CPA becker financial exam review part 2 2014

PART-2


Becker Professional Education I CPA Exam Review

IX.

Financial 6

SUMMARY
A.

Method

Asset and liability approach-balance sheet approach.
B.

Differences

Differences between income tax returns and GAAP financial statements fall into two groups:
1.

Permanent

No deferred tax asset or liability is required because the difference
2.

will never reverse.

Temporary

Deferred tax asset or liability must be recorded because the temporary difference

will

reverse.

a.

Deferred Tax Liabil ity

The consequences of temporary differences that will reverse in the future and
create future taxes.
b.

Deferred Tax Asset

The consequences of temporary differences that will reverse in the future and
create future tax benefits.
(1 )

Val uation Allowance

The contra-asset that is to be established to reflect that it is "more likely
than not" that the deferred tax asset will not be completely realized .
C.

Measurement

Use applicable enacted tax rates. This is the tax rate expected to apply to taxable income in
the future periods that the deferred tax asset or liability is expected to be paid or realized.

1.

Tax Rate Changes

Adjusted in the period of a new tax rate (when signed i nto law). The new impact
(increase or decrease) to the deferred tax account will be reflected in "income from
continuing operations" (IDEA).
D.

C lassification

Criteria for current vs. noncurrent:
1.

Balance Sheet Related

Classify according to the related asset or liability causing the temporary difference.
2.

Non-balance Sheet Related

Classify based upon the expected reversal or benefit period .
3.

Netti ng I Offsetting

Current (asset and liability) must be netted.
Noncurrent (asset and liability) from a particular jurisdiction must be netted .

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F6·S1


Financial 6

Becker Professional Education I CPA Exam Review

C O R P O RAT E TAXAT I O N S U M MARY
I Re
TAX RETURN

GAAP
F I NANCIAL STAT E M ENTS
G R OSS I N C O M E .

../

Gross sales

Income

Income

Installment sales

Income

Income when received

../
../

Rents and royalties in advance

Income when earned

Income when received

State tax refund

Income

Income

Dividends
Equity method

Income is subsidiary's earnings

Income is dividends received

100 / 80 / 70% exclusion

No exclusion

Excluded forever

../
../

../

I T E M S NOT I N C L U D I B L E IN "TA X A B L E I N C O M E " .

State and municipal bond interest

Income

Not taxable income

../

Life insurance proceeds

Income

Generally not taxable. income

../

Gain / loss on treasury stock

Not reported

Not reported

../
../

O R D I N A RY E x P E N S E S .

Cost of goods sold

Uniform capitalization rules

Uniform capitalization rules

Officers' compensation Itop)

Expense

$1,000,000 limit

Bad debt

Allowance lestimated)

Direct write-off

../

Estimated liability for contingency (e.g., warranty)

Expense (accrue estimated)

No deduction until paid

../

Interest expense

Business loan

Expense

Deduct

Expense

Not deductible

Contributions

All expensed

Limited to 10% of adj. taxable income

Loss on abandonment / casualty

Expense

Deduct

../
../

Tax-free investment

../

-

../

Loss on worthless subsidiary

Expense

Deduct

Depreciation
MACRS vs. straight line

Slow depreciation

Fast depreciation

../

Section 179 depreciation

Not allowed (must depreciate)

2012 = $125,000

../

Different basis of asset

Use GAAP basis

Use tax basis

Expense

$5,000 maximum / 15 year excess

../

Amortization
Start up / organizational expenses
Franchise

Amortize

Amortize over 15 years

../

Impairment Test

Amortize over 15 years

../

Cost over years

Percentage of sales

../

Not allowed

Percentage of sales

Profit and pension expense

Expense accrued

No deduction until paid

../

Accrued expense (sO% owner I family)

Expense accrued

No deduction until paid

../

State taxes (paid)

Expense

Deduct

Percentage in excess of cost

Meals and entertainment

Expense

../

../

../

Goodwill

Depletion
Percentage vs. straight line (cost)

../

../

../

../
../

Generally 50% deductible

G A A P E x P E N S E I T E M S THAT A R E N OT TAX D E D U CT I O N S :

life insurance expense (corporation)

Expense

Not deductible

../
../

Penalties

Expense

Not deductible

Lobbying / political expense

Expense

No deduction

../

Expense

Not deductible

../

Income

Income

Federal income taxes

SPECIAL ITEMS

Net capital gain

../

Report as loss

Not deductible

../

Carryback / carryover 13 year> back 1 5 years forward)

Not applicable

Unused loss allowed as a STCL

../

Related shareholder

Report as a loss

Not deductible

Net capital loss

../

Net operating loss

Report as a loss

Carryback 2 or carryover 20

../

Research and development

Expense

Expense / Amortize / Capitalize

../

F6-52

../

../

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Financial 6

Becker Professional Education I CPA Exam Review

APPEN DIX

I F RS

vs. u.s. GAAP

Note: U nless specifically noted, I FRS and U.s. GAAP accounting rules are the same. This chart highlights the significant
differences between IFRS and U.s. GAAP covered in this lecture.

ISS U E

IFRS

U .S. GAAP

Defined benefit
pension plans

The defined benefit obligation ( DBO) is the defined
benefit pension plan liability.

The projected benefit obligation (PBO) is the
defined benefit pension plan liability.

