to learn. Let's go back to the definition.

How did we define net income applicable to common stockholders? Didn't we say? That net income applicable to common stockholders is defined as the company's net income minus what the current year's preferred dividend back out, the current year's preferred dividend. What does the current year's preferred dividend?

4% of two 50, 10,000. You don't necessarily look at what they paid because they could be paying off some arrears. See, every year you back out 4% of two 50. It's a lesson. You have to remember what you're always backing out is the current years, but for a dividend, not what they paid in the current year.

What's the current year for a dividend every year. It's 4% of two 50. Last year. You would have backed out 4% of two 50 the year before you would have backed out 4% of two 50. So be careful. So if I take the company's net income, 500,000 back out, the current year's preferred dividend, 4% of two 50, 10,000.

Divide by the number of weighted shares outstanding for the period 200,000. That gives me answer B. So be careful of that lesson, you don't necessarily look at what they paid for. It could be the same, but in this problem is a difference because they could be paying off some arrears. We don't really know.

All we know is every year we back out the current year's preferred dividend. Every year, we back out 4% of two 50.

Now I want you to also remember that we use basic earnings per share. When a corporation has a simple capital structure, again, we're going to use basic earnings per share. When a corporation has a simple capital structure. In other words, all they have. Our common shares. Outstanding. What we're going to get into next is what we do with earnings per share.

When a corporation has a complex capital structure, now listen carefully for earnings per share purposes for earnings per share purposes. A corporation has a complex capital structure when besides common shares outstanding. In addition to common shares, outstanding, the corporation has other securities outstanding that are not legally common stock, but.

These securities have the potential to become common stock. They are potentially dilutive securities. That is what makes a complex capital structure for earnings per share purposes. When a corporation, in addition to common shares, outstanding, in addition to common shares, outstanding, they have other securities outstanding that have the potential to become common stock.

These securities are potentially diluted. When a corporation has potentially diluted securities outstanding, that corporation has a complex capital structure. And when a corporation has a complex capital structure, now earnings per share becomes the dual presentation. Now you must present both. You must present both basic and diluted earnings per share.

So that's how you get into this. When a corporation has a complex capital structure, now you must present both. Basic and diluted earnings per share. And what I'm going to give you next is the formula for diluted earnings per share. Here we go. It's going to be pretty familiar when you calculate diluted earnings per share in the numerator, you still want net income applicable to common stockholders, by the way, to find exactly the way we always have.

It's the company's net income minus the current year's preferred dividend. So in the numerator, I still want. Net income applicable to common stockholders in the divisor. I still divide by the weighted average common shares. Outstanding for the period. Don't forget your basic lessons in the divisor. You still have to weight the shares by how many months they've been outstanding.

But the difference is when you do diluted earnings per share in the divisor, you would also include these diluted securities. That's the difference when you calculate diluted earnings per share. In the divisor you would also add, and he diluted securities. Now, please listen. Only put these securities in the calculation.

If they cause earnings per share to go down, they have to dilute the picture. Remember diluted means down the DS, go together. So you're only going to put these securities in the calculation. If they cause earnings per share to go down, diluted goes means down the DS, go together. Now, listen carefully. If you were to put these securities in the calculation and they caused earnings per share to go up then they would be anti diluted and they don't belong in the calculation.

So that's how it works. You only gonna to put these securities in the calculation, if they cause earnings per share to go down. Diluted means down, but if you put these securities in the calculation and they cause earnings per share to go up, they are anti diluted. They don't belong in the calculation. So keep that in mind.

All right now with all that said, what are these potentially dilutive securities? Let's go over the ones to look out for first, watch out for stock options or stock warrants. Now, this, if a company has stock options outstanding or stock warrants, outstanding, they're really the same thing. Our stock warrants, stock options.

Are they legally coming and stock? No, but they have the potential to become common stock. They are potentially dilutive. Also watch out for convertible preferred stock. You know what that is? Convertible preferred stock is preferred stock that can be converted into common stock and convertible preferred stock is not legally common stock, but it has the potential to become common stock it's potentially dilutive.

And then also watch out for convertible bonds. Convertible bonds are bonds that you can convert into stock are convertible bonds, legally common stock. No, but they have the potential to become a common stock. So they are potentially dilutive. So that's what you're looking out for. Watch out for stock options or warrants, convertible bonds, convertible preferred stock.

When you see a corporation that has any of these securities stock options, stock warrants, convertible preferred stock convertible bonds. You see a cooperation with any of these securities that is a complex capital structure because those securities are potentially diluted. All right. So let's start with that in mind, let's start with stock options or warrants.

Now I think, my point, if you're in the FAR CPA Exam and you see a corporation that has stock options, stock warrants, outstanding. Are they automatically dilutive? Are they automatically diluted? No, they're potentially dilutive. So your job in the FAR CPA Exam is to test the options, to see if they're diluted or not.

See that's your job in the test. You have to test those options to see if they're diluted or not. How do you do that with the treasury stock method? That's what you need. You need the treasury stock method to test the options, to see if they're diluted or not. And that's what I want to show you next.

What I want to show you next is the treasury stock method. Let's go to questions. 33 and 34. It's a set. Let's do 33 and 34 33 says. Man had 300,000 shares of common issued outstanding December 31 year. One that on July one year two, they issued another 50,000 shares of common for cash. Man also had unexercised stock options to purchase 40,000 shares of common at $15 a share.

Once you circle that 15, that's your option price. People have the option to buy the shares at that fixed price. It's called the option price or the exercise price, $15 a share. They were outstanding at the beginning and the end of the year. So none were exercised. Then they say the average market price of mans common was $20 during year two.

I want you to underline average market price, underline that and circle the number 20. Number one says, what is the number of shares that would be used in computing? What basic earnings per share? And number 34 says, what is the number of shares? That would be used in computing diluted earnings per share.

So 33 wants to know, Hey, what, what would be the number of shares you would use in the divisor, calculating basic earnings per share, and number 34. What is the number of shares that you would use in the divisor? If you're computing diluted earnings per share are let's do basic together. If I were calculating the weighted average shares for basic, I would say there were 300,000 shares outstanding for the entire year.

So I'd give those 300,000 shares, a full weight of one. That's 300,000 way to chairs, and then they issued another 50,000 shares on July one. They've been outstanding for six months or a half a year, so I'd give those away to have a half that's another 25,000 way to chairs. I think we agree if we were doing basic earnings per share, we would divide by answer a 300 and twenty-five thousand way to chairs.

So the answer to number 33 is a that's basic earnings per share. And notice when I do basic, I don't worry about the stock options. I ignore them. But now in number 34, they want to know the number of shares we would use in con computing, diluted earnings per share. Now I have to consider the options. Now listen carefully.

When I figure out the number of way to chairs per diluted, I start the same way. I still say there's 300,000 shares outstanding for the full year. Give those a full weight of one that's 300,000 way to chairs. I still say there's 50,000 shares outstanding for six months. Give those away to behalf that's 25,000 way to cheers.

I still start the same way, but the difference is I have to test the stock options. These options are not automatically diluted, but they're potentially diluted. So I have to test the options to see if they diluted or not. And the way I do this is with the treasury stock method. And I'll tell you that with the treasury stock method, There's a long approach and there's a short approach.

I'm not even going to show you the long approach. I'll just show you the shortcut. Cause it's fast. Here's the fastest way. I know how to do the treasury stock method in this problem. What's the average market price for the period $20. What's the exercise price 15. So let's do it. I'm going to take the average market price of the period 20 minus the exercise price 15 over the market price 20.

That's how you set it up. Take the average market price for the period 20. Minus the exercise price 15 over the market price, 2020 minus 15, over 20, that factors down to five over 20, which is one quarter, one quarter of those 40,000 options would be diluted. So when I do diluted earnings per share in the divisor, I would add another 10,000 diluted shares.

Add another 10,000 diluted shares. So when I do diluted earnings per share, I'm going to divide not by 325,000 shares. I'll divide by answer B 335,000 shares. I take the average market price of the period 20 minus the exercise price 15 over the market price 20 that factors down to five or 20, which is one quarter, one quarter of those 40,000 options would be diluted.

So in the divisor, add another 10,000 shares. So when you calculate. Diluted earnings per share. You won't divide by 325,000 shares. You'll divide by 335,000 shares. Answer B. Now a couple of points. Notice in this problem that the average market price 20 is above the exercise price. 15. I want you to notice that notice in the problem, the average market price for the period 20 is higher than the exercise price 15.

And I want you to know as long as the average market price. Is above the exercise price, they're diluted. So go through the calculation, but listen carefully. If you ever see an average market price, be low, the exercise price, those options are anti diluted. Ignore them. I'll say that again. As long as the average market price is above the exercise price, they're diluted.

So go through the calculation as we did here, but if you ever see an average market price below the exercise price, those options are anti diluted. Ignore them. I'm not sure the FAR CPA Exam would do that. Because I think they're more interested in seeing if you know how to do the treasury stock method. Another point I want to make when you apply the treasury stock method.

Always use the average market price for the period. Notice I use the 20 and I want to mention that because they could throw in the ending market price also, and that would mess up a lot of people. Now in the treasury stock method, we always use the average market price for the period. As I say, they could just throw in the ending market price to see if you'd grab for it.

A lot of students would now in the treasury stock method, we always use the average market price for the period. All right. So if you're in the exam, stock options, you have to apply the treasury stock method to see if the options are diluted or not. So make sure you know that shortcut

now let's get into convertible preferred stock convertible bonds. Now it's the same thinking. If you're in the FAR CPA Exam and you see a company that has convertible preferred stock, convertible bonds, outstanding are convertible preferred shares, convertible bonds. Are they automatically dilutive? No, they are potentially diluted.

So your job in the FAR CPA Exam is to test that convertible preferred test those convertible bonds to see if they're diluted or not. How do you do that with the, if converted method? That's what we're going to get into next. This is how earnings per share breaks down. We apply the treasury stock method to options and warrants to see if they're diluted or not.

We apply the, if converted method to convertible securities to see if they're deluded diluted enough, let's go to a problem. Number 35 done had 200,000 shares of $20 par common and 20,000 shares of a hundred dollar par 6% cumulative. Convertible, you might want to circle that word convertible preferred outstanding for the entire year.

Ending December 31, each preferred share is convertible into five shares of common. I want to stop. You let's do a calculation. You might want to just show this below the question. We know what there are 20,000 shares of convertible preferred. Each share of preferred is convertible into five shares, a common show.

This calculation show, the 20,000 shares of preferred times five. I want you to show that the preferred is convertible into a hundred thousand shares of common. So keep that in mind in this problem, the preferred is convertible into a hundred thousand shares of common. Let's read on Dunn's net income for the year 840,000.

For the current year and the December 31, what is diluted earnings per share before we do diluted, let's figure out basic, let's do it together. The formula for basic, when we calculate basic earnings per share in the numerator, we want net income applicable to common stockholders. So we're going to take the company's net income in this case, 840,000.

Minus the current years for a dividend what's the current year's preferred dividend, isn't it? 6% of $106 a share times 20,000 preferred shares. Outstanding let's agree. The current years before a dividend is 120,000. If I take the company's net income, 840,000 back out the current years prefer a dividend, 120,000 net income applicable to common stockholders.

It's 720,000. And I divide by way to chairs since they had 200,000 common shares outstanding for the entire year. Give those a full weight of one divided by 200,000 way to chairs. Basic comes out to answer, say $3 and 60 cents a share. You might want to just for your own purposes, right next to answer C basic there's basic earnings per share.

Now they don't want basic. They want diluted. Earnings per share. Now you'll notice in this problem, we have one potentially dilutive security, the convertible preferred. Is it automatically dilutive? No, it is potentially diluted. So our job is to test that preferred. See if it's diluted or not. How do I do that?

The, if converted method, here we go. Under the, if converted method. We just assume you just assume that the preferred was converted to common at the earliest possible point. Again, I'm just going to assume the preferred was converted to common at the earliest possible point. That would be January one here because it was outstanding all year.

So think what would happen if the preferred was converted to common back on January one, how many more common shares would I have in the divisor? Another a hundred thousand, right? Isn't the preferred convertible into a hundred thousand shares of common. So if the preferred. Was convertible into common.

If the preferred was converted to common back on January one, my device would go from 200,000 way to chairs up to 300,000 way to chairs. True. I'd have another a hundred thousand shares and the divisor would anything else change? Sure. Now I don't have to pay anybody a preferred dividend. There is no preferred dividend.

If the preferred was converted to common back on January one, I don't have to pay anybody a preferred dividend. There is no preferred dividend, so I'm just back to net income. 840,000. You have to be consistent. If the preferred was converted to common back on January one, I don't have to pay anybody preferred dividend.

It can't be common and preferred stock at the same time, you have to be consistent. So I'm just back to net income. There is no preferred dividend. So if I take the net income, 840,000 divided by 300,000 chairs that comes out to $2 and 80 cents. Now listen to my questions, listen carefully. What was earnings per share before I consider the preferred.

$3 and 60 cents answer. See that's basic, right? What's earnings per share. When I consider the preferred $2 and 80 cents, notice it went down. What we just proved about that preferred it's diluted. It stays in the calculation and that's why the answer is B because it dilutes the picture diluted means down.

