CPA Exam — Financial Accounting and Reporting (FAR) — All Questions

Mace Corp. reports pretax financial income of $500,000. Tax depreciation exceeds book depreciation by $60,000 (a temporary difference arising this year), and $10,000 of nondeductible fines are included in pretax income. The enacted tax rate is 21% for all years, and there were no other differences. What is total income tax expense?

• a.$105,000
• b.$81,900
• c.$94,500
• d.$107,100✓

Taxable income is $500,000 - $60,000 + $10,000 = $450,000, so current tax is $94,500. The depreciation difference creates a deferred tax liability of $60,000 x 21% = $12,600 (ASC 740-10-30-2). Total expense is $107,100, which also equals ($500,000 + $10,000) x 21% because permanent differences never reverse. $94,500 is the current portion alone, $105,000 ignores the nondeductible fines, and $81,900 subtracts the deferred portion.

At December 31, Year 1, equipment has a book carrying amount of $380,000 and a tax basis of $300,000. The current tax rate is 21%, but legislation already enacted sets a 25% rate for the years in which this difference will reverse. What deferred tax liability should be reported?

• a.$95,000
• b.$80,000
• c.$20,000✓
• d.$16,800

Deferred taxes are measured using the enacted rate expected to apply when the temporary difference reverses (ASC 740-10-30-8): ($380,000 - $300,000) x 25% = $20,000. $16,800 uses the current rate, $80,000 is the temporary difference before tax effect, and $95,000 applies the rate to the full book carrying amount.

Nell Co. has a $40,000 allowance for credit losses on its books; for tax purposes it deducts bad debts only when they are written off. The enacted rate is 21%. How should the resulting deferred tax item be reported in a classified balance sheet?

• a.An $8,400 deferred tax liability, classified as noncurrent
• b.An $8,400 deferred tax asset, classified as noncurrent✓
• c.A $40,000 deferred tax asset, classified as noncurrent
• d.An $8,400 deferred tax asset, classified as current

The allowance creates a deductible temporary difference, giving a deferred tax asset of $40,000 x 21% = $8,400 (ASC 740-10-25-20). Since ASU 2015-17, all deferred tax assets and liabilities are classified as noncurrent in a classified balance sheet (ASC 740-10-45-4); current classification is the superseded rule. It is an asset, not a liability, and $40,000 is the difference itself rather than its tax effect.

Under ASC 740, when must an entity reduce a deferred tax asset with a valuation allowance?

• a.When current-year taxable income is less than the deferred tax asset
• b.When it is more likely than not that some portion will not be realized✓
• c.When it is probable that some portion of the asset will not be realized
• d.When it is reasonably possible that the asset will not be realized

ASC 740-10-30-5(e) requires a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that some portion or all of the deferred tax asset will not be realized. 'Probable' is the higher ASC 450 threshold, 'reasonably possible' is lower, and one year's taxable income is only one piece of the evidence.

Opus Co. takes a tax position that it concludes is more likely than not to be sustained on examination. It estimates the possible settlement outcomes (tax benefit, probability) as: $100,000, 30%; $80,000, 25%; $60,000, 25%; $40,000, 20%. What tax benefit should Opus recognize?

• a.$73,000
• b.$100,000
• c.$80,000✓
• d.$60,000

A position that meets the more-likely-than-not threshold is measured at the largest amount of benefit that is greater than 50% likely to be realized on settlement (ASC 740-10-30-7). Cumulative probabilities are 30% at $100,000 and 55% at $80,000, so $80,000 is recognized. $100,000 is only 30% likely, $60,000 is not the largest amount above 50%, and $73,000 is the probability-weighted expected value, which ASC 740 does not use.

Pace Co. owns an interest rate swap that is not traded on an exchange. It measures fair value with a model whose significant inputs are observable market interest rate yield curves. In which level of the fair value hierarchy does the measurement fall?

• a.Level 1
• b.Outside the hierarchy
• c.Level 2✓
• d.Level 3

Level 2 inputs are inputs other than quoted prices in active markets for identical assets that are observable, directly or indirectly, including interest rates and yield curves observable at commonly quoted intervals (ASC 820-10-35-48). Level 1 requires quoted prices for identical assets in active markets, and Level 3 applies when significant inputs are unobservable. Every fair value measurement is categorized within the hierarchy.