Defined benefit
pension plans

Defined benefit cost includes service cost and net
interest on the defined benefit liability (asset).

The components of net periodic pension cost are
SI RAGE-�ervice cost, interest cost, Return on

plan assets, Amortization of prior service cost,
yain/loss amortization, ,fxisting net obligation/
asset amortization.

Defined benefit
pension plans

The components of defined benefit cost are generally The components of net periodic pension cost must
be aggregated and presented as one amount on
reported separately on the income statement; there
is no requirement that these amounts be aggregated the income statement.
and presented as one amount.

Defined benefit
pension plans

Prior service cost is referred to as past service cost.
When a plan is amended, past service cost increases
the DBO and is reported as defined benefit service
cost on the income statement. Under I F RS, past
service cost is not booked to other comprehensive
income.

Prior service cost increases the PBO and other
comprehensive income in the period incurred and
is then a mortized to pension expense over the
plan participant's remaining years of service.

Defined benefit
pension plans

Gains and losses are referred to as remeasurements
of the net defined benefit liability (asset) and
are reported in other comprehensive income.
Remeasurements of the net defined benefit
liability (asset) reported i n OCI a re not reclassified
(amortized) to the income statement in subsequent
periods.

Entities have two choices when accounting for
gains and losses:

The funded status (DBO - fair value of plan assets) of
the pension plan is reported on the balance sheet as
the net defined benefit liability (asset). A liability is
reported if the plan is underfunded (DBO > fair value
of plan assets) and an asset is reported if the plan
is overfunded (DBO < fair value of plan assets). If a
net defined benefit asset is reported, the amount of
the asset cannot exceed the present va lue of future
economic benefits available to the entity in the form
of cash refunds or reductions in future contributions
that result from the overfunding. I FRS do not specify
whether an entity should classify the net defined
benefit liability (asset) as current or noncurrent.

The funded status of an overfunded pension plan
is reported in full as a noncurrent asset. The
funded status of an underfunded pension plan is
reported i n ful l as a current liability, a noncurrent

liability, or both.

Defined benefit
pension plans

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1. Recognize on the income statement in the
period incurred.
2. Recognize in other comprehensive income in
the period incurred and then amortize to
pension expense using the corridor approach.

F6-53


Financial 6

Becker Professional Education I CPA Exam Review

ISSUE

IFRS

Defined benefit
pension plans

Remeasurements of the net defined benefit liability
Unrecognized prior service cost and unrecognized
(asset) are included in other comprehensive income

pension gains and losses are reported in
and are not reclassified (amortized) to the income
accumulated other comprehensive income. The
statement in subsequent periods. However, a n entity pension benefit asset or liability is equal to the
can transfer those amounts recognized in other
funded status of the pension plan.
comprehensive income within equity.

Sick pay benefits

Entities are required to accrue sick pay benefits as
services are rendered by employees.

Employers are not required to accrue nonvesting
accumulating rights to receive sick pay benefits.
Sick pay benefits are accrued only when the four
criteria for liability recognition are met and the
estimate is reliable.

Accounting for

Va luation allowances are not permitted. A
deferred tax asset is recognized when it is
probable that sufficient taxable profit will be
available against which the temporary d ifference
can be utilized.

A valuation allowance is recognized when it is
more l i kely than not that part or all of the deferred
tax asset will not be realized.

Uncertain tax positions are not specifically
addressed. The tax consequences of events should
be accounted for in a manner consistent with the
expected resolution of the tax position with tax
authorities as of the balance sheet date.

Uncertai n tax positions are recognized using a two
step process:

Accounting for
income taxes

Current and deferred taxes are calculated using
enacted or substantively enacted tax rates.

Current and deferred taxes are calculated using
enacted tax rates only.

Accounting for

Adjustments for changes in deferred tax balances
due to changes in tax laws or rates are recognized
on the income statement, except when the
deferred tax balance arises from a transaction or
event that is recognized i n other comprehensive
income. When a deferred tax balance arises from
a transaction or event that is recognized in other
comprehensive income, adjustments should also
be recorded in other comprehensive income.

All adjustments for changes in deferred tax
balances due to cha nges in tax laws or rates are
recognized on the income statement.

Under I FRS, deferred tax assets and deferred tax
liabilities are reported as noncurrent on the balance
sheet. Deferred tax assets and deferred tax liabilities
may be netted if the entity has a legally enforceable
right to offset current tax assets against current tax
liabilities and the deferred tax assets and deferred
tax liabilities relate to income taxes levied by the
same tax authorities.

Deferred tax l iabilities and assets should be
classified and reported as current or noncu rrent
on the balance sheet based on the classification of
the related asset or liability. If there is no related
asset or liability, then the timing of the reversal is
used. All deferred tax assets and liabilities
classified as current must be offset (netted) and
presented as one amount (a net current asset or a
net current l iability). All deferred tax liabilities and
assets classified as noncurrent must be offset
(netted) and presented as one amount (a net
noncurrent asset or a net noncurrent liability).

income taxes

Accounting for

income taxes

income taxes

Accounting for
income taxes

F6·54

U.S. GAAP

1. Recognition of the tax benefit.
2. Measurement of the tax benefit.

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Financial 6

Becker Professional Education I CPA Exam Review

CLASS QU EST I O N S

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CLASS Q U E S T I O N S A N S W E R WORKSHEET

1.