It caused earnings per share to go down. Now, the answer is B here, and I don't know if you're with me or not. And I don't know if this is subtle or not, but let me say it I'd always calculate basic first because I'm only going to put the preferred in the calculation. If it causes earnings per share to go down from what basic.

See, what I'm saying is if we did this calculation, when I took out the preferred, and if that came out to $3 and 81 cents, the answer is C three 60, right? If I took out, if I took out the preferred, if I applied the, if converted method to the preferred and it came out to $3 and 81 cents a share that preferred is anti diluted.

So diluted earnings per share would be answered, say $3 and 60 cents because the preferred doesn't belong in the calculation. I'll all I'm saying is I don't trust them. I would always calculate basic first. How long does that take? I think, maybe you're not used to it yet, but when you get used to it, basically just take 30 seconds.

And it's just good to know, because now you're going to test the preferred to see if it brings you below three 60, whether it's deluded or not. So I'm just saying for me, because I don't trust them, I'd always calculate basic first, just so I know what diluted is, but in this case, basic was $3 and 60 cents.

When I figure out the preferred, when I figured that into the calculation comes out to $2 and 80 cents a share that preferred is diluted. It stays in the calculation and that's why the answer is B. Now you also may notice that up until this point. What we've talked about is earnings per share. What if you're doing a loss per share now just listen carefully.

Now, if you're doing a loss per share, there's two things to be careful about. You see how. When we do basic earnings per share, we take the company's net income minus the current year's preferred dividend. If you're doing a loss per share, the current year's preferred dividend is added to the loss.

I hope that makes sense to you. If you're doing a loss per share, the current year's preferred dividend is added to loss because the current year's preferred dividend makes the loss worse for common shareholders. Doesn't it? The current is, but for dividend makes the loss worse. For common shareholders.

So the current use for a dividend would be added to the loss. Now, another point to remember how about potentially dilutive securities, ignore them when you're doing a loss per share, don't put potentially dilutive securities in the divisor, because if you put more securities in the divisor, it would cause loss per share to shrink that improves the picture that makes things look better.

So potentially dilutive securities are anti dilutive to a loss per share. Hope that makes sense to you. Potentially dilutive securities can just be ignored with a loss per share because potentially dilutive securities are anti dilutive to a loss per share. You put more securities in the divisor, it would cause earnings per share.

Excuse me, loss per share to go down. That actually makes things look better. So ignore them. So that's, those are the two things you have to be careful about with a loss per share. The current is preferred. Dividend is added to the loss and then ignore potentially dilutive securities. Just divide by.

Weighted average, common shares outstanding for the period. Let's do 36 and 37. It's a set. You'll see. In 36 and 37, we have two potentially dilutive securities. We have some convertible preferred. We also have some convertible bonds now, number 36. They say for the current year, what is basic earnings per share?

And number 37 says for the current year, what is diluted earnings per share. I'd like you to shut FAR CPA Review course down, just do basic. We'll do diluted together, but just, why don't you take a minute, get basic and then we'll do diluted together.

I know that you're getting better and better at basic. When you do basic earnings per share in the numerator, you want net income applicable to common stockholders. So you're going to take, in this case, the company's net income, 980,000. Back out the current years, but for a dividend 45,000 and divide by way to chairs.

And since they had 90,000 common shares outstanding for the entire year, you give those a full weight of one divided by 90,000 way to chairs. And the answer for basic is answer be $10 and 39 cents a share. And I know you just ate that up. At least I hope he did. Hope you're getting more and more comfortable with basic and notice when I do basic earnings per share, I ignore the convertible preferred.

I ignore the convertible bonds. I don't worry about potentially dilutive securities when I'm doing basic earnings per share. Now, when I do diluted earnings per share question number 37, now I have to worry about these potentially dilutive securities. But as they're not automatically diluted.

They are potentially diluted. So I have to test these securities to see if they're deluded or not. I have some convertible preferred stock here. Let's test that preferred. See if it's dilute or not. Let's apply the, if converted method, you know what to do under the, if converted method, we just assume that the preferred was converted to common at the earliest possible point.

And here it would be January one because it was outstanding for the entire year. So we just assume the preferred was converted to common at the earliest possible point. In this case, January one, I'll think about it. If the preferred was converted to common back on January one, how many more shares would I have in the divisor?

Wouldn't I have another 30,000 shares in the divisor. Wouldn't I devise a go from 90,000 up to 120,000. I'd have another 30,000 shares in the, my divisor. Would anything else change? Sure. Now there is no $45,000 preferred dividend. If the preferred was converted to common back on January one, I don't have to pay anybody a preferred dividend.

It can't be common and preferred stock at the same time. It's either common or it's preferred. If we assume it's now common. There's another 30,000 common shares in the divisor. I don't have to pay anybody to prefer a dividend. So I'm just back to net income, 980,000. And if you take that net income, 980,000 divided by 120,000 way to chairs that comes out to $8 and 17 cents a share.

And my thinking, what was earnings per share before I consider the preferred $10 and 39 cents a share, that was the answer to number 36 basic what's earnings per share. When I consider the preferred. $8 and 17 cents a share what we just proved about that preferred it's diluted. It's diluted. It caused earnings per share to go down.

So it stays in the calculation. We know the preferred is going to stay in the calculation. Now we're going to test the bonds. We also have some convertible bonds. Now, before I test the bonds, before we apply the, if converted method to the bonds, I want to emphasize. That our new measuring point now is $8 and 17 cents a share, not $10 and 39 cents a share.

In other words, I'm going to test these bonds to see if they bring me below $8 and 17 cents a share not below 10 39. See, that's what I have now. I now have a new measuring point. I'm going to test these bonds to see if they bring me below $8 and 17 cents a share, not below $10 and 39 cents a share.

That's my new measuring point. And by the way, in terms of, the order you test, the security is just test them in the order. They give them to you that  it should not make a difference. Just test them in the order they give them to you. So now let's test the bonds. As these convertible bonds, they're not automatically diluted.

They are potentially diluted. So we have to test the bonds to see if they're deluded or not. How do we do that? The, if converted method let's apply it under the, if converted method, we just assume. The bonds were converted to stock at the earliest possible point. And that would be January one here, cause they were outstanding all year.

So think about it. If the bonds were converted to common at the earliest possible point, January one, how many more shares would I have in my divisor? Another 20,000 wouldn't I devise or go from 120,000 up to 140,000. Would anything else change? Sure. If the bonds were converted to stock back on January one, now I'd have no interest expense on my income statement.

I don't have to pay anybody any interest. There'd be no interest expense on my income statement because it can't be bonds and stock at the same time. If the bonds were converted to stock back on January one, I don't have to pay anybody any interest. So what I have to do now is add that interest back to my net income.

And I have to add it back net of tax because interest is deductible for tax purposes. So let's work it out. The interest rate on the bonds. Here's 10%. I'm going to take the 10% times the million let's agree. The bonds paid a hundred thousand and interest 10% of a million, but I'm going to add it back net of tax.

Interest is deductible for tax purposes. So because they have a 40% tax rate, I add back 60% of the interest or 60,000 to my net income. By the way, that's always a function of a hundred. If the tax rate is 34%, add back 66% of the interest, right? It's always a function of a hundred. If the tax rate is 32%, add back 68% of the interest in this case, the tax rate is 40% add back 60% of the interest or 60,000.

So if you take the net income nine 80, add back that interest net of tax 60,000. Now the income is 1,000,040 thousand divided by 140,000 way to chairs that comes out to $7 and 43 cents. And you know what my thinking is, what was earnings per share? Before I consider the bonds $8 and 17 cents a share what's earnings per share.

When I consider the bonds $7 and 43 cents a share what we just proved about those bonds, they are diluted. They caused earnings per share to go down. They stay in the calculation and the answer is D. I hope you follow that if converted method. Now another point you may have noticed that I keep using a phrase and it may be something you've been thinking about.

I keep using the phrase, assume the bonds were converted to stock at the earliest. Possible point. I keep saying that don't I, you assume the bonds were converted to stock at the earliest possible point at the earliest possible point here, the bonds were outstanding for the entire year. So that was easy.

January one. Let me ask you a question. What if the convertible bonds had been issued on July one? Think about this, please. What if the bonds had been issued on July one? When is the earliest they could have been converted. July one. So those extra 20,000 shares in the divisor would have to be weighted at a half.

Be careful. Yeah. I assume the bonds are converted to stock at the earliest possible point. So if the convertible bonds had been issued on July one, the earliest they could have been converted is July one. So you'd have to wait those extra 20,000 shares in the divisor at a half and right in the numerator only add back I half the year's interest net of tax only a half a year's interest.

So dates do matter there. So that's why I keep saying, you assume the bonds were converted to stock at the earliest possible point. It's not necessarily January one. If the convertible bonds had issued on July one, then the earliest they could have been converted is July one. So those extra 20,000 shares in the divisor would have to be weighted at a half.

And I'd only in the numerator add back a half the years interest. So always be careful of dates as well. Okay. That concludes our discussion on stockholders' equity and partnership, accounting and foreign operations and ratio analysis from all of us at the bisque review. We want to wish you the best of luck on the FAR CPA Exam study heart.

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Hello and welcome the bisque 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 class. And in this FAR CPA Review course, we're going to be covering a very important topic. And that is how you prepare. A statement of cash flows.

And as you'll see, as we go through this statement of cash flows, it makes a great multiple choice question. And it certainly has the potential to be a simulation as well. So going into the exam, you've got to be ready for this topic. You have to be comfortable with how you prepare a statement of cash flows.

Before we begin. Let me just give you some quick advice about the best way to use this class. The important thing is to treat this like any other class. Take good notes, really participate, try to avoid sitting back passively and just watching FAR CPA Review course do problems with me. There'll be times in FAR CPA Review course where I'll ask you to shut FAR CPA Review course down, solve the problem, get your answer before you come back and we solve the problem together.

And I really want you to do those things. And I think you'll find that if you do these things, you'll get the most that you can from this class. And that's certainly what we both want. So with that said, Let's get into how you prepare a statement of cash flows. Let's dive right in a statement of cashflows has three separate and distinct sections.

Let's go over them. Section number one would be cash flows from operating activities. That's cash flows from operating activities. And you want to always think of this as your income statement section. That's what this is. It is your income statement. Section. My point is, as you go through a problem, If you see any item that affects revenues, expenses, gains losses right away, you think of this section because it is your income statement.

Section it's cash flows from operating activities. Now there's also one more thing that goes in this section, and it's important that it's in your notes. And that is if a company buys or sells, if a company buys or sells trading securities that's cash flows from operating activities. Let's go to the second section.

The second section is cash flows from investing activities. Now what goes in here? Several things first, if a company buys or sells, held to maturity, securities buys or sells availed for sales, securities, that's cash flows from investing activities. Again, if a company buys ourselves held to maturity, buys ourselves available for sale securities that's cash flows from investing activities.

This more. If a company buys or sells property, plant and equipment, property, plant, and equipment that's cash flows from investing activities. And one more thing. If a company buys or sells equity investments, that's cash flows. From investing activities. Now what I'm going to say next is probably obvious, but let me quickly say this very often.

What the FAR CPA Exam is testing in multiple choice in this topic is whether or not a student is comfortable about where cash belongs in the statement. And one of the things I want us to accomplish in this FAR CPA Exam Review course is to make that as automatic as possible. So I'm going to give you a memory tool here, and it might sound silly, but it works.

Just remember investing always makes you happy. AAJ, PP E investing always makes you happy. H a P E E. You see what it stands for. If I buy yoursel held to maturity age, buy or sell available for sale a if I buy herself PP and E property, plant and equipment, or I buy herself equity investments. That's when I go to the section, cause investing always makes me happy.

Just a quick way to remember what goes in that section. The third section is cash flows from financing activities. Now what goes in here? Several things. First thing you want to remember is that principle, if a company, borrows debt, principal, that's cash provided. By a financing activity. If the company pays down debt, principal, that's cash used in a financing activity.

There's more, if a company pays a dividend, I don't care if they pay a dividend on common stock. If they've had a dividend on preferred stock, when a company pays a dividend that's cash used in a financing activity, if a company issues stock, if they issue common stock, if they issue preferred stock that's cash provided by a financing activity.

And one more thing. Don't forget. Treasury stock. If a company buys treasury shares, that's cash used in a financing activity. If they sell off treasury shares, that's cash provided by a financing activity. That's what goes on in this section. Now I'm going to give you a memory tool on this one as well, because as I say, we want this to be automatic.

Now we already know investing makes you happy. By herself held to maturity by herself. They for sale by herself, sell PPMD, buy or sell equity investments. That's when I go to that section just remember you're always financing for Prince divots. Oh yeah. You're always financing for Prince divots.

Prince is debt. Principal div is paid dividends. Ay is issued stock and Ts is treasury stock transactions. So investing makes you happy, but you're always financing for Prince divots. You have to know where cash belongs. In the statement.

Once we get that down, now we're ready to attack a problem. Now, before we start the problem, there's something else we need to say. And that is that there are two acceptable methods of preparing a statement of cash flows. There is the direct method and there is the indirect method you have to notice.

There are two acceptable methods of preparing a statement of cash flows. We've got the direct method and we also have the indirect method. And I want this clear in your notes. The direct method is theoretically preferred and they could ask you that the direct method is theoretically preferred, but I want you to listen carefully, even though the direct method is theoretically preferred and it is the CPA exam.