An asset is traded in two markets. In Market A, its principal market, the price is $26, transaction costs are $3, and transport costs to that market are $1. In Market B, the price is $27, transaction costs are $5, and transport costs are $1. What is the asset's fair value?

• a.$26
• b.$22
• c.$21
• d.$25✓

Fair value is measured using the price in the principal market (ASC 820-10-35-5). The price is not adjusted for transaction costs, which are specific to a transaction rather than a characteristic of the asset, but it is adjusted for the costs to transport the asset to that market (ASC 820-10-35-9B and 35-9C): $26 - $1 = $25. $22 deducts transaction costs, $26 omits transport, and $21 is Market B's net amount, relevant only if there were no principal market.

Rye Co. acquires land that it uses for a factory; in that use the land is worth $5 million. Market participants would convert it to residential use, which zoning permits and is physically possible and financially feasible, making the land worth $7 million after conversion costs. At what amount is the land measured at fair value?

• a.$7 million✓
• b.$6 million
• c.$12 million
• d.$5 million

Fair value of a nonfinancial asset reflects its highest and best use by market participants, meaning a use that is physically possible, legally permissible and financially feasible, even if the entity uses it differently (ASC 820-10-35-10A to 35-10E). That use is residential, so fair value is $7 million. $5 million reflects the entity's own current use, $6 million averages two uses, and $12 million adds values that cannot both be realized.

To measure the fair value of a specialized machine, an appraiser uses the amount that would currently be required to replace its service capacity. Which valuation approach is this?

• a.Market approach
• b.Income approach
• c.Cost approach✓
• d.Residual approach

ASC 820-10-35-24A and 55-3D describe the cost approach as reflecting the amount that would be required currently to replace the service capacity of an asset, often called current replacement cost. The market approach uses prices from market transactions for identical or comparable assets, the income approach converts future amounts such as cash flows to a single discounted amount, and a residual approach is not one of the three ASC 820 approaches.

Which single fact, on its own, requires a lessee to classify a lease as a finance lease?

• a.The lessee must pay the asset's maintenance, insurance, and property taxes
• b.The lease requires each annual payment at the beginning of the year
• c.The lease has a purchase option the lessee is not reasonably certain to exercise
• d.The lease term covers the major part of the asset's remaining economic life✓

ASC 842-10-25-2 lists five criteria, any one of which makes the lease a finance lease: transfer of ownership, a purchase option the lessee is reasonably certain to exercise, a lease term for the major part of the remaining economic life, present value of payments amounting to substantially all of fair value, or an asset so specialized it has no alternative use to the lessor. Paying executory costs and paying in advance are not criteria, and a purchase option counts only if exercise is reasonably certain.

On January 1, Year 1, Sage Co. leases equipment for five years with payments of $50,000 due each December 31. The rate implicit in the lease is 6% and is known to Sage; there are no initial direct costs, incentives, or prepaid rent. What lease liability should Sage recognize at commencement?

• a.$210,618✓
• b.$173,255
• c.$223,255
• d.$250,000

The lease liability is the present value of the lease payments not yet paid, discounted at the rate implicit in the lease if readily determinable (ASC 842-20-30-1 and 30-3): $50,000 x 4.21236 (ordinary annuity, 5 periods, 6%) = $210,618. $250,000 is undiscounted, $223,255 treats the payments as an annuity due (payments at the beginning of each year), and $173,255 discounts only four payments.

Sage Co.'s five-year lease has a commencement lease liability and right-of-use asset of $210,618, a 6% discount rate, and $50,000 payments each December 31. The lease is a finance lease, and the asset's useful life is five years. What total lease expense should Sage recognize in Year 1?

• a.$42,124
• b.$54,761✓
• c.$50,000
• d.$62,637

A finance lease produces interest on the liability plus amortization of the right-of-use asset (ASC 842-20-25-5): interest $210,618 x 6% = $12,637, and straight-line amortization $210,618 / 5 = $42,124, for a total of $54,761. $50,000 is the single straight-line cost of an operating lease, $42,124 is amortization alone, and $62,637 adds interest to the cash payment.

Tate Co. signs a five-year operating lease with payments of $50,000 each December 31. The commencement lease liability is $210,618 at a 6% discount rate. What lease cost should Tate recognize for Year 1, and what is the lease liability at December 31, Year 1?