2.
Task-based simulation

3.
4.

5.
6.
7.
8.
9.
10.
11.

12.
13.
14.
G R A DE

Attempt

Multiple-choice Questions

Task-based Simulations

1st

Questions correct

.;. 13 questions

=

%

Questions correct

: 1 questions

=

%

2nd

Questions correct

: 13 questions

=

%

Questions correct

.;. 1 questions

=

%

3rd

Questions correct

.;. 13 questions

=

%

Questions correct

.;. 1 questions =

%

Final

Total questions correct

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.;. 14 questions

=

%

F6-55

Financial 6

Becker Professional Education I CPA Exam Review

NOTES

F6-56

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Becker Professional Education I CPA Exam Review

Financial 6

1 . CPA·00690

The following information pertains to Gali Co.'s defined benefit pension plan for the current year:
Fair value of plan assets, beginning of year
Fair value of plan assets, end of year
Employer contributions
Benefits paid

$350,000
525,000
1 1 0,000
85,000

In computing pension expense, what amount should Gali use as actual return on plan assets?
a.
b.
c.
d.

$65,000
$ 1 50,000
$ 1 75,000
$260,000

2.

CPA·OS398

Big Books, I nc. has the following information related to its defined benefit pension plan:
December 31. Year 1

Projected benefit obligation
Fair value of plan assets
Unrecognized prior service cost
Unrecognized net transition asset

$ 1 , 500,000
1 ,400,000
200,000 .
60,000

December 3 1. Year 2

Projected benefit obligation
Fair value of plan assets
Service cost

$ 1 ,740,000
1 ,670,000
220,000

Assumptions

Discount rate

6%

Expected return on plan assets

8%

Big Books makes an annual pension plan contribution of $200,000. The company's employees had
an average remaining service life of 20 years on December 3 1 , Year 1 . The company paid benefits of
$70,000 in Year 2 and expects to pay benefits totaling $ 1 70,000 to retired employees in Year 3. Big
Books has an effective tax rate of 30%. The actual return on plan assets was 1 0%. What is the funded
status of Big Books' pension plan on December 3 1 , Year 1 ?
a . $70,000 underfunded .
b. $70,000 overfunded.
c. $ 1 00,000 underfunded .
d. $1 00,000 overfunded.

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F6-57


Becker Professional Education I CPA Exam Review

Financial 6

3. TBS-0001 6

O n December 3 1 , Year 1 and Year 2 , Simple Fields Company had the following defined benefit pension
plan balances:
1 213 11Y1

1 213 11Y2

Fair value of plan assets

$ 1 ,900,000

$ 2 , 1 65,000

Projected benefit obligation

$ 2 , 1 25,000

$ 2,352,500

Unrecognized prior service cost

$

$

Unrecognized net gain

$ 250,500

$ 284,700

Unrecognized net transition obligation

$

$

1 75,000
35,000

1 57,500
0

At December 3 1 , Year 1 , the employees participating in the plan had an average remaining service period
of 1 0 years. During Year 2, the company completed the amortization of its unrecognized net transition
obligation, made a contribution of $275,000, and paid benefits of $200,000. The Year 2 service cost was
$300,000. The company uses an expected return on plan assets of 8% when calculating net periodic
pension cost, but had an actual return on Plan A's assets of 1 0% in Year 2. The company's discount rate
is 6%.
Calculate the U.S. GAAP net periodic pension cost for Year 2 . Enter the amounts in the shaded cells in
Column A.
A

1. Service cost
2. Interest cost
3. Return on plan assets (expected)
4. Amortization of prior service cost
5. Gain/loss amortization
6. Existing net transition obligation amortization

4. CPA-00702

Bounty Co. provides postretirement health care benefits to employees who have completed at least
1 0 years service and are aged 55 years or older when retiring. Employees retiring from Bounty have
a median age of 62, and no one has worked beyond age 65. Fletcher is hired at 48 years old. The
attribution period for accruing Bounty's expected postretirement health care benefit obligation to Fletcher
is during the period when Fletcher is aged:
a.
b.
c.
d.

48 to 65.
48 to 58.
55 to 65.
55 to 62.

F6-58

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Financial 6

Becker Professional Education I CPA Exam Review

5. CPA-00703

What information should be disclosed by a company providing health care benefits to its retirees?
I.

II.

The assumed health care cost trend rate used to measure the expected cost of benefits covered by
the plan.
The accumulated postretirement benefit obligation.

a.
b.
c.
d.

I and I I .
I only.
I I only.
Neither I nor I I .

6 . CPA-00701

An employer's obligation for postretirement health benefits that are expected to be provided to or for an
employee must be fully accrued by the date the:
a.
b.

c.
d.

Employee i s fully eligible for benefits.
Employee retires.
Benefits are utilized.
Benefits are paid.

7. C PA-00704

Which of the following is not one of the liability reporting criteria for post-employment benefits?
a. The amount of the obligation can be reasonably estimated.
b. The obligation relates to rights that vest or accumulate.
c. The obligation depends upon whether the individual continues to be available for questions and
assistance after employment ceases.
d. The payment of the compensation is probable.
8. CPA-00925

The following information pertains to Rik Co.'s two employees:
Vacation rights
Weekly

Number of

vest or

Name

salary

weeks worked

accumulate

Ryan
Todd

$800
$600

52
52

Yes
No

Neither Ryan nor Todd took the usual two-week vacation during the current year. In Rik's December 3 1
financial statements, what amount of vacation expense and liability should b e reported?
a.
b.
c.
d.