Has tested the indirect method far more often, that might seem odd, but that's just a fact of the matter that even though the direct method is theoretically preferred, the CPA exam has tested the indirect method far more often. And I'll tell you why that is. What you're going to see later in this FAR CPA Exam Review course is that when they talk about the direct method, it's not really a different method of solving statement of cash flows.

The direct method is really just a presentation difference. You'll find in the direct method, one of the sections operating activities gets presented differently. I honestly don't think of it as a different method. It's really just a presentation difference because one of the sections operating gets presented differently.

But let me make my point. There's only one method of breaking down a statement of cash flows problem, and that is the indirect method. So let me put it this way. When you're in the exam, the only time you're going to worry about the direct method is if the CPA exam specifies solve this problem under the direct method, that's the only time you have to worry about it.

If they say solve this problem onto the direct method, that you'll worry about it. But if they're silent, what would you do? It solve the problem under the indirect method, because that's really the only method of breaking the problem down. And you'll worry about the direct method if they specify. And we'll look at the direct method in more detail later on in this FAR CPA Review course.

But my point is, I want to begin by going over the indirect method and I'll tell you what my personal goal is in this FAR CPA Exam Review course. My personal goal is to show you a technique and I'm not exaggerating when I tell you that. This technique is foolproof. Once you get it down, it takes a little getting used to, but when you get this technique down, it's really a good method to know, because if you get this technique down, I don't care how they test this.

I don't care whether it's multiple choice or a simulation, you can always break it down.

It is a very valuable technique to have down. And I'll tell you that my technique involves two things. It involves two of my favorite things, journal entries, and T accounts. That's how we're going to break cash flows down. Let's go to some questions. If you look in your viewers guide, you will see Pharrell corporation.

Okay. And that's the problem we're going to be working on. And you'll see, in feral corporation, we're given comparative balance sheets at the end of year four and the end of year five. Now the first thing we're going to do. Step one go right to cash. Notice in the last year, cash went from 180,000 to 275,000.

So in the last year, cash has increased by a $95,000 debit. And you want to make note of that. Hey, in the last year, cash has increased by $95,000 debit. And I sure you know this when we're done with our statement of cash flows, it has to prove why cash increased. By a $95,000 debit. In other words, this is one of those odd accounting problems where you start by knowing the answer, because your statement has to prove why cash increased by $95,000 debit.

So they give us the comparative balance sheets. On the next page, we have the statement of income and retained earnings for feral for the year ended December 31 year five. And also there are six bullets. Of additional information. All right. So when you're faced with a problem like this, and of course this could be a simulation, there's a lot going on here.

This is detailed enough where it's more like a simulation there's so much that has to be done here. And when you're faced with something like this, as I said, I like you to use by technique, which involves journal entries and T accounts. So the first thing we're going to do right off the bat, It's set up three big T accounts, and I'm sure you guessed what they are.

We're going to set up a T account for operating activity and, in the heading, you can put ice slash S that's your income statement section. As I say, you're going through a problem. You see any item that affects revenues, expenses, gains losses, right away. You think of this section because it is your income statement.

Section cash flows from operating activities, the second T account investing activities. And you can put it right in the heading. Happy always makes me happy by herself, held to maturity by herself, available for sale by herself.  by herself equity investments. It's when I go to that section and then finally financing activities, and I'm always financing for Prince divots Prince.

His debt principal did is pay dividends. I is issue stock Ts is treasury stock transactions. So you get those three big T accounts set up. So you have those set up. Now what's the next step. Now you put down a small T account. For every account, they give you in the balance sheet except for cash and put the net change in each one of those accounts.

So that's my next step. Now we're going to put down a small T account for every account. They give us in the balance sheet except for cash and put the net change in each one of those accounts. And you see what we're about to do. What we're about to do is explain the change in cash by looking at the net changes in all the other accounts, except for cash.

Because that's where the answer has to be true. You have to look at the net changes and all the other accounts, except for cash to explain the change in cash. All right. So if you look in your viewers guide, we've set up all those T accounts for you, but we have to put the change in each account. Let's start with accounts receivable.

In the last year accounts receivable, it went from 305,000 down to 295,000. That is a net $10,000 credit decrease to that account. So what you want to do. It's put a $10,000 credit change in that account and double underlined because that account changed by it went down by a credit of 10,000. So what that $10,000 credit change in that account?

Double underline that inventory went from four 30, one to five 49. That's a net debit increase to that account of 118,000. So put that $118,000 debit increase in that account. Double underline that investment in hall under the equity method. Went from 60,000 a year ago, up to 73,000. That's a net debit increase to that account of 13,000 double underline that we land went from 200,000 to three 50.

That's a net debit increase to that account of 150,000 planting equipment went from 606,000 to six 24. That's a net debit increase to plant equipment of 18,000. But that debit change, that account double underline that accumulated depreciation went from 107,000 up to 139,000. That's a net credit increase to that account of 32,000.

So put that $32,000 credit change. That credit increase in that account. Dumble underline that Goodwill went from 20,000 down to 16,000. That's a net credit decrease to that account of 4,000. We double underline that. Accounts payable. If you will. All accounts payable and accrued expenses went from five 63 up to 604.

That's a net credit increase to that account of 41,000 notes. Payable went from nothing up to one 50, a net credit increase of 150,000 bonds payable went from two 10 down to one 60. That's a net debit decrease to that liability of 50,000. Deferred tax liability went from 30,000 up to 41,000. A net credit increase of 11,000 common stock increased by a credit of 30,000.

A pic increased by a credit of 51,000 retained earnings increased by a credit of 98,000. And then finally treasury stocks, a little tricky treasury stock. Remember it gets reported on a balance sheet. As a debit and stockholders equity. That's why there's a bracket around that 17,000 at the end of year four, because there's a debit and stockholders' equity.

It's a reduction of stockholders' equity. Remember treasury stock is a Contra equity item. That's why there's brackets around it. So what happened in the last year is that went from a debit in stockholders' equity down to nothing down to zero. So that would be a credit decrease to that account of 17,000.

So put that credit change in that account and double underline that. All right. So we've got that step done. So what am I steps so far? What was the first thing we do find the change in cash. Cause that's what we're proving out to. And we know right off the bat, then in the last year, cash increased by $95,000 debit.

Always good to have that in your mind. What's the second step three big T accounts, one for operating one for investing, one for financing. And then my third step, I put down a small T account. For every account, they gave us in the balance sheet except for cash and put the net change in each one of those accounts.

So we have done that. Now. I know you with me. We haven't started our analysis yet. All we've done is set up this simulation, preparing for our analysis.

Now we're going to begin our analysis. And let me say that there is a way that I always begin on the analysis of cash flows. And you don't have to start this way. And I'll quickly say that no textbook is going to tell you that you have to start this way because you don't. But I want you to trust me that this is the most logical place to start really the best way to start your analysis, to prove out the retained earnings.

So let's do that first. Let's prove out the retained earnings. If you look at your T account, we know in the last year retained earnings increased by a $98,000 credit. We've double underline that was the net increase to retained earnings. Can we prove that out? Let's prove that out. If you go to the second page of this problem, we have the statement of income and retained earnings.

I want you to find the net income for the year for Farrell. Notice the net income for the year for Farrell was 141,000. So let's post that. I'm going to go to my first big T account. Which is operating activity. This is income state. That's my income statement section. I'm going to go to my first big T account operating activity.

And I'm going to put that 141,000 net income in as a debit to that account. Now, why is it a debit? Because what you're going to see as we go through this is that in your three big T accounts operating, investing, and financing, the debit side is provided. The credit side is used. I always remember that.

And your three big T accounts operating, investing, and financing. Think of the debit side as provided the credit side as used. And the point is net income provides cash from operations. It doesn't use it. So we're going to put net income in the 141,000 as a debit to operating activity. And what was the credit presumably to retain earnings?

Net income would have been posted as a credit to retained earnings of 141,000. So you want to put that in your T account, make sure you're  doing this problem with me. Step-by-step so that 141,000 of that income would be credited to retain earnings. All right. Now let's find the dividend. If you go back to page two towards the bottom of the statement of income and retained earnings, you see there was a cash dividend paid August 14th, year five of 43,000.

Now, remember I said that my technique really involves two things. T accounts, journal entries. Now we've got all our T accounts. We've got those all set up and the habit Ironman. I always make the dividend, my first journal entry. When I see that dividend, I have to assume that fact, or would've made the normal entry.

They would debit retained earnings 43,000. Remember dividends come directly out of retained earnings. They're not on the income statement. They come directly out of retained earnings. So I'm going to debit retained earnings, or they would have debited retained earnings, 43,000. And credit cash, 43,000. I'm assuming they would have made the normal entry for a dividend.

Now what's the first thing you notice about that entry cash. That minute cash in any entry. It has to go somewhere. It's either operating, investing, or financing. So here's my question. What kind of cash is that? 43,000. Is it operating? No. Is it happy? No, it's not happy. It's Prince divots. Remember the div and divots to pay dividends.

So we're going to go to our third, big T account, which is financing activity. And we're going to post that $43,000 credit right there. The fact is that's 43,000 of cash used in a financing activity. We're always financing for Prince divots. Prince is debt. Principal div is pay dividends. I is issue stock.

Ts is treasury stock transactions. So we posted that dividend. Now I want you to find the net income for the year. The, we know the net income was 141,000. That's been posted. We know that the dividend we've taken care of that. Look at your retained earnings T account. Have we proven why retained earnings increased?

By net credit of 98,000, we have, cause net income would have caused retained earnings to go up 141,000. The dividend would have caused retained earnings to go down 43,000. Haven't we proven why retained earnings increased by a net credit of 98,000, put an X through it. That's the process. Once we've proven the change in an account you want to exit out.

You never want to look at it again. And as I said, I think that proving out retained earnings is the most logical place to begin. You don't have to, but I think it is sensibly where you should start your analysis of cash flows. All right. So we've done that.

Now what's my next step. Now we go down the additional information. There are six bullets of additional information, and we're going to put down a journal entry for every transaction. They describe it. I think it's always good to start with an entry to get your organized. Let's look at the first bullet they say on January 2nd.

Year five barrels, sold equipment costing 45,000 with a book value of 24,000 for 19,000 cash. Let's put an entry down. We know they would have debited cash, 19,000. We know they would have credited the equipment for two original cost, 45,000. And because they said the equipment has a book value of 24,000, presumably there's what, there's 21,000 of.

Accumulated depreciation on that equipment. If the original cost is 45,000, but book value is 24. There must be 21,000 of accumulated depreciation on that equipment. So I'm going to debit accumulated depreciation 21,000. Notice the entry doesn't balance. We need a $5,000 debit to balance the entry out that's because there was a loss on sale.

So you get the entry down. Now, what is the first thing you noticed about that entry? This cash, the minute cash in any entry, it has to go somewhere. What kind of cash is that? Is it operating? No. Is it happy? It is P and so we're going to go to our second big T account, which is investing activity, and we're going to post that $19,000 debit right there.

The fact is that is cash provided. By an investing activity. Investing always makes me happy by herself, held to maturity by herself. They will for sale by or sell and L buy or sell equity investments. When I go there, let's post the rest of it. I go to plant and equipment. I posted that $45,000 credit.

Have we explained the change in that account? No, we leave it open. There's still more to do. I go to accumulated depreciation. I post that $21,000 debit. To accumulated depreciation. Have we explained the change in accumulated depreciation? No, we have more work to do. How about the loss on sale? Oh, that's an income statement that goes to operating.

Remember, once you put an entry down, everything gets posted somewhere. That's the thing about cash flows. You have to be meticulous. The con, if you forget to post something, it's going to mess you up. So remember that's what you start with an entry. And every everything in that entry has to be posted somewhere.

The loss would be posted, of course, as a debit to operating activity. Now you say Bob, why are we doing this? The reasoning behind that going to operating is simply this, when we're all done, what that operating section is going to do, what that operating T account is going to do is convert income on the accrual basis.

To income on the cash basis. That's the purpose of the operating T account really to convert net income from the accrual basis to the cash basis. And the point is that laws did not require the outlay of cash. Now, the way to look at this, you can't show this both as a loss on your income statement and also 19,000 cash provided by an investing activity.

You'd be double counting it. So that's another thing that's going on there. You can't show this bolts both as a loss on your income statement. And 19,000 of cash provided by an investing activity. You'd be double counting it, but don't, you don't have to worry about all that. Don't worry about remembering all that reasoning.

Just post it, get an entry down and everything in the entry has to be posted somewhere. Let's do another one second bullet on April one year five, feral issued a thousand shares of stock for 23,000 cash. We have to assume they'd make the normal entry. They would debit cash 23,000. They would credit common stock for par value.

And if you look at the balance sheet, the power is $10 a share. So credit common stock for a thousand shares at $10, a share or 10,000 and credit API, additional paid-in capital for the rest 13,000. What's the first thing you notice about that entry there's cash. It's got to go somewhere. So help me on this kind of cash.

Is that. Is it operating? No. Is it happy? No. It's Prince divots. Remember the I, and it is just issue stock. So we're going to go to our third, big T account financing activity, and we're going to post that $23,000 debit right there. That is cash provided by a financing activity. We're always financing for Prince divots.