• a.$12,637 cost; $173,255 liability
• b.$50,000 cost; $173,255 liability✓
• c.$50,000 cost; $160,618 liability
• d.$54,761 cost; $173,255 liability

For an operating lease, a single lease cost is recognized on a straight-line basis over the lease term, here $50,000 a year (ASC 842-20-25-6). The liability is still measured at the present value of the remaining payments: $210,618 + $12,637 accretion - $50,000 = $173,255 (ASC 842-20-35-3). $54,761 is the front-loaded finance lease expense, $160,618 reduces the liability by the full payment without accretion, and $12,637 is the accretion component alone.

A lessee guarantees that the leased asset will be worth $20,000 at the end of the lease. At commencement, the lessee expects the asset to be worth $15,000 then. What amount related to the guarantee is included in the lessee's lease payments when measuring the lease liability?

• a.$5,000✓
• b.$15,000
• c.$20,000
• d.$0

For a lessee, lease payments include amounts probable of being owed under residual value guarantees (ASC 842-10-30-5(f)). With a $20,000 guarantee and an expected value of $15,000, the lessee expects to owe $5,000. The full $20,000 guarantee and the $15,000 expected value are not amounts owed, and $0 ignores an expected shortfall.

Una Co. leases a retail store for $10,000 a month plus 2% of the store's monthly sales. How are the two components treated in measuring the lease liability?

• a.Neither component is included, because part of the rent is variable
• b.Both components are included, using the forecast of store sales
• c.Only the 2% rent is included, because it reflects the store's use
• d.Only the fixed $10,000 is included; the 2% is expensed as incurred✓

Lease payments include fixed payments and variable payments that depend on an index or rate (ASC 842-10-30-5). Variable payments based on performance or usage, such as a percentage of sales, are excluded from the liability and recognized in the period incurred (ASC 842-20-25-5 and 25-6). Including forecast sales, excluding the fixed rent, or including only the variable part misapplies that split.

Vico Co.'s year ended December 31, Year 1; its financial statements were issued March 1, Year 2. At year-end Vico had accrued $100,000 for a lawsuit filed in Year 1. On February 10, Year 2, the suit settled for $150,000. How should Vico reflect the settlement?

• a.Record the $50,000 difference in Year 2 net income
• b.Disclose the additional $50,000 only in the notes
• c.Increase the year-end accrued liability to $150,000✓
• d.Take no action, because the settlement came after year-end

A settlement after the balance sheet date of litigation whose underlying event occurred before that date provides additional evidence about conditions existing at the balance sheet date, so it is a recognized subsequent event and the estimate is adjusted (ASC 855-10-25-1 and 55-1). Disclosure alone applies to nonrecognized events, deferring the difference to Year 2 misstates Year 1, and ignoring it overlooks recognized subsequent events.

Wolf Co.'s fiscal year ended December 31, Year 1. On February 5, Year 2, before its statements were issued, a fire destroyed one of its warehouses, causing a material loss. How should Wolf report the fire in its Year 1 financial statements?

• a.Disclose the fire and an estimate of its effect; adjust nothing✓
• b.Neither recognize nor disclose it, because it happened after year-end
• c.Record a Year 1 contingent liability equal to the estimated loss
• d.Recognize the loss in Year 1 because it occurred before issuance

Events that provide evidence about conditions that did not exist at the balance sheet date, such as losses from a fire after year-end, are nonrecognized subsequent events (ASC 855-10-25-3 and 55-2). If material, the nature of the event and an estimate of its financial effect (or a statement that one cannot be made) are disclosed (ASC 855-10-50-2). Recognizing the loss or a liability in Year 1 misdates it, and omitting it could make the statements misleading.

Through what date must an entity that is neither an SEC filer nor a conduit bond obligor evaluate subsequent events?

• a.The balance sheet date plus a fixed period of 90 days
• b.The date the financial statements are available to be issued✓
• c.The date the entity files its annual income tax return
• d.The date the financial statements are actually issued

ASC 855-10-25-1A requires SEC filers and conduit bond obligors to evaluate subsequent events through the date the financial statements are issued; all other entities evaluate through the date they are available to be issued (ASC 855-10-25-2) and disclose that date (ASC 855-10-50-1). No fixed 90-day window exists, and the tax return date is unrelated.