$2,800
$ 1 ,600
$1 ,400
$0

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F6-59


Financial 6

Becker Professional Education I CPA Exam Review

9. C PA-00782

Zeff Co. prepared the fol lowing reconciliation of its pretax financial statement income to taxable income
for the year ended December 31 , Year 1 , its first year of operations:
Pretax financial income

$ 1 60,000

Nontaxable interest received on municipal securities

(5,000)

Long-term loss accrual in excess of deductible amount

1 0,000

Depreciation in excess of financial statement amount
Taxable income

(25.000)
$1 40,000

Zeffs tax rate for Year 1 is 40%.

In its Year 1 income statement, what amount should Zeff report as income tax expense-current portion?
a.
b.
c.
d.

$52,000
$56,000
$62,000
$64,000

1 0. CPA-00783

Zeff Co. prepared the following reconciliation of its pretax financial statement income to taxable income
for the year ended December 31 , Year 1 , its first year of operations:
Pretax financial income

$ 1 60,000

Nontaxable interest received on municipal securities

(5,000)
1 0,000
(25.000)
$1 40,000

Long-term loss accrual in excess of deductible amount
Depreciation in excess of financial statement amount
Taxable income
Zeffs tax rate for Year 1 is 40%.

In its December 3 1 , Year 1 , balance sheet, what should Zeff report as deferred i ncome tax liability?
a.
b.
c.
d.

$2,000
$4,000
$6, 000
$8,000

1 1 . CPA-00785

As a result of differences between depreciation for financial reporting purposes and tax purposes, the
financial reporting basis of Noor Co.'s sole depreciable asset, acquired in Year 1 , exceeded its tax basis
by $250,000 at December 3 1 , Year 1 . This difference will reverse in future years. The enacted tax rate is
30% for Year 1 , and 40% for future years. Noor has no other temporary differences. In its December 3 1 ,
Year 1 , balance sheet, how should Noor report the deferred tax effect of this difference?
a. As an asset of $75,000.
b. As an asset of $1 00,000.
c. As a liability of $75,000.
d . As a l iability of $1 00,000.

F6·60

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Financial 6

Becker Professional Education I CPA Exam Review

1 2. CPA-00781

On its December 31 , Year 2, balance sheet, Shin Co. had income taxes payable of $ 1 3,000 and a current
deferred tax asset of $20,000 before determining the need for a valuation account. Shin had reported a
current deferred tax asset of $ 1 5,000 at December 31 , Year 1 . No estimated tax payments were made
duri ng Year 2. At December 31 , Year 2, Shin determined that it was more likely than not that 1 0% of the
deferred tax asset would not be realized. In its Year 2 income statement, what amount should Shin report
as total income tax expense?
a.
b.
c.
d.

$8,000
$8,500
$ 1 0,000
$ 1 3,000

1 3. CPA-00791

Thorn Co. applies Statement of Financial Accounting Standards No. 1 09, Accounting for Income Taxes.
At the end of Year 1 , the tax effects of temporary differences were as follows:
Deferred
tax assets
{/jabilitiesJ
Accelerated tax depreciation
Additional costs in inventory for tax purposes

($75,000)
25,000
($50,000)

Related asset
classification
Noncurrent asset
Current asset

A valuation allowance was not considered necessary. Thorn anticipates that $ 1 0,000 of the deferred tax
liability will reverse in Year 2. In Thorn's December 3 1 , Year 1 , balance sheet, what amount should Thorn
report as noncurrent deferred tax liability under U.S. GAAP?
a.
b.
c.
d.

$40,000
$50,000
$65,000
$75,000

1 4. CPA-00789

Mobe Co. reported the following operating income (loss) for its first three years of operations:
Year 1
Year 2
Year 3

$ 300,000
(700,000)
1 ,200,000

For each year, there were no deferred income taxes (before Year 1 ), and Mobe's effective income tax rate
was 30%. In its Year 2 income tax return, Mobe elected the two year carryback of the loss. In its Year 3
income statement, what amount should Mobe report as total income tax expense?
a.
b.
c.
d.

$ 1 20,000
$ 1 50,000
$240,000
$360,000

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F6-61


Financial 6

NOTES

F6-62

Cl OeVry/Becker Educational Development Corp. All rights reserved.

FINANCIAL 7
Stockholders' Equity, Cash Flows, and Ratio Analysis

1.

Stockholders' equity

2. Earnings per share

.

.

................ ........................................................................................................ .........................................

. .

. .

.

..

. .

3

. . . . 23

.................. .. .... ... ...... .................................................................................. . .... ............ ... .......... ... . . .

3. Statement of cash flows............................................................................................................................................................ 32
.

4.

Appendix I : Ratio analysis

5.

Appendix II: I FRS vs. U.S. GAAP

6.

Class questions

.

.

.

..

. .

.

.

.... ................. ....... ....................................................................................... .. ......... ...... ..............

.

.

44

.............. ....... . .................... .......... ..................................................... ..................................