Prince is that principle. DIB is paid dividends. I issue stock Ts as treasury stock transactions. Let's post the rest of it. We're going to go to common stock and post a $10,000 credit to common stock. Have we explained the change in common stock? No, we haven't. So leave it open. We have more work to do.

We're going to go to API pic post a credit of 13,000. Have we explained the change in API C though? We haven't leave it open. Let's do another one third bullet on May 15th. Feral sold all of its treasury stock for 25,000 cash. They sold all of their treasury stock, all of it, but 25,000 cash. So what's the entry.

Of course, you're going to debit cash 25,000. What should I credit the treasury stock? Don't we know if you look at your tea account that the treasury stock account went down by a credit of 17,000. This must've been the transaction because they sold it all. So they must've credited treasury stock 17,000.

Cause we know that account dropped by 17,000. They sold all of it. And I'm hoping you remember this. Anytime there's a gain indicated in any type of treasury stock situation, what do we always credit? API C they would have credited API C. Four 8,000. Anytime there's a gain indicated in any type of treasury stock situation, it's always a credit to additional paid in capital in this case for 8,000.

So of course the first thing we notice about this entry, this cash it's got to go somewhere. Is that operating? No. Is it happy? No. It's Prince divots. The Ts on divots it's treasury stock. So you go to your financing T account post that $25,000 debit because we know that's $25,000 of cash provided. By a financing activity.

Let's post the rest of it. We go to treasury stock. We post that $17,000 credit. That explains the change in that account. Just exit out. Don't want to look at it again, go to API post that $8,000 credit. Have we explained the change in API? No, we have more work to do.

Let's do another one fourth bullet on June one year five individuals holding $50,000. Face value of ferals bonds, exercise, their conversion privilege. So what we have here are some convertible bonds. Each of the 50 bonds converted into 40 shares of stock. So that's the conversion ratio. Every bond get turned in, you get 40 shares of stock.

So how many shares are going out? 50 times 42,000 shares of stock are going out. 50 bonds came in. The conversion ratio is 40 to one 40 times. 50 50 bonds came in. The company issues, 2000 shares of stock. So as always, let's start with the entry. We know that if you're Farrow, you would debit bonds payable for 50,000, the bonds are turned in the illegally retired, that debt is retired.

So you're going to debit bonds payable, 50,000. You're going to credit common stock for the 2000 shares at par 10, 20,000 and credit API for the rest. 30,000. Now, I don't know how much you recall about convertible bonds at this point. I don't want to dwell on it, but there are two ways you can do convertible bonds.

There's the book value method. There's the fair value method. I know they didn't want the fair value method here, cause I don't know the fair value of the stock. I just, in case you thought of that issue, we don't know the fair value Pharrell stocks. We couldn't have used the fair value method anyway.

So I just use the book value method. Where we get rid of the debt debit, bonds payable 50,000, and we issue the stock credit common stock for 2000 shares with par 10, 20,000 and credit API for the rest 30,000. Now, when you look at that entry, the first thing you notice, there's no cash, there's no cash. Do I post it?

Yes. Everything gets, when you put an entry down, everything gets posted. Otherwise you're going to mess things up. So even though it doesn't involve cash, it's got to be posted. So let's post it. We're going to go to bonds payable, post that $50,000 debit to that account. Have we explained the change in bonds payable?

Yes, we have exit out. Don't want to look at it again, go to common stock, post that $30,000 credit. Have we explained the change in common stock? We have exit out, go to API, see post that $30,000 credit. And we explained the change in API. We have, you can X that out as well. We can do another one. The fifth bullet down on July one year five feral purchased equipment for 63,000 cash.

So we assume they made the normal entry. They would debit equipment for 63,000 and credit cash. 63,000 while this cash involved. Is that operating? No, it's happy. It's PPD. So we go to our second big T account investing. We post that $63,000 debit right there. Excuse me, that's $63,000 credit. That is cash used in an investing activity.

Have we explained the change in plant and equipment we have now we've explained it exit out. Don't want to look at that again because when we post that $63,000 debit to plant in equipment that we have now explained the change, the plant and equipment, we can X that out. And the 63,000 cash. As I say, as a credit to investing activity because it's PPD, that's cash used in an investing activity.

The final bullet on December 31 year five land with a fair market value of 150,000 was purchased through the issuance of longterm debt. A long-term note in the amount of 150,000. Nope. His interest at 15% is due in five years and all of that. What's the entry. If you buy land by issuing a note, You're going to debit land in this case, 150,000 and credit notes payable, 150,000.

Now, once again, notice it doesn't involve cash. Now I'm going to say more about these later, but this, what this represents is a non-cash investing and financing activity. That's what this is. Notice no cash is involved. It was a straight exchange of debt for property. That's what this is. It's a straight exchange of debt for property.

It's what they would call a non-cash investing and financing activity. And we'll talk about these later, but this non-cash item, it's not in the statement of cash flows. It gets footnoted at the bottom of the statement as a supplemental disclosure. So that's what this has got to be. It's a supplemental disclosure.

I'll say more about that later, but even though it's not in the body of the statement, we have to post it. You put an entry down, everything gets posted somewhere. So we're going to go to land post that $150,000 debit to land. We've explained the change in land, exit out. We go to notes payable. We credit notes payable for 150,000.

We've explained the change in notes payable. We exit out. We don't want to look at that again either. So my point is now we are done with the additional information. Now, once you're done with the additional information, there's only one step left. What I want you to do is circle. In your viewers guide, circle all the accounts we have not explained.

That's what I want you to do. Circle all of the accounts. We've not explained, take a moment to do that. And then we'll do the final step.

Now, if you have circled all the accounts that we have not explained. You should have seven that we have not explained accounts receivable, inventory investment in hall, accumulated depreciation, Goodwill accounts, payable, and deferred tax liability. There are seven accounts we have not explained now, before I show you the way I'd like you to do this last step.

And I hope this is clear. Once we've explained all the accounts we're basically done. And before I show you this last step, I want to quickly say that there are good, solid accounting reasons for everything we're about to do. And I'm not going to dwell on the reasons why because some of them get involved.

And to me, if you just do this in a mechanical way, in other words, if, when we're done with this class, your big, your basic thinking is if it's a debit here, I credit this. If there's a credit here, I debit that. That's fine. I want you to know that I have deliberately chosen a method that is somewhat mechanical.

Now, why do you think I did that? Because I'm always afraid that you could be in the exam. You have perhaps a simulation to do on this. And time is short. I'm always worried about timing of the exam. And that's my, one of my main concerns that you have perhaps a simulation to do on cash flows. You a little bit short on your time.

So I, I'm trying to show you a technique that as I say is somewhat mechanical so that you can do it more quickly. So if at the end of all this, you just do this in a mechanical way. That's no problem at all. Let me show you the mechanical approach. The first item accounts receivable. Now you have to look at each item and ask is it an operating item?

Is it an investing item? Is it a financing item? Because when you get to the end and you have these accounts that have not been explained, you could have operating items that have not been explained. Investing items that have not been explained financing items that have not been explained here. They happen to all be operating, but that's unusual.

You could have all three types here. They're all operating. But anyway, you look at the first item accounts receivable. It's an operating item. It has to do with sales and getting to cash sales. But here's the mechanical approach since accounts receivable. Went down by a credit of 10,000, then we're going to go to operating and do the opposite.

See, at the end, you just do the opposite. I'm going to debit operating 10,000, just do the opposite. Councilor will went down by a credit of 10, go to operating debit, operating 10 inventory. It's an operating item has to do with cost of goods. Sold inventory increased by a debit of one 18. It increased by a debit of 118,000.

I go to operating. I'll do the opposite. Credit operating 118,000 investment in hall. Under the equity method, you might be like Bob isn't that the unhappy buy or sell equity investments got to be careful. They didn't buy or sell an investment in hall. Why did investment hall go up 13,000? Because Pharell picked up their share of Hall's income.

In other words, they must if you remember the equity method, they must've debit it. Investment in hall and credit equity and suburb innings 13,000. And if you look on page two in the problem, look on the statement of income. You'll see that equity in the earnings of hall is there. So that remember the Ian happy, the second Ian happy is buy or sell equity investments.

They didn't buy or sell an equity investment here. They picked up their share of sub income. So investment in hall increased by a debit of 13,000, go to operating, do the opposite credit operating 13,000. And I think you see the reasoning there, there wasn't any cash. We just simply picked up our share of sub income.

We didn't get the cash. So it has to be backed out. As I said earlier in the class, what the first big T account does operating is convert income on the accrual basis to income on the cash basis. And the fact is we didn't get that cash. Not yet. So that's going to be a credit to operating 13,000 now, accumulated depreciation.

The reason this is an operating item is we have to find the depreciation expense for the year. Do this analysis with me. Don't we know that accumulated depreciation increased. By a net credit of 32,000, right? That was the bottom line. During the year, accumulated depreciation increased by a net credit of 32,000.

And yet all we saw in our journal entries was a debit to that account of 21,000. My point is this the only way that account could have increased by a net credit of 32,000, we infer that had to be another credit net account. To make a balance of 53,000. We go over that again. I know accumulated depreciation increased by net credit of 32,000.

During the year we had double underlined that all we saw in our journal entries was a debit to that account of 21,000. It had to be another credit in that account for it to increase by a credit of 32,000. There must've been another credit in that account of 53,000. That must've been the depreciation expense for the year.

So because that's a credit to accumulated depreciation of 53,000, go to operating, do the opposite debit operating 53,000. We're adding back the depreciation expense because it didn't involve the outlay of cash. You I'm sure  that when you debit depreciation expense, you don't credit cash, you credit accumulated depreciation.

It is an expense. That does not require the outlay of cash. Now I know you might be saying Bob, if you look on page two and you look at the income statement, they gave you the depreciation expense for the year. It was 53,000. I know that, but very often they don't give it to you. That's why I showed you how to find it.

Because very often in the exam, they want you to find the depreciation expense in this problem. It turns out they gave it to us. It is on the income statement. You can see it, but as I say so often in the exam, They won't tell you the depreciation expense for the year. So you have to find it. I want to make sure you know how to do that.

How about Goodwill? Why did Goodwill go down by a credit of 4,000 amortization? Did Goodwill go down by 4,000 because of amortization? I hope you remember. Goodwill is not amortized. It's tested for impairment, at least annually. If Goodwill went down by 4,000. There must've been an impairment loss on the income statement.

Again, we don't advertise Goodwill. We test it for impairment at least annually. And if Goodwill went down by 4,000 by a credit, it must be because there was an impairment loss on the income statement. So that was a credit to Goodwill of 4,000. Go to operating through the opposite debit operating 4,000 accounts payable.

It's an operating item because. It has to, again, to do with figuring out cost of goods, sold accounts payable increased by a credit of 41,000. Go to operating, do the opposite debit operating 41,000 and then finally deferred tax liability. Deferred tax liability increased by a credit of 11,000. Go to operating, do the opposite debit operating 41,000.

Excuse me, in this case, 11,000. You would debit operating 11,000 again, deferred tax liability increased by a credit of 11,000. You're going to go to operating through the opposite debit operating 11,000. And of course, the reason we're doing that is because not all their income tax was paid in cash. Some of it was deferred.

So the deferred portion gets added back. As I said, there are good solid accounting reasons for everything we're doing, but the mechanical approach is just buying to Hey for a tax liability, went up by a credit of 11. Go to operating debit, operating 11,000. And as I say, the reason you're doing that is because not all their income tax was paid in cash.

Some of it they deferred. So the amount that you defer it gets added back. All right. So if you add it all up, if you, now you have all the information in your T account, it turns out that cash provided by operating activity. If you add it all up was $134,000 debit. Remember the debit side is provided. The credit side is used.

And the net cash provided by operating activities. 134,000. Looking at investing in activity. We had 19,000 cash provided by selling equipment. 63,000 cash used to buy equipment net cash used in investing activity. 44,000. How about financing activity? We had 43,000 cash to pay a dividend 23,000 cash provided by selling stock 25,000 cash provided by selling treasury stock net cash provided by financing activity.

5,000

Now, if you look at the next page, you'll see the actual statement of cash flows for feral. And I want to show you this because if in the exam, perhaps in a simulation, you actually had to do the statement of cash flows or fill it in. You just take the information right out of the T account. Look at the first section cash flows from operating activities.

We start with the net income, 141,000. We add back the decrease in receivables. We take out the increase in inventory. We add back the increase in payables. We add back the depreciation expense. We add back the impairment of Goodwill. We add back the loss in the sale of equipment. We subtract the. Equity and earnings of sub.

We add back the increase in deferred tax liability, net cash provided by operating activity right out of your T account, 134,000. So if you actually had to do the statement or fill in the statement, you have all the information you need in your T account cash flows from investing activities. We have proceeds from the sale of equipment, 19,000 payments to acquire equipment 63,000 net cash used in investing activity 44,000.

And then finally cash flows from financing activity. We have proceeds from the issue of stock 23,000 proceeds from the sale of treasury stock, 25,000 and a cash dividend paid a 43,000 net cash provided by financing activity 5,000. And did you notice this? If I take $134,000 debit and a $44,000 credit and a $5,000 debit, what's it all come out to a $95,000 debit and didn't we know when we started the problem.

