Many asset accounts are frequently tested for on the financial accounting and reporting (FAR) test of the CPA exam. The balance sheet formula is Assets – Liabilities = Equity.
Prepaid assets
The term prepaid assets refers to an account created when a company pays in advance for a product or service. This topic is very common on the FAR test. The two most common prepaid accounts are prepaid rent and prepaid insurance.
Bad debt and accounts receivable
In addition to cash, accounts receivable is considered a current asset balance. Current assets are assets that are in cash, or that will be converted to cash, within 12 months.
The FAR test covers the two ways a company can account for bad debt expense:
Direct write-off method: When a receivable is determined to be uncollectable (maybe because the customer went out of business), the company debits (increases) bad debt expense and credits (reduces) accounts receivable.
Allowance method: The allowance method matches revenue with the expenses incurred to generate the revenue. In this case, bad debt expense is matched with revenue from sales. Accountants prefer this method because it complies with the matching principle.
Inventory valuation
Inventory is often the largest asset account balance for a firm. How a large balance in inventory is valued has a big impact on a company’s profit. The valuation method assigns a dollar amount to inventory, which is posted to cost of sales when the item is sold.
Several issues are related to inventory valuation: the principle of conservatism, lower of cost or market (LCM), and the issue of obsolete inventory.
Accountants must apply the