51

.........................................................................................................................................................................

53

.


Becker Professional Education I CPA Exam Review

Financial 7

NOTES

F7-2

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Becker Professional Education I CPA Exam Review

Financial 7

STOCKHOLDERS' EQUITY
I.

OVERVIEW

Stockholders' equity (also called shareholders' equity or owners' equity) is the owners' claim
to the net assets (i.e., assets minus liabilities) of a corporation. It is generally presented on
the statement of financial position (balance sheet) as the last major section (following liabilities).
The various elements constituting stockholders' equity must be clearly classified according to
source. The stockholders' equity section of the balance sheet contains five major components: (1 )
capital stock (also called legal capital); (2) additional paid-in capital; (3) retained earnings or deficit;
(4) accumulated other comprehensive income; and (5) treasury stock, which is accounted for
differently, depending upon the method used by the company (detailed discussion follows). When
an entity presents consolidated financial statements, any noncontrolling interest must be shown in
equity.
EXAMPLE

Capital Corp.

Consolidated Shareholders' Equity-December 31, Year 1
CAPITAL STOCK (capital equal to par or stated value)
Preferred stock, non-cumulative, $100 par value, authorized 1,000 shares,

$

50,000

issued and outstanding 500 shares
Common stock, $10 par value, authorized 50,000 shares, issued 30,000
shares of which 5,000 are held in the treasury

300,000
350,000

ADDITIONAL PAID-IN CAPITAL (capital in excess of par or stated value)
Excess of issue price over par value of common/preferred stock sold

$ 29,000

Excess of sales price over cost of treasury shares sold

15,000

Excess of FMV over par of stock issued as stock dividend

20,000

Defaulted stock subscriptions

10,000

FMV of common shares contributed by shareholders to corporation

75,000

FMV of fixed assets contributed by local government

60,000

209,000

RETAINED EARNINGS
Appropriated (reserved) for general contingencies

50,000

Appropriated (reserved) for possible future i nventory decline

20,000

Appropriated (reserved) for plant expansion

40,000

Appropriated (reserved) for higher replacement cost of fixed assets
Unappropriated (unreserved)

60,000
200,000

370,000
929,000

Accumulated other comprehensive income

10,000

Less: Cost of shares in treasury

(85,OOO)

Total Capital Corp. shareholders' equity

854,000

Noncontrolling interest
Total equity

25,000

� 879,000

Note: The preceding example assumes that treasury stock is reported under the cost method. (If the par value method is
used to account for treasury stock, then treasury stock must be reported as a deduction from the same class of stock.) A
detailed discussion of the methods to account for treasury stock is presented in this module.

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Devry/Becker Educational Development Corp. All rights reserved.

F7-3


Becker Professional Education I CPA Exam Review

Financial 7

II.

CAPITAL STOCK (legal capital)
Legal capital is the amount of capital that must be retained by the corporation for the protection of
creditors. The par or stated value of both preferred and common stock is legal capital and is
frequently referred to as "capital" stock.

A.

Par Val ue

Generally, preferred stock is issued with a par value, but common stock may be issued with
or without a par value. No-par common stock may be issued as true no-par stock or no-par
stock with a stated value. Any excess of the actual amount received over the par or stated
value of the stock is accounted for as additional paid-in capital.
B.

Authorized, Issued, and Outstanding

A corporation's charter contains the amounts of each class of stock that it may legally issue,
and this is called "authorized" capital stock. When part or all of the authorized capital stock is
issued , it is called "issued" capital stock. Because a corporation may own issued capital
stock in the form of treasury stock, the amount of issued capital stock in the hands of
shareholders is called "outstanding" capital stock. In summary, capital stock may be (1 )
authorized , (2) authorized and issued, or (3) authorized, issued, and outstanding. The
number of shares of each class of stock authorized , issued, and outstanding must be
disclosed.
C.

Common Stock
Common stock is the basic ownership interest in a corporation. Common shareholders bear

the ultimate risk of loss and receive the ultimate benefits of success, but they are not
guaranteed dividends or assets upon dissolution. Common shareholders generally control
management. They have the right to vote, the right to share in earnings of the corporation,
and the right to share in assets upon liquidation after satisfaction of creditors' claims and
those of preferred shareholders.

Common shareholders may have preemptive rights to a proportionate share of any additional common stock issued if
granted in the articles of incorporation.

1.

Book Value per Common Share

Book value per common share measures the amount that common shareholders would
receive for each share if all assets were sold at their book (carrying ) values and all
creditors were paid. Book value per common share can be determined as follows:
Book value per common share

2.

Common shareholders' equity
=

Common shares outstanding

Common Stockholders' Equity Formula

Total shareholders' equity
- Preferred stock outstanding (at greater of cal l price or par value)
- Cumulative preferred dividends in arrears
=

F7-4

Common shareholders' equity

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Becker Professional Education I CPA Exam Review

D.

Financial 7

Preferred Stock
Preferred stock is an equity security with preferences and features not associated with

common stock. Preferred stock may include a preference relating to dividends, which may
be cumulative or non-cumulative and participating or nonparticipating. Preferred stock may
also include a preference relating to liquidation. Usually, preferred stock does not have
voting rights.
1.