The cash increased by a $95,000 debit. Notice it does reconcile. If you take $134,000 debit of $44,000 credit and a $5,000 debit, it all does come out to a $95,000 debit. And wasn't that the change in cash for the year. So it does reconcile. And then the way you finish the statement, you show cash and cash equivalents, January one, and then cash and cash equivalence, December 31.

So if you actually have to do the statement, or as I say, fill in the statement then you just go right to your T accounts. You have all the information that you need. All right. Now, I think it's important that you get some practice on this technique and in your viewers guide, you'll see dice corporation.

I want you to try that on your own. Now you notice there's three questions you have to answer. We have to know the cash provided by operating activity. We have to know the cash used in investing activity, the cash provided by financing activity. So I want you to shut this glass down, give yourself,  don't try to do this in two minutes.

Give yourself, you have to get used to this technique. You give yourself 15 minutes, maybe 20 minutes. See if you can answer those three questions and then come back and we'll go through it together.

Welcome back. Let's turn our attention to the set of questions on dice corporation. And I really hope that you did what I asked that you took the time 15, 20 minutes to try the technique that we've gone over. And try to come up with the answers yourself. You'll find that the more you work with this technique, of course, you get more comfortable with it and it might be a lot faster than you think.

That it is when you first see it, you first see it. You might think it's slow, but when you get used to it, it's also a fairly quick technique as well. All right. What's the first thing you do with dice? They gave you comparative balance sheets. You go right to cash notice in the last year, cash went from a hundred thousand to 230,000.

So we know in the last year, cash has increased by $130,000 debit. And as it's good to know that because. That's what our statement of cash flows has to prove out to why did cash increased by $130,000 debit? Now the next step is to put down your three big T accounts, one operating that's your income statement, section one for investing.

Hey, investing makes you happy. And one for financing activity, you're always financing for Prince divots. You get those three big T accounts set up the next step. You put down a small T account for every account they gave you in the balance sheet except for cash and put the net change in each one of those accounts.

So let's do it. Accounts receivable. No. The first one is available for sale securities available for sale securities, went from nothing a year ago, up to 300,000. So there's been a net debit increase to that account of 300,000. You put that $300,000 debit change in that account. Double underline it, accounts receivable notice that there was no net change to accounts receivable during the year.

The net change was zero because there was no net change. We're not even going to set up a T account for inventory went from 600,000 to six 80. That is a net debit increase of 80,000 to that account. Held to maturity securities went from 300,000 down to 200,000. That's a net credit decrease to that account of a hundred thousand plant assets went from a million to 1,000,007.

That is a net debit increased to that account of 700,000. Now, if you look at accumulated depreciation, there was no net change to accumulated depreciation, but even though there was no net change to accumulated depreciation. We are going to set up a T account for it because as you're going to see fairly soon and as I'm sure you did see there's some activity in that account.

So we're going to set up a T account for accumulated depreciation, but there was no net change. Goodwill went from a hundred thousand down to 90,000, a net credit decrease to that account of 10,000. Accounts payable went from 720,000 to 825,000. A net credit increase of 105,000 short-term debt went from nothing to 325,000.

That's a net credit increase to that account 325,000. And then finally common stock increased by a credit of a hundred thousand API C increased by a credit of 120,000 and retained earnings increase. By a credit of 450,000. So hopefully you got all those T accounts set up. Now you're ready for your analysis.

And I hope you remembered where I think you should start your analysis by proving out the retained earnings. Let's do that first. It's the logical place to start, go to the additional information they said net income for the year was 690,000. So let's post that. We're going to go to our first big T account operating activity.

And remember we post that in as a debit. For net income, 690,000. And you know why it's a debit because net income provides cash from operations. It doesn't use it. And we go to retain earnings and post that credit of 690,000. Presumably that income was posted as a credit to retain earnings of 690,000.

Next bullet cash dividends of 240,000 were declared and paid. I like to make that. My first journal entry. When I see that dividend, I assume they would have made the normal entry. They would have debited retained earnings, 240,000 credit cash, 240,000. And of course the first thing we noticed about that entry there is cash.

So it's got to go somewhere. So the question is, what kind of cash is that? Is it operating? No. Is it happy? No, it's not. It's Prince divots because the div in divots is paid dividends. So we're going to go to our third big T account, which is financing activity. We're going to post that $240,000 credit because that's cash used in a financing activity.

We're always financing for Prince divots. Prince is debt. Principal div is paid dividends. Ay is issue. Stock Ts is treasury stock transactions. We go to retain earnings. We post that $240,000 debit notice. We've explained the change to retained earnings. So we can just X that out.

Now we turn our attention to the rest of the digital information, because notice we have proven out the change in retained earnings. We're done with that. So now we want to go down the additional information. One item at a time, put a journal entry down for every transaction they describe and post everything in those entries.

Next bullet says equipment costing 400,000 with a carrying amount of 150,000 was sold for 150,000. So let's start with an entry. We know they would have debit and cash for that 150,000. We know they would have credited equipment for its original costs. 400,000. And if the equipment had a carrying value of 150,000, that had to be 250,000 of accumulated depreciation on that equipment.

So we're going to debit accumulated depreciation 250,000. That's the journal entry they must've made and notice there was no gain or loss on sale. Of course, the first thing that's obvious about that entry that's cash. So we know it has to go somewhere. Is it operating? No, it's happy. It's P and E. So we go to investing activity.

We post that $150,000 debit because we know that's 150,000 of cash provided by an investing activity. We go to plant and equipment. We post that $400,000 credit. We have not explained the change in that account. We leave it open. We go to accumulated depreciation and we post that debit of 250,000. So now we know.

There is some activity in that account. And there's going to have to be more activity later because the net change to that account was zero. Let's go to the next one. Okay. I held the maturity security was sold for 135,000. There were no other transactions that affected, held to maturity securities. So let's put the entry down.

We know they would have debit and cash for what they collected 135,000. What did they credit to. Investment in held to maturity. It must've been a hundred thousand because if you look at your T account on held to maturity, that account did go down by a credit of a hundred thousand. And they said that when no other transactions that affected, held to maturity securities, this must've been it.

So we're going to credit investment and held to maturity for a hundred thousand. And the point is we're going to credit gain on sale. 35,000. There was a gain on sale. Now we put that entry down. There is cash. What kind of cash is it? Is it operating? No, it's happy. It's investing. Isn't it? That's they make you happy.

And the agent happy is buy or sell, held to maturity. So we're going to go to our second big T account investing activity. We're going to post that $135,000 debit. Because that is cash provided by an investing activity. Investing always makes us happy by herself, held to maturity by herself, available for sale by herself P N buy or sell equity investments.

And we go there we go to investment in held to maturity, post that credit of a hundred thousand notice we've explained the change in that account. Wipe it out. We don't want to look at it again. Sticks it out. How about the gain on sale? It's an operating item. Go to your operating T account. And post that $35,000 credit as a game, that game goes to operating and you know why it goes to operating because we can't show this both as a gain on sale, on the income statement and 135,000 cash provided by an investing activity.

Can't show it in both places. You'd be double counting it. But as I said earlier in this FAR CPA Exam Review course, you don't have to think all that through just post everything. Why don't you put an entry down, post everything. In that entry, everything's got to go somewhere. The last bullet 10,000 shares of common stock were issued for $22 a share.

We have to assume they would've made the normal entry. They would debit cash for 10,000 shares at 20 to 220,000. They credit common stock for par value, 10,000 shares at part 10 that's in the balance sheet. That's a hundred thousand in credit API, additional paid-in capital for 120,000. So once again, you get that entry down.

Hey, this cash, what kind of cash is it? Is it operating? No. Is it happy? No. It's Prince divots. The I and it's is issue stock. So we're going to go to our third, big T account financing activity. We're going to post that $220,000 debit to that account because the, that is that's cash provided by a financing activity.

Let's post the rest of it. We go to common stock. We post that a hundred thousand dollars credit. To that account. And that explains the change in that account. Exit out. We go to API, see post $120,000 credit. That explains the change in that account. We can X that out and the additional information is done.

Now, when you get done with the additional information, There's only one step left. Now you circle all the accounts. You've not explained because as the last phase, the last step in this technique is to now deal with all of the accounts you've not explained. And we're just going to do this in a mechanical way.

Let's go to the first one available for sale securities. Tell me operating, investing, or financing. You're right. It's the a and happy it's investing. So it's an investing item. Don't we know that. Available sell securities increased during the year by a net debit of 300,000. So you're going to go to investing, do the opposite number at the end, do the opposite.

I'm going to credit investing 300,000. I'm going to assume that was 300,000 of cash used in an investing activity. Ready? Let's go to inventory, operating, investing, or financing. It's an operating item. It has to do with cost of goods sold. Since inventory increased by a debit of 80,000, I go to operate and do the opposite credit operating 80,000, held to maturity while we've explained that.

Now here's an interesting one plant assets. Don't we know that property plant equipment plant assets during the year increased by an EDD debit of 700,000. That was the net change to that account. But all we saw in our journal entries. Was a credit of 400,000 to that account. That should be all you have.

My point, is this the only way that account could have increased by a net debit of 700,000 is if there was another debit in that account, we infer there must have been another debit in that account, a 1 million, 100,000 to make it come out. That's why you need this technique because in the exam. They hide things.

They play games with you. We didn't know anything about that. We had to find it. That's why the T account approach, I think really helps you because you're taking an exam. They're not going to be above board about everything. They hide things. You have to find it. So again, all I know is the plant assets increased by a net debit of 700,000.

During the year, all we saw in our journal entries was a credit to that account of 400,000. We had to infer there must have been another debit to that account to make it come out. Of 1 million, 100,000 is an operating, investing, and financing. We know it's P any it's happy it's investing. So that was a 1 million, $100,000 debit.

The plant assets go to investing, do the opposite. We're going to credit investing 1,000,001. I have to assume that was 1 million, 100,000 of cash used in an investing activity. Cause it's PP and E. All right. Now, if you look at your investing T account, now we have one. They had 150,000 of cash provided by selling equipment.

125, 135,000 cash provided by selling held to maturity securities 300,000 cash used to buy a bill for sales, securities, and 1,000,001 cash used to buy equipment. You would do out the math, the net cash used in investing activity 1,115,000. So the answer to the second question. Number two net cash used in investing would be answered B 1 million, 115,000.

You just have it in your tea account. Net cash used in investing 1,115,000. All right, here's another one accumulated depreciation. Tell me, is it operating, investing, or financing? It's an operating item. We're trying to find the depreciation expense for the year. Now. Look at your. Accumulated depreciation account don't we know that the net change during the year to accumulate a depreciation was zero.

There was no net change to that account. And yet in our journal entries, we posted a debit to that account of 250,000. The only way the net change to that account could be zero. Is there had to be another credit in that account. They had to be a credit in that account. Of 250,000, we infer that must've been the depreciation expense for the year.

So that was a credit to accumulated depreciation, 250,000 go to operate and do the opposite. I'm going to debit operating 250,000. So often in the exam, you have to find that depreciation expense. So I hope that made sense to you because you may be in that position, in the FAR CPA Exam where you have to, as we did here in for what the depreciation expense for the year must've been, how about Goodwill?

Goodwill went from a hundred thousand down to 90,000. What does that tell you that must've been an impairment loss. We test Goodwill for impairment, at least annually. And the fact account went down there must have been an impairment loss on the income statement of 10,000. It's an operating item. So because Goodwill went down by a credit of 10,000, we'll go and go to operating, do the opposite debit operating 10,000 because of that impairment loss.

Accounts payable went from seven 20 to eight 25, a net credit increase of 105,000. Is that operating, investing, and financing? It's an operating item. Again, it has to do with cost of goods sold, so that increased by a credit of 105,000. Go to operating through the opposite debit, operating 105,000 and we have another one.

If you add it all up, net cash provided by operating activity 940,000. So the answer to number one, net cash provided by operating activity would be answer C. We've got that one. Now there's only one account left. The only account we have not explained is short-term debt. Short-term debt increased by a net credit of 325,000.

Operating investing and financing. Is it operating? No. Is it happy? No. It's Prince divots. It's the Prince in Prince divots. We haven't really seen a lot of that, but if short term debt went up by a credit of 325,000, we must have borrowed some debt principle. That's the Prince and Prince did it. It is a financing item.

So because short-term debt increased by a credit of 325,000, we're going to go to financing and do the opposite. Debit financing 325,000 and we have the other one net cash provided by financing activity is 305,000. So the answer to number three is a.

Now if you, with me on how we arrived at those answers, if you look at the next page, you'll see the actual statement of cash flows for dice corporation. And you can see that we just pull the information right out of the T account. If I have to do net cash from operating activities, I've got the net income, six 90.

I take out the gain on sale of held to maturity. I take out the increase in inventory. I add back the depreciation expense for the year. I add back the goal Goodwill impairment loss. I add back the increase in payable, increase in accounts payable, net cash provided by operating activity, 940,000. Just take the information right out of your T account.

If you actually have to do the statement. Or, fill it in, say as part of a simulation, how about cash flows from investing activity? Again, you take it right out of your T account. We have proceeds from the sale of equipment, 150,000 proceeds from the sale of held to maturity hundred and 35,000 payments to purchase available for sale securities, 300,000 payments to purchase property, plant equipment, 1 million, one net cash used in investing 1 million, one 15, and then finally cash flows from financing activities right out of your T account.

I have 240,000 cash paid for a dividend. I have 220,000 proceeds from the sale of stock. 325,000 approvals from issuing short term debt, net cash provided by financing activities 305,000. And again, you notice if I take a $940,000 debit and a 1 million, $115,000 credit and a $305,000 debit, it all comes out.

And nets out to $130,000 debit. And didn't, we know when we started the problem, that was the increase in cash for the year. During the year, cash increased by $130,000 debit. So it does reconcile. And then as we pointed out earlier, the way you finish the statement is to show cash and cash equivalents, January one, and then cash and cash equivalents, December 31.

So if you actually have to, as part of a simulation, fill out a statement, Just take the information right out of the T accounts. It should be able to fill it in. I want you to get some more practice on this technique. Now I want you to shut FAR CPA Review course down and do questions four and five. It's a set of multiple choice questions on cash flows for car corporation.

So get, please get your two answers. Come back and we'll go through them together.

Welcome back. Let's do this set of questions on car incorporated together. And I'm hoping that as you work with this technique more and more, you find that you're getting faster at this technique and more comfortable with it. Now in this set. They're asking two questions. They want to know the cash used in investing activity, and they want to know the cash provided by operating activities.

So right away you set up two T accounts, one for investing and, investing makes you happy by herself, held to maturity by herself, available for sale, hers LPP and E by herself equity investments. That's when we're going to go there, you set up a T account for operating activity and don't forget what starts off that T account.

Is net income that gave you the net income for the year 300,000. And that would go on the debit side because as net income provides cash from operations, doesn't use it. So you get that set up now, what's your next step? Did you remember? Did you know what to do next? You set up a small T account for every account.

They give you in the balance sheet except for cash and put the net change in each one of those accounts. So we only have three equipment. Increased during the year by a net debit of 25,000. Put that debit change in that account. Double underline it accumulated depreciation increased by a net credit of 40,000.

So put that $40,000 credit increase in that account. Double underline it and notes payable increased by 30,000. So put a $30,000 net credit increase to notes payable, double underline that for 30,000. So we've done that. Now, what do you do next? Are you getting used to the process? That's right now you put down a journal entry for every transaction they describe.

And there's a couple of them here. First they say during the year cars sold equipment costing 25,000. So we know they would have credited equipment, 25,000 with accumulated depreciation of 12,000. So we know they would have debited accumulated depreciation. 12,000, there was a gain of 5,000. So we know they would have credited gain on sale 5,000, the entry doesn't balance.

We need an $18,000 debit to balance the entry out. It's a plug that must've been the cash. See, that's the thing about the exam. There are missing pieces. That's why journal entries T accounts help you because they're not going to necessarily tell you everything. What was missing here is the cash you had to find it.

Now what kind of cash is it? It's P and eats happy. So you're going to go to investing. You're going to post that $18,000 debit because we know that's cash provided by an investing activity. Let's post the rest of the entry. We're going to go to equipment post that $25,000 credit. Have we explained the change in that account?

No, we know that account increased by a net debit of 25,000. All we've seen is a credit increase to that account. Of 25,000, we still have more work to do. We go to accumulated depreciation. We post that $12,000 debit. We have not explained the change in that account. We leave it open and we also have a game.

That's an operating item member. Once you put an entry down, everything gets posted somewhere. So we're going to go to operating activity and post that $5,000 credit to operating because of the gain on sale. That's an operating item. And again, the reason that has to be done is because we can't show this both as 18,000 cash provided by the investing activity and the gain on our income statement, you'd be double counting it.

But as I said earlier in the class, you don't really have to think it all through. Just post it, get an entry down, everything gets posted somewhere. Now there's another transaction they say in December, Car purchased equipment costing 50,000 cat, 50,000 for 20,000 cash and a $30,000 note. The entry of course would be debit equipment, 50,000 you'd credit cash, 20,000 and you'd credit notes payable, 30,000.

This cash involved it's P and E. So you go to investing activity, post that $20,000 credit. And now we can answer one of the questions net cash used. And investing activity 2000. So the answer to number four is a let's post. The rest of it. We go to equipment. We post that $50,000 debit. We've explained the change in that account.

Exit out. Don't want to look at it again. We go to notes payable. We post that $30,000 credit. We've explained the change in that account. Exit out. Don't want to look at it again. All right. So we're done with the additional information. Now, what do you do? You circle all the accounts. You've not explained.

There's only one account. We have not explained accumulated depreciation and it's an operating item. We're trying to find the depreciation expense for the year. Now let's look at this T account don't we know that accumulated depreciation during the year increased by a net credit of 40,000. And yet all we saw in our journal entries was a debit to that account of 12,000.

The only way that account could have increased by a net credit of 40,000 is if there was another credit to that account of 52,000, that must've been the depreciation expense for the year cumulated depreciation increase during the year by a net credit of 40,000. Yet all we saw in our journal entries was a debit to that account of 12.

There must have been another credit to that account to make it come out of 52,000 and presumably. That would be the depreciation expense for the year. So that was a credit to accumulated depreciation, 52,000 go to operating, do the opposite debit operating 52,000. And now we can answer the other one. Net cash provided by operating activity would be 347,000.

So the answer to number five is B. And I know you might be saying Bob, they gave us the depreciation expense for the year. Anyway, it was given, it was 52,000. I know that. But so often than the exam, they will not give it to you. That's why a couple of times in this FAR CPA Exam Review course I've made you analyze that accumulated depreciation account.

So you could find the depreciation expense. If you have to, because in the FAR CPA Exam they may not give it to you. It could be a missing piece of information. Let's get some more practice on this method. I'd like you to try number six tab, and then when you get your answer, come back.

Welcome back. Let's do number six together. In number six, they're asking in tabs year five statement of cash flows. What was the net cash used in financing activity? So one way you could approach this, you could set up a quick T account for financing activity and you're always financing for Prince divots Prince.

His debt principal div has paid dividends. I is issued stock. Ts is treasury stock transactions. Let's look at the list. They have payment for early retirement of long-term bonds. Is that part of Prince divots? Sure. If you retire bonds, aren't you paying off debt principal. That's the Prince in Prince divots.

We haven't seen a lot of that. But remember bonds are a debt security. So anytime you retire bonds, what you're doing is paying down debt principal. That is the Prince in Prince divots. Let me ask you this. What I use the seven 40 or the seven 50. We don't care about the carrying value of the bonds. The seven 40, we are analyzing cash.

All we care about is the cash that went out to retire the debt. That's the 750,000 that's cash used in a financing activity. Next. Distribution in year five of a cash dividend that was declared in year four. We know the dividends would be the div and divots. So we know it's a financing item and this, it doesn't matter that it was declared in year four.

If the cash went out into year five, that's cash used in your five for a financing activity. So we know that's 62,000 of cash used. In a financing activity. How about the carrying amount of convertible preferred stock converted into the carrying amount of convertible preferred stock converted into common stock?

Well preferred stock converted to common stock that doesn't affect cash. You want to just right next to that's a non-cash item. Non-cash doesn't affect cash. You have convertible preferred stock being converted into common stock. Doesn't affect cash. It's a non-cash item. I'll say more about that in a minute, but we don't have to worry about that.

No effect on cash. And then finally, the proceeds from the sale of treasury stock. We know that treasury stock is the Ts on divots. It is financing. What I use the 86,000 or the 95,000. You're right. I don't care about the 86,000. I don't care about the carrying value. The treasury stock. All I care about is cash.

Cash flows is an analysis of cash. And if I collected 95,000 cash from selling my treasury stock, that's cash provided by a financing activity. So put that $95,000 debit in that account. And we can answer the question net cash used in financing activity, 717,000 answer a I'm hoping that you eat up a question like that.

If Prince divots, I'm hoping you go right through it.

Now I want to go back to this non-cash item. The carrying amount of convertible preferred stock converted into common stock. As I mentioned a little earlier in this FAR CPA Exam Review course, these are called non-cash. Investing in financing activities. Again, these are all called non-cash investing and financing activities.

There are four big ones and you've got to know them. Let's go over the four big ones. Number one is this one preferred stock converted to common stock. That is a non-cash investing and financing activity. Number two, when we saw earlier convertible bonds converted into stock. If you see convertible bonds converted into stock, that is a non-cash.

Investing in financing activity. Number three, another one. If you see a straight exchange of debt for property, again, any time there's a straight exchange of debt for property, you see a company issue, a note for an asset that is a non-cash investing and financing activity. It's a straight exchange of debt for property.

That's a non-cash investing and financing activity. And then finally, A straight exchange of stock for property. If you see a company issue stock for an asset, Hey, that is a non-cash investing and financing activity. And let me just give you a quick note here. These non-cash investing and financing activities are not in the statement of cash flows.

They're not in the body of the statement. However, they get footnoted at the bottom of the statement as a supplemental disclosure. That's what these are. They're not in the body of the statement, but they do get footnoted at the bottom of the statement as a supplemental disclosure, a couple more points.

Again, those are all supplemental disclosures in the statement of cash flows. Now stock dividends, stock splits again, stock dividends, stock splits, retained earnings appropriations, stock dividends, stock splits, retained earnings appropriations. They're not in the body of the statement of cash flows and then out of supplemental disclosure and a statement of cash flows, stock dividends, stock splits, retained earnings appropriations.

They're not in the body of the statement of cash flows and then not a supplemental disclosure in the statement of cash flows. And just one other quick point, there's no requirement that accompany footnote cash flow per share. I know they've asked that there is no requirement that in a statement of cash flows, they footnote cash flow per share.

That is not a requirement. Let's go to number seven.

It's a question that would bother a lot of people. Seven says men purchased a three month treasury bill men's policy is to treat as cash equivalents, all highly liquid investments with an original maturity of three months or less. When purchased, it was nice of the exam. Wasn't it to remind you of that three month rule, we have a security with, either a certificate of deposit or some kind of commercial paper with an original maturity of three months or less.

It's the same as cash. It's a cash equivalent. And they say, how would the purchase of this cash equivalent be reported in the statement of cash flows? And I want you to look at this question because a lot of students. I would say it is answer a, in other words, they might go I remember what Bob said.

Bob said, if you buy or sell trading securities that has cash flows from operating activity. I remember Bob saying that if you buy or sell trading securities, Hey, that's cash flows from operating activities. So they go for a, it's not a, why is this? Is this a trading security? No, it's a cash equivalent.

It's not a trading security, it's a cash equivalent. And what might help you is just think for a moment, what is the entry that we make? If we go out and purchase a cash equivalent, just think what the entry is when you purchase a cash equivalent, what would be the entry that you'd make you would debit cash, credit cash.

It's not reported at all. The answer is D. You're just moving around different parts of cash. That's all you're doing. Remember cash equivalents are the same as cash. This is no different than moving your cash form from one bank account to another bank account. It's the same idea. So you go out and buy a cash equivalent that is not reported in a statement of cash flows.

I'd like you to try another set. I'd like you to try eight and nine and then come back.

Welcome back. Let's look at this set together. And number eight, they want to know the cash used in investing activity and a number nine. They want to know the cash provided by financing activities. So you could set up right away to a T account. You have a T account for investing activity, what makes you happy?

You have a T account for financing activity, always financing for Prince divots. Now they gave us a list of items to consider here. Here's what I'd like to do. Let's go down this list together and let's label each item on the list over operating I for investing F for financing. How about the gain on equipment?

That's an operating item. Put an O there proceeds from the sale of equipment. That's P and L that's happy. That would be investing and I, their purchase of an investment in bonds that are available for sale securities. That's the a and happy that's an investing item, amortization of a bond discount.

That's an operating item. Now with dividends, we know that's the dividend divots, it's a financing item. Do we care about what they declared or what they paid? I put a line through declared. All we're analyzing is cash. So next to the 38,000, they actually paid for dividend. That would be cash used. In a financing activity.

And then finally the proceeds from the sale of treasury stock, we know the treasury stock would be the Ts on divots. That's a financing item, 75,000. Now, if you did that, it turns out we have two investing items. We have 10,000 cash provided by selling equipment. 180,000 cash used to purchase available for sale securities, net cash used in investing is 170,000 a for number eight.

We have two financing items for number nine 30, 8,000 cash used to pay a dividend 75,000 cash provided by selling treasury stock net cash provided by financing activities would be 37,000 answer D you know what I'm hoping. I'm hoping that if happy and Prince divots, you just hopefully just go right through a set like that very quickly.

That's what I'm hoping.

Now you'll notice that up until this point in class, all we've talked about is the indirect method of preparing a statement of cash flows. Because as I said, at the beginning of class, it is by far the most heavily tested method. Let's get into the direct method. First of all, if you see the direct method in the CPA exam, remember investing activity is exactly the same.

You're still investing to make you happy by herself. Held to maturity by herself, ill for sale by herself P and E by herself equity investments. I want you to know that all still work for you. Investing still makes you happy financing activity in the direct method is exactly the same. We're still financing for Prince divots.

Prince is dead. Principle. Div is paid dividends. I is issued stock TSS, treasury stock transactions, investing activity. Exactly the same financing activity. Exactly the same. The only thing that's different in the direct method is that the operating section has to be presented differently. And that's what I want to get into next.