Cumulative Preferred Stock

The cumulative feature provides that all or part of the preferred dividend not paid in any

year accumulates and must be paid in the future before dividends can be paid to
common shareholders. The accumulated amount is referred to as dividends in arrears.
The amount of dividends in arrears is not a legal liability, but it must be disclosed in
total and on a per share basis either parenthetically on the balance sheet or in the
footnotes.
2.

Non-Cumulative Preferred Stock

With non-cumulative preferred stock, dividends not paid in any year do not accumulate.
The preferred shareholders lose the right to receive dividends that are not declared.
3.

Participating Preferred Stock

The participating feature provides that preferred shareholders share (participate) with
common shareholders in dividends in excess of a specific amount. The participation
may be full or partial . Fully participating means that preferred shareholders participate
in excess dividends without limit. Generally, preferred shareholders receive their
preference dividend first, and then additional dividends are shared between common
and preferred shareholders. Partially participating means preferred shareholders
participate in excess dividends, but to a limited extent (e. g . , a percentage limit).
4.

Non·Participating Preferred Stock

When preferred stock is non-participating, preferred shareholders are limited to the
dividends provided by their preference. They do not share in excess dividends.
5.

Preference upon Liquidation
Preferred stock may include a preference to assets upon liquidation of the entity. If the

liquidation preference is significantly greater than the par or stated value, the liquidation
preference must be disclosed . The disclosure of the liquidation preference must be in
the equity section of the balance sheet, not in the notes to the financial statements.
6.

Convertible Preferred Stock
Convertible preferred stock may be exchanged for common stock (at the option of the
stockholder) at a specified conversion rate.

7.

Callable ( Redeemable) Preferred Stock
Callable preferred stock may be called (repurchased) at a specified price (at the option
of the issuing corporation). The aggregate or the per share amount at which the
preferred stock is callable must be disclosed either on the balance sheet or in the
footnotes.

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F7-S


Becker Professional Education I CPA Exam Review

Financial 7

8.

Mandatorily Redeemable Preferred Stock (Liability)
Mandatorily redeemable preferred stock is issued with a maturity date. Similar to debt,

mandatorily redeemable preferred stock must be bought back by the company on the
maturity date. Mandatorily redeemable preferred stock must be classified as a liability,
unless the redemption is required to occur only upon the liquidation or termination of
the reporting entity.
E X A M P L E - DI S T R I B U TIO N O F D IVID E N D S T O P A R T I C I P A T I N G P R E F E R R E D S T O CK H O L D E R S

On January 1, Year 1, Samuel Co. issued 100,000 shares of $5 par common stock and 25,000 shares of $10 par fully
participating 8% cumulative preferred stock. No dividends were paid i n Year 1. Cash d ividends of $101,000 were
decla red and paid in Yea r 2.
Schedule 1: Dividends Remaining for Distribution
Cash dividends

$ 101,000

Year 1 preferred d ividends in arrears [(25,000 x $10) x .08)

(20,000)

Preferred dividends accumulated in Year 2

(20,000)
61,000

Common stock [( 100,000 x $5) x .08) *

(40,000)

Remaining for proration between
preferred and common stock

$ 21,000

Schedule 2: Proration of Remaining Dividends According to Par Values
Preferred stock
250,000

x

$21,000

$7,000

x

$21,000

$ 14,000

750,000
Common stock
500,000
750,000

Schedule 3: Total Dividends Paid on Preferred and Common Stock
Preferred stock

$7,000 + $20,000 + $20,000 =

Common stock

$ 14,000 + $40,000

Total cash dividends distributed

=

$ 47,000
54,000
$ 101,000

*The principle applied here is that, with participating cumulative preferred stock, before any proration of dividends may
exist, the common shareholders must receive an equal dividend as the preferred shareholders. In this case, preferred
shareholders receive an 8% dividend first; common shareholders receive an 8% dividend second; and the balance
($21,000) is shared pro rata.

III.

ADDITIONAL PAID-IN CAPITAL

Additional paid-in capital is generally contributed capital in excess of par or stated
value. It can also arise from many other different types of transactions. Examples include the sale
of treasury stock at a gain, quasi-reorganization, the issuance of liquidating d ividends, conversion
of bonds, and the declaration of a small stock dividend. Additional paid-in capital from these
sources may be aggregated and shown as one amount on the balance sheet.

F7-6

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Becker Professional Education I CPA Exam Review

IV.

Financial 7

RETAINED EARN INGS
Retained earnings (or deficit) is accumulated earnings (or losses) during the life of the corporation

that have not been paid out as dividends. The amount of accumulated retained earnings is
reduced by distributions to stockholders and transfers to additional paid-in capital for stock
dividends. Retained earnings does not include treasury stock or accumulated other comprehensive
income. If the retained earnings account has a negative balance, it is called a deficit.
A.

Formula
Net income/loss
Dividends (cash, property, and stock) declared
±

Prior period adjustments

±

Accounting changes reported retrospectively

+

Adjustment from quasi-reorganization
Retained Earnings

B.

Classification of Retained Earni n gs (appropriations)

Retained earnings may be classified as either appropriated or unappropriated. The purpose
of appropriating retained earnings is to disclose to the shareholders (usually the common
shareholders) that some of the retained earnings are not available to pay dividends because
they have been restricted for legal or contractual reasons (e.g. , a bond indenture) or as a
discretionary act of management for specific contingency purposes (e.g., plant expansion).
An appropriation of retained earnings may not be used to absorb costs or losses and may not
be transferred to income.
The following entry should be recorded when an appropriation is to be made (and should be
reversed when the purpose of the appropriation has occurred):
11m
t.WB

C.

Retained earnings (unappropriated)
Retained earnings appropriated for [purpose)

Quasi-Reorganization

A quasi-reorganization (or corporate readjustment) is an accounting adjustment (not a legal
reorganization) that revises the capital structure of a corporation as though it had been

legally reorganized. It allows a corporation with a significant deficit in retained earnings to
eliminate that deficit and have a "fresh start." A quasi-reorganization requires formal approval
by the shareholders.
1.

Purposes

The purposes of a quasi-reorganization are to restate overvalued assets to their lower
fair values (and thus reduce future depreciation) and to eliminate a retained earnings
deficit (and thus facilitate the declaration of dividends).

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F7-7


Becker Professional Education I CPA Exam Review

Financial 7

2.

Procedures

a.

Revalue assets to current fair values and liabilities to their present values. (No
net increase in asset value is permitted, and the write-down is charged directly to
retained earnings, thus increasing the deficit temporarily.)

b.

Bring retained earnings to zero (i.e., eliminate the deficit) against additional paid­
in capital. (If additional paid-in capital is insufficient to absorb the deficit, more
additional paid-in capital can be created by reducing the par or stated value of
the stock, thus reducing capital stock.)

c.

Following a quasi-reorganization, retained earnings on the balance sheet must
be dated to show the date of the adjustment, and that date must continue to be
disclosed until such time as it is insignificant (usually 3-1 0 years).
E X A M P L E - A CCO U N TI N G FO R Q U A S I- R E O RGA N IZ A T I O N S

On December 31, Year 4, the stockholders' equity section of Duffy Co.'s balance sheet consisted of the
following:
Common stock, $30 par, 10,000
shares authorized and outstanding

$300,000
150,000

Additional paid-in capital
Retained earnings (deficit)

(210,000)

Total Equity

$240,000

On January 2, Year 5, Duffy put into effect a stockholder-approved quasi-reorganization by reducing the par
value of the stock to $5 and eliminating the deficit against additional paid-in capital.

Journal Entry: To eliminate the deficit in retained earnings
11m

Common stock

(W8

Retained Earnings

(W8

Additional paid-in capital

$250,000
$210,000
40,000

After the quasi·reorganization the stockholders' equity section of Duffy's Co. 's balance sheet consisted of:
Common stock, $5 par, 10,000
shares authorized and outstanding
Additional paid-in capital
Retained earnings
Total Equity

F7·g

$ 50,000
190,000
o

$ 240,000

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Becker Professional Education I CPA Exam Review

V.

Financial 7

ACCUM ULATED OTHER COMPREHENSIVE INCOME

Components of accumulated other comprehensive income include pension adjustments, unrealized
gains and losses on available-for-sale securities, foreign currency translation adjustments,
deferred gains and losses on the effective portion of cash flow hedges, and revaluation
surpluses (I FRS only).
These components of other comprehensive income are not included in determining net income and,
therefore, do not enter into retained earnings. Rather, they are recognized in the period in which
they occur and are combined with net income to determine comprehensive income. Total
accumulated other comprehensive income must be shown in the shareholders' equity section
separate from capital stock, additional paid-in capital, and retained earnings.

VI.

TREASURY STOCK

Treasury stock is a corporation's own stock that has been issued to shareholders and subsequently
reacquired (but not retired). Treasury stockholders are not entitled to any of the rights of
ownership given to common shareholders, such as the right to vote or to receive dividends. In
addition, a portion of retained earnings equal to the cost of treasury stock may be restricted
and may not be used as a basis for the declaration or payment of dividends (depending on
applicable state law).
A.

Methods of Accountin g for Treasury Stock

Two methods of accounting for treasury stock are permitted: (1 ) the cost method and (2) the
legal (or par/stated value) method. The primary difference between the two methods is the
timing of the recognition of "gain or loss" on treasury stock transactions. Note that under both
methods, the "gains and losses" are recorded as a direct adjustment to stockholders' equity
and are not included in the determination of net income. Also, under both methods, shares
held as treasury stock are not considered to be outstanding shares.
1.

Cost Method (used by entities approximately 95% of the time)

Under the cost method , the treasury shares are recorded and carried at their
reacquisition cost. A gain or loss will be determined when treasury stock is reissued or
retired , and the original issue price and book value of the stock do not enter into the
accounting. The account "additional paid-in capital from treasury stock" is credited for
gains and debited for losses when treasury stock is reissued at prices that differ from
the reacquisition cost. Losses may also decrease retained earnings if the additional
paid-in capital from treasury stock account does not have a balance large enough to
absorb the loss. Net income or retained earnings will never be increased through
treasury stock transactions.

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F7-9


Becker Professional Education I CPA Exam Review

Financial 7

E X A M P L E - CO S T M E THO D

Original Issue
10,000 shares $10 par value common stock sold for $15 per share.
Cash

$ 150,000
Common stock (10,000 x $10 par)

$ 100,000

Additional paid-in capital-CIS

50,000

Buy Back Above Issue Price
200 shares were repurchased for $20 per share.
Treasury stock (200 x $20)

4,000

Cash

4,000

Reissue Above Cost
100 shares repurchased for $20 were resold for $22.
Cash (100 x $22)

2,200

Treasury stock ( 100 x $20)

2,000

Additional paid-in capital-TIS

200

The following journal entry was made after the preceding entry:
Reissue Below Cost
100 shares repurchased for $20 were resold for $13.
Cash (100

x

$13)

1,300

Additional paid-in capital-TIS

200

Retained earnings

500

Treasury stock (100 x $20)

2.

$2,000

Legal (or Par/Stated Value) Method (used by entities approximately 5%
of the time)

Under the legal method , the treasury shares are recorded by reducing the amounts of
par (or stated) value and additional paid-in capital received at the time of the original
sale. Treasury stock is debited for its par (or stated) value. APIC-Common Stock is
debited (reduced) for the pro rata share of the original issue price attributable to the
reacquired shares. Additional paid-in capital from treasury stock is credited for gains and
debited for losses when treasury stock is repurchased at prices that differ from the
original selling price. Losses may also decrease retained earnings if the "additional
paid-in capital from treasury stock" account does not have a balance large enough to
absorb the loss. Note that, under this method, the sources of capital associated with the
original issue are maintained.

F7-10

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Becker Professional Education I CPA Exam Review

Financial 7

E X A M P L E - P A R VA L U E M E T H O D

Original Issue
10,000 shares of $10 par val ue common stock sold for $15 per share.
$ 150,000

Cash

$ 100,000

Common stock (10,000 x $10 par)

50,000

Additional paid-in capital-CIS
Buy Back above Issue Price
200 shares repurchased for $20 per share.
$2,000

Treasury stock (200 x $10 par)
Additional paid-in capital-CIS

1,000

Retained earni ngs'

1,000
$4,000

Cash

'This entry should be made to retained earnings if there is no balance in the additional paid-in capital-TIS account.
Buy Back below Issue Price
200 shares repurchased for $12 per share.
$2,000

Treasury stock (200 x $10 par)

1,000

Additional paid-in capital-CIS (200 x $5)

$2,400

Cash (200 x $12)

600

Additional paid-in capital-TIS
Reissue Shares
100 shares repurchased for $20 were resold for $22.
$2,200

Cash ( 100 x $22)
Treasury stock (100 x $10 par)

$1,000

Additional paid-in capital-CIS

1,200

Reissue Shares
100 shares repurchased for $20 were resold for $13.
$1,300

Cash (100 x $13)
Treasury stock (100 x $10 par)

$1,000

Additional paid-in capital-CIS

300

E X A M P L E - E FFE C T O F C O S T A N D P A R VA L U E M E T H O D S O N B A L A N C E S H E E T P R E S E N TA T I O N

The equity sections of the cost balance sheet and par value balance sheet would appear as fol lows, assuming the treasury
shares were repurchased for $20 per share:
Par Value Method

Cost Method

$100,000

$ 100,000

Common stock (par value)

50,000

Less: Treasury stock at par

{2,0001

Total paid-in capital

150,000

Common stock ols at par

98,000

Retained earnings

75,000

Additional paid-in capital

49,000

Common stock (par value)
Additional paid-in capital

147,000

225,000
Less: Treasury stock at cost
Total stockholders' equity

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{4,0001
$221,000

Retained earnings
Total stockholders' equity

74,000
$221,000

F7-11


Becker Professional Education I CPA Exam Review

Financial 7

B.

Retirement of Treasury Stock

When treasury stock is acquired with the intent of retiring the stock (regardless of whether it is

accomplished) and the price paid is in excess of the par or stated value, that excess may
be charged against either (1 ) all paid-in capital arising from past transactions in the same
class of stock or (2) retained earnings. When the price paid for the acquired treasury stock is
less than par or stated value, the difference must be credited to paid-in capital.
The retirement of treasury stock would be accomplished with the following journal entries
under the cost method and the par value method:
E X A MPLE

I f a l l 200 treasury shares reacquired for $20 were retired rather than reissued, the following entry would b e made:
Retirement of Shares (Cost Method)
200 shares of $10 par common stock origina l ly sold for $15 and reacquired for $20 are retired.
Common stock (200 x $10)

$2,000

Additional paid-in capital-CIS (200 x $5)

1,000

Retained earnings

1,000

Treasury stock (200 x $20)

$4,000

To retire treasury stock under the par value method, debit common stock at par and credit treasury stock at par.
Retirement of Shares (Par Value Method)
Common stock (200 x $10 par)

$2,000

Treasury stock (200 x $10 par)

c.

$2,000

Donated Stock

Donated stock is a company's own stock received as a donation from a shareholder. There
is no change in total shareholders' equity as a result of the donation, but the number of
shares outstanding decreases, resulting in higher book value per common share. The
company should record donated stock at fair market value, as follows:
Donated treasury stock (@FMV)

$XXX
$XXX

Additional paid-in capital (@FMV)

If the donated stock is sold, the journal entry would be:
Cash (@ sales price)
Additional paid-in capital (if SP < Original FMV)
Additional paid-in capital (if SP > Original FMV)
Donated treasury stock (@ book value, or Original FMV)

F7-12

$XXX
xxx

$XXX
XXX

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