I want to show you how we have to present the operating section under the direct method. You really have to know this when you're doing cash flows from operating activities under the direct method, you're going to start with cash sales. In other words, you don't start with net income. You start with cash sales, what they sometimes call cash collected from customers.

And then you put in four categories of cash expenses. First you have cash cost of goods sold. Sometimes they call it cash paid to suppliers. So you're getting, you have four categories of expenses. First cash cost of goods, sold cash, paid to suppliers. Second one cash for selling and administrative expenses.

It's primarily salaries and wages, but it would be cash paid for selling and administrative expenses and then cash paid for interest. And then finally cash paid for taxes. And it comes out the same. That's what they mean by the direct method. You show cash sales, cash collected from customers and those four categories of cash expenses.

Now, remember I said earlier that the FAR CPA Exam has tested the indirect method far more often, and you might be wondering do they ever test the direct method they might? And if the FAR CPA Exam hits you on the direct method, they could ask you to figure out cash sales, figure out cash cost of goods sold.

Let me show you what I mean, if you go to question number 10,

it says, do company reported cost of goods sold of 270,000 for the current year, that would be on the accrual basis. The income statement should be on the accrual basis and on the accrual basis. They're showing cost of goods sold of 270,000 at the bottom. It says if Duke uses the direct method, notice they're specifying.

As I said earlier in the class, only worry about the direct method. If they specify and here they are, if Duke uses the direct method, what amount would Duke report as cash paid to suppliers for the year? In other words, what's cash cost a good soul. And I wanted to show you this because this might be the one they test the most.

How do you. How do you bring cost of goods sold on the accrual basis to cost of goods sold on the cash basis? There's more than one way you can do this, but I want to show you the way I like to do this. We know that cost of goods sold on the accrual basis is 270,000. And for me, if I want to convert cost of goods sold from accrual to cash, I always start by figuring out purchases.

I just think that's the best way to do it. It's not the only way to do it. But I want to figure out purchases. So thanks for a minute. How would I go from what they sold to what they purchased? You'll look at change in inventory. If you want to go from what they sold, what they purchased, go to the change in inventory notice in the last year, inventory went from 45,000 back on January one, up to 60,000, December 31.

Inventory has increased by 15,000. So think about it. The only way inventory could go up. Is I must've purchased a lot. I must have purchased enough merchandise to cover all the goods I sold. Plus I added to inventory again, the only inventory can go up is if I purchase a lot, I must've purchased enough merchandise to cover everything I sold.

Plus I added inventory. So I'm going to add that to 70 plus 15 purchases. Must've been 285,000. Now, the reason I like to figure out purchases is because at that point I can just do an entry. I'm going to debit purchases. I figured that this company, Duke must've debit purchases 285,000. Now the question is, was it all cash?

What happened to accounts payable in the last year? Accounts payable went from 39,000.

down to 26,000. It went down. So in this century they must've debit to the accounts payable 13,000 because it went down and the credit to cash. Must've been 298,000. And the answer is D. That was the cash they paid for merchandise. That was the cash cost of goods sold. That was the cash paid to suppliers.

That's the way I like to do that. Once you figure out purchases, you can just do an entry.

What I'd like you to do is go back in your viewers guide. I'd like you to go back. To the first problem that we did in this FAR CPA Review course feral corporation. I want to show you a couple of things. If you go back to Farrow corporation, now you remember that we solved feral corporation under the indirect method.

And if you go back to feral corporation for a moment, look at the statement of cash flows that we did for feral under the indirect method. If you back to there, you see that. Cash flows from investing activity was 44,000. That would be in the direct method. That would be exactly the same. The cash flows from financing activities came out to 5,000 and the direct method.

That would be exactly the same. You got to remember that investing activity exactly the same financing activity. Exactly the same, all that would be different in the direct method. If I were to solve feral corporation under the direct method is how I would present the operating section. Now we know. From our earlier solution that the net cash provided by operating activity is 134,000.

Let me show you how we would do that in the direct method, in the direct method. I want to start with cash sales. Now, look at the income statement for Pharaoh. What were sales on the accrual basis? 1,000,009 50. Let's think about an entry. You're always like entries. So if the sales were 1 million, nine 50, I got that on the income statement for feral.

We know they credited sales 1 million, nine 50. Now I know, you know this. If I want to convert sales from a cruel to cash, I look at generally what change in accounts receivable in the last year. If you look at the balance sheet for Farrow accounts receivable went from 305,000 a year ago down to 295,000.

It went down 10. So when this entry they must've credited. Accounts receivable, 10,000 and the debit to cash. Must've been just the plug 1,960,000. So that tells me cash sales. That's how I think of our cash sales. So I'd have cash sales. If I were doing feral statement of cash flows under the direct method, I'd start with, when I do cash flows from operating activities, I'd start with cash sales or cash collected from customers.

1,000,009 60. And I'm hoping you see where I got that. Now I want to add in, excuse me, I want to subtract four categories of cash expenses. First cash cost of goods, sold cash, paid to suppliers. Let's work that out together. If you look on the income statement for Pharaoh, what was cost of goods sold on the accrual basis?

1 million, one 50. I hope you see that now. The way I like to do this, I want to figure out purchases. How do I go from what they sold? To what they purchased. I look at change and inventory. If you go to the balance sheet, you'll notice in the last year inventory for Farel went from 431,000 up to 549,000 inventory in the last year went from 431,000 up to 549,000 didn't inventory go up by 118,000.

So think about it. What is the only way inventory can go up? I must have purchased a lot. I must have purchased enough merchandise. To cover all the goods I sold. Plus I added the inventory. So I'm going to add that. Add that one 18. My total purchases, must've been 1 million, 268,000. So once I've got purchases, I can do an entry.

I know that farewell must've debit purchases, 1 million, 268,000. Now it was it all cash we'll look at accounts payable on the balance sheet in the last year, accounts payable increased by 41,000. So I know in this entry they would have credited accounts payable. 41,000 and the rest must've been cash credit cash, 1 million, 227,000 that's cash cost of goods, sold cash paid to suppliers.

So we put that in. So we have the cash collected from customers. 1 million, nine 60. We have cash paid to suppliers, cash cost of goods sold 1 billion, 227,000. How about cash selling and administrative expenses? If you look on the income statement, the selling and administrative expenses for the year, 505,000.

That was it. All cash. What you have to be careful about here. Remember I said earlier that this is primarily salaries and wages and you have to see if there's any wages payable there. Isn't you look on Pharaoh's balance sheet. There's no wages payable, so it must be all cash. So cash paid for selling an administrative expenses, 505,000.

Now cash paid for interest. If you look on the income statement, For feral cash paid for interest or their interest expense for the year was 15,000. Was it all cash? What you want to look for here is any interest payable, but if you look on the balance sheet, there was no interest payable. So it must be all cash again, once you have to be careful about with interest, if interest payable went up well, then some of it wasn't cash.

If it went down well, I paid my current expense in cash. Plus I paid down the payable and when you have to watch out for the interest payable, but on the balance sheet, There was no interest payable. So the 15,000 must have all been cashed. And then finally cash paid for taxes. Do I just pick up their total income tax expense?

90,000? No, not what they deferred. I just want what they paid in cash so that the increase, the deferred tax liability. I don't care about just pick up the current portion, 79,000. So notice it all comes out the same. If I take the cash collected from customers cash sales, 1,000,009 60. Back out cash cost of goods, sold cash, paid to suppliers, 1 million to 27 cash selling administrative expenses, five Oh five cash paid for interest.

15,000 cash paid for tax is just the current portion. 79,000. You get the same answer. Net cash provided by operating activity 134,000. That's what they mean by the direct method. Investing activity is exactly the same financing activity is exactly the same, but you have to present. The operating section differently.

You have to show up for cash sales, cash collected from customers and these four categories of cash expenses. Now, one other point, if you go back for a moment to the statement of cash flows we did earlier for feral, go back to their operating section under the indirect method you see where we have net income, one 41.

We add back the decrease in receivables. We take out the increase in inventory. We add back the increase in payables. We add back the depreciation expense. We add back the Goodwill impairment loss. We add back the loss on equipment. We take out the subs earnings. We add back the increase in deferred tax liability.

Now listen, even in the direct method that schedule shows up at the bottom of the statement as a supplemental disclosure. Anyway, let me say that again, even yes. In the direct method you would present the operating section the way I said. Show cash sales and those four categories of cash expenses. But the schedule that we have under the indirect method, where you show the net income and you add back the decrease in receivables and so forth.

And so on, that shows up at the bottom of the statement as a supplemental disclosure. Anyway, that's why you can't get away from the indirect method, because even in the direct method, you have to have a supplemental disclosure where you reconcile from a cruel income to cash income. Anyway. So in reality, you can't get away from the indirect method.

So I'll say one more time. You're only going to worry about the direct method in the CPA exam. If they specify they want the direct method, let me show you what they could do. I'd like you to go back to the multiple choice. We're going to do 11 to 15 flax. I'd like you to shut your tape down. Try that set 11 to 15 and then come back, get your answers first.

Welcome back. Let's do this set of questions together. They say flax uses the direct method to prepare its statement of cash flows. As I've said all through this class. The only time you worry about the direct method in the CPA exam is when they specify if they were silent, I'd always solve something under the indirect method.

But when they specify, you have to worry about the direct method. It says we have the trial balances that December 31 year seven and year six, we have some additional information. Now they ask. Five questions. 11, 12, 13, 14, and 15. Now, before we look at the questions, I want this to make sense to you.

Remember we said that when you see the direct method, we know investing activity is exactly the same, no differences there financing activity is exactly the same. There's no differences there. All that's different in the direct method, as you know is that the operating section gets presented differently.

We have to show cash sales. And four categories of cash expenses. And look at these five questions. Question number 11, what's cash collected from customers what's cash sales, 12 what's cash cost of goods, sold cash paid to suppliers, 13 cash paid for interest, 14 cash paid for taxes, 15 cash for selling, really what else can they do with this?

They could ask for investing activity, they could ask for financing activity, but it's the same. This is pretty much what they can do with. The direct method. I hope he tried these 11 says, all right, what's cash collected from customers. If you go to the comparative trial balances, go to the credit side, the last credit listed, we know the sales for year seven, 538,800.

Now, you know me, I like an entry, so don't, we know they credited sales 538,800. Now was it all cash? What do you want to look at? Accounts receivable go to the debit side. In the last year, accounts receivable went from 30,000 up to 33,000. So in this entry, they must have debited accounts receivable, 3000, cause it changed.

It went up and the rest must've been cash. You would debit cash for 535,800. And the answer is D entries. I think help you a lot. Just try to get an entry down and I hope you get to answer D very quickly. That's cash collected from customers cash sales, five 35, eight. Now I really hope you did well on number 12 because it's probably the one they asked the most cash paid to suppliers, cash cost of goods sold.

Let's do it together. What was cost of goods sold on the accrual basis? If you go to the debit side about halfway down cost a good soul for two for year seven, under the accrual basis, 250,000. Now, you know what I like to do, I want to go from what you sold, what you purchased. I want to figure out purchases because then I can just do an entry.

How do you go from what you sold to what you purchased? Look at the change in inventory. On the debit side in the last year, inventory went from 47,000 down to 31,000. Didn't it go down 16,000. If inventory went down 16,000. I didn't purchase all the goods that I sold. I took 16,000 out of my inventory. I backed that out.

Then I purchased the rest two 50 minus 16, 234,000. Again, if inventory went down, I didn't purchase all the goods I sold. I took 16,000 out of my inventory. Take the 250,000 back out 16,000. I must have purchased the rest 234,000. Now, as I keep saying, once you've got purchases now, it's just a matter of doing an entry.

We know they debit purchases 234,000. Was it all cash go to the change in payables on the credit side, the trade accounts payable. In the last year, went from 17 five to 25,000. So when this entry didn't, they credit accounts payable, 7,500 and the rest must've been cash, plug it credit cash 226,500. And the answer is D I want you to be really comfortable with converting cost of goods sold from accrual to cash.

Might be the most common one they ask.

How about cash paid for interest? If you go to the debit side towards the bottom, notice the interest expense for your seven 4,300. So we know they debit interest expense 4,300. Now the question is, was it all cash now? I really mean this. Give yourself credit. Give yourself a gold star. If you thought of interest payable, that's normally what you have to be careful about.

Was there any interest payable, interest payable has gone up. I credit interest payable for the increase. The rest presumably is cash. If interest payable has gone down during the year, then I debit interest payable for the decrease and the rest must've been cash. But notice on the credit side, there is no interest payable.

There's no interest payable to worry about. So it is all. Is it all cash? No. 'cause you gotta be, you have to look at everything. They give you on the debit side about halfway down. No, they notice they had an unamortized bond discount that in the last year went from 5,000 down to 4,500. So in this entry, they must have credited discount, 500.

Again, you have to look at everything they give you here. In the last year unamortized bond discount went from 5,000 down to 4,500. They must've amortized some of the discounts. That's part of your interest adjustment. So in this entry, they must've credited discount 500 and the rest must have been cash credit cash.

3,800. The answer is C because there is no interest payable. Number 14. How about the cash paid for taxes? Let's do an entry is really help go to the debit side. The last debit listed. Interest expense, excuse me, income tax expense for year seven, 20,400. Last debit listed your income tax expense for your seven 20,400.

So we know they would have debited income tax expense, 20,400. Now is it all cash? No. Gotta look at everything they get. Yeah. On the credit side didn't they have a deferred tax liability. That went from 4,600 up to 5,300. So in this entry, they would have credited deferred tax liability, 700. What else watch out for income tax payable in the last year, income tax payable went from 27,100 down to 21,000.

So when the century they must've debited income tax payable, 6,100. Now you need a credit, the balance, the entry out of 25,800, and it must've been to cash that must've been the cash they paid for taxes. And the answer is a always come back to entries. They usually help you clarify something. And then finally, what was the cash paid for selling?

If you go to the debit side about halfway down the selling expense for your seven 141,500, so we know they debit it. Selling expense, 141,500. And now the question is it all cash? Here again, give yourself credit. If you thought of wages payable, that's mostly wages and you want to look on the balance sheet and see if there's any wages payable related to selling.

They'd have to specify wages payable related to selling. There isn't any, since there are no wages payable related to selling, is it all cash? Again, you've got to read everything they give you. Any the additional information. The second bullet says flax allocates one-third of their depreciation expense to selling well, if they allocate one third of their depreciation expense to selling depreciation is a non-cash expense.

It is an expense that does not require the outlay of cash. So the question is, do we know the depreciation expense for the year? We can figure it out, go to the credit side, find the accumulated depreciation. In the last year, accumulated depreciation went from 15,000 up to 16 five. We infer that the depreciation expense for the year must've been 1500 again in the last year, accumulated depreciation went from 15,000 to 16 five.

We have to infer that the depreciation expense for the year must have been 1500. Since one third of that went to selling. In the century, they would have credited accumulated depreciation for one third of 1500, 500. And the rest must have been cash credit cash, 141,000. The answer is C because there is no wages payable related to selling or other possible non-cash expenses that we know about.

I hope you did well on that set. And as I say, what should make you feel good about that set is that there's really not that much they can do with the direct method. They may ask you to figure out. Cash paid to suppliers, cash cost of goods sold. They may ask you to work out cash collected from customers, cash sales, but there's when you get right down to it, not much they can do with the direct method.

And as long as you can get back to an entry and work it out, I think you'd be fine with whatever they come up with. Why don't we do one more thing on the indirect method. If you look in your viewers guide, there is a simulation on. The indirect method, Zac corporation. I'd like you to shut FAR CPA Review course down, give yourself about 20, 25 minutes.

There are five questions that you have to answer. Please answer those five questions and then come back. We'll go through them together.

welcome back, Jack. Let's take a look at this simulation together and it's a little bit different. Isn't it? It says the following are selected balance sheet accounts of Zac corporation at December 31 year nine and year eight and increases or decreases in each account. From year eight and year nine, also presented as selected income statement information.

So when they have selected information, and if you look at it, we have selected balance sheet accounts. We have selected income statement information. We have some additional information as well, and it says items one through five represent activities that will be reported in Zach's statement of cash flows at December 31 year nine.

And the following two responses are required for each of them. You have to determine the amount, the dollar amount that would be reported in the statement of cash flows and also the category, which it falls in operating, investing, or financing. All right. The first thing we like to do is go to the change in cash.

Cause we prove out to that. I don't know cash. I only have selected. Balance sheet accounts and cash. Just isn't one of the ones they selected. So I don't know the change in cash. So let's go to my next step. I put down three big T accounts. I'm going to set up a T account for operating activity. I'm going to set up a T account for investing activity and a T account for financing activity.

Got that done. Then we put down a small T account for every account. They give us in the balance sheet except for cash. We don't have cash. Anyway, put the net change in each account. Let's do that in the last year. Accounts receivable went from 24,000 to 34,000. That's a net debit increased to that account.

10,000 property. When equipment went from two 47 to two 77, a net debit increased to that account of 30,000. Accumulated depreciation went from one 67 to one 78 on net credit increase to that account 11,000. So you put those changes in those accounts and double underline them. Bonds cable went from 46,000 to 49,000.

That's a net credit increase to that account of 3000 double underline that there was also a net credit increase to dividends payable went from 5,000 to 8,000. A net credit increase to dividends payable of 3000. Double underline that. And then finally, a $3,000 credit increase to common stock. A $6,000 credit increase to API C and a $13,000 credit increase to retain earnings.

So we get that set up

now, where do we begin our analysis? I always say, prove out the retained earnings. We know that this past year retained earnings increased by a net credit of 13,000. See if we can prove it out. If you go to select it income statement information, we do know the net income for the year 28,000. Let's post that we're going to go to our first big T account, which is operating activity.

Post that $28,000 debit to that account. We know it's a debit because net income provides cash from operations. Doesn't use it. And we post the credit to retain earnings. Presumably net income is always posted as a credit to retain earnings 28,000. Now I want you to look at that retained earnings account.

You have to infer something here. Maybe we only have selected information don't we know that retained earnings increased by a net credit of 13,000 and yet we know income was posted at 28,000 a credit of 28,000. The only way retained earnings. Good increase by a net credit of 13,000. That had to be another debit in that account that had to be a debit to retained earnings.

You plug it in a 15,000. That must have been the dividend. You had to find the dividend here. So we're going to debit. Let's do our entry here. I always make the dividend. My first entry. We know they're going to debit retained earnings, 15,000. Again, I had a plug that to make retained earnings prove out they didn't give it to me.

I only have selected information. So I'm going to debit. Retained earnings for that 15,000. So now I've proven the change in retained earnings exit out. Don't want to look at it again now, should I credit cash 15,000? Was it all cash? No. Look at dividends payable. During the year, there was an increase to dividends payable of 3000.

So in this entry, they must have credited dividends payable, 3000. So post that explains the change in that account. Exit out. And the rest must've been cash credit cash 12,000. So now we can answer one of the questions. Remember in a simulation like this, you are very driven to just answer the questions.

In other words, don't do more work than you have to. You'll only work enough to answer these five questions. We can answer one number four. What would the cash dividends paid? The answer was 12,000 from our entry and we know it's financing. It's the dividend divots. We're always financing for Prince divots.

Prince is debt. Principal div is pay dividends. I issue stock triaged. Ts is treasury stock transactions. It's a dividend, it's the dividend divots. So it's 12,000 financing activity. So we found that we've proven out retained earnings. What do we do next? Now we go to the additional information and there isn't much, all they said in the first bullet was.

First they said accounts receivable relate to sales merchandise, which you'd assume. And then the second bullet says during year nine equipment costing 40,000 was sold for cash. So they didn't say much. They just said during year nine equipment costing 40,000 was sold for cash. Let's see if we can piece this entry together.

We know they credited equipment 40,000. Do we know anything else about that entry shore in the selected income statement information don't we know there was a gain on sale of equipment of 13,000. So in this entry, they must've credited gain on equipment 13,000. Anything else? Do we know the accumulated depreciation that was on that equipment?

We can figure it out. Can't we go to your T account on accumulated depreciation. Don't we know that during the year accumulated depreciation increased. By a net credit of 11,000. Now, do we know the depreciation expense for the year? We do look at selected income statement information they gave you that the depreciation expense fee was 33,000 that was given.

So during the year they must've debited depreciation expense, 33,000 credit accumulated depreciation, 33 thousands of what that in there was a $33,000 credit because of depreciation expense. And here's my point if accumulated depreciation. Increased by net credit of 11,000. And yet the depreciation expense resulted in a credit of 33,000.

There must've been another debit in that account to make it come out there. Must've been a debit to accumulated depreciation of 22,000. And as far as we know, this is the only entry that explains it. So back to our entry, they would have debit accumulated depreciation, 22,000, that must've been 22,000 of accumulated depreciation on that equipment.

The Andrew doesn't balance. I need a $31,000 debit to balance the entry out. That must have been the cash. And now we can answer another question. Number three. What were the proceeds from the sale of equipment? It must've been 31,000 and of course investing cause it's PPE. It's happy. It's PP and E so 31,000 investing.

We've got that one. All right. Now I'll go back to the initial information. It says. During year nine, 20,000 of bonds payable were issued in exchange for property plant equipment. And there was no amortization of bond discount or premium. If 20,000 bonds payable were issued in exchange for PP and E the entry, they would have debited property, plant equipment, 20,000 and credit bonds payable 20,000.

And you know what? This is a straight exchange of debt for property. It is a non-cash. Investing in financing activity. It's not going to be in the statement of cash flows. It's not in the body of the statement, but it is footnoted as a supplemental disclosure, but do I post this entry? Of course everything has to be posted.

So we're going to go to property, plant and equipment. We're going to post that $20,000 debit. That was not, we've not explained the change in that account. In fact, I want to make sure that we posted everything in our prior entry. Let me just go back to the prior entry where we sold the equipment. We should have gone to property, plant and equipment and credit property, plant equipment for 40,000.

We still have more work to do there. We've not explained the change in that account. We've proven out the change in accumulated depreciation. How about the cash? The 31,000 we know that would go to investing activity. It's P and E. And how about the gain of 13,000? That's an operating item. So hopefully you went to your operating T account and credited operating for 13,000 for the gain on equipment, get the entry down, post everything.

So now we're posting this other entry where we debit property plant equipment, 20,000 and credit bonds payable 20,000. So we go to property, plant equipment, post a $20,000 debit. We still have not explained the change in that account. So we leave it open. We go to bonds payable. We post a $20,000 credit to that account.

We have still not explained the change in that account. We have to leave it open. So that takes care of all the additional information. It's all they said.

We've answered a couple of the questions. What's my next step. In fact, what's my last step. You circle all the accounts. You've not explained. Let's go to the first one. We have not explained accounts receivable. We know it's an operating item. If accounts receivable has increased by a net debit of 10,000, go to operating, do the opposite credit operating 10,000.

Now look at the next one. Look at property plant equipment. Don't we know that during the year property plant equipment increased. By net debit of 30,000. Now, what have we seen in our journal entries? We saw our credit of 40,000. When we sold the equipment, we saw a debit of 20,000 when we bought equipment, the only way the net change in that account could be an increase of 30,000.

There had to be another debit in that account. We have to infer there was another debit and that account of 50,000. I'll do that again. We know that property plant equipment increased during the year. Buying a debit of 30,000. And what have we seen in our entries, a credit of 40,000 and a debit of 20,000, that had to be another debit of 50,000.

So we infer at some point during the year they debit property, plant equipment, 50,000, and it must've been a credit to cash because there's no other account that makes sense. There's no debt, no mortgage. It must've been cash of 50,000. As I've said all through this class, the problem with the FAR CPA Exam is they play games with you.

There's missing information. We had to find that. Now we can answer another question. Question number two. What were the payments for the purchase of property? Plant equipment 50,000. And of course we know it's and it's happy it's investing. We can label that one. Now accumulated depreciation we've explained let's go to bonds payable.

Don't we know that during the year bonds payable increased. By a net credit of 3000, just 3000 in our entries, we saw our credit to bonds payable when they bought the property plant equipment of 20,000, the only way the net change to bonds payable could be an increase of just 3000. Is if there was another debit to that account that had to be a debit to that account of 17,000.

I hope you see that we credited bonds payable for 20,000. When we issued bonds in exchange for fixed assets. But the net change, that account was only 3000. The had to be a debit in that account of 17,000. They must have redeemed bonds payable. You had to find that. So they must have debit bonds payable, 17,000 credit cash, 17,000.

So now we can answer another question. Number five, the redemption of bonds payable. Must've been 17,000. Must've been, and of course that's financing activity because it's debt principal. If you retire bond, You're paying off that principal. And as that's the Prince and Prince divots now that's as far as I, I wouldn't finish the problem.

Figure out cash flows from operating activity, investing activity, financing activity. Cause they didn't ask, as I say, in a simulation, you're very focused on just answering what they want. Cause you don't want to waste time. So we've answered questions. Two, three, four, and five. Now there's also question one.

What were cash collections from customers under the direct method, as I've said again, and again, only worry about the direct method if they specify and they are here in questions, two, three, four, and five, nothing was specified. And I just went with the indirect method. And of course you also know that investing activity, financing activity, which is what questions two, three, four, and five were all about are exactly the same, whether it's direct method or indirect method, it doesn't matter.

But anyway, in number one, they are specifying what were the cash collect collections from customers or under the direct method? What were cash sales? The way I like to do this, let's do an entry. Look back in the information, go to selected income statement, information in selected income statement information.

We know the sales revenue, 155,000. So we know they credited sales 155,000 and you know what to do. If I want to convert sales from accrual to cash, I look at what change in. Accounts receivable, look at your accounts receivable account. That's one of the selected accounts they gave you in the last year.

Didn't accounts receivable gold from 24,000 up to 34,000. It increased. So think about our entry. We know they credited sales 155,000 that was given sales revenue. But if accounts receivable went up 10,000 in the century, they must've debit to the accounts receivable. 10,000, the rest must've been cash debit cash, 145,000.

That must've been the cash collected from customers. So the answer to number one is 145,000, and obviously it is operating. I hope you're feeling good about this technique. I want to wish you the best of luck on the FAR CPA Exam from all of us at bisque CPA review. We wish you the best of luck on the test. Study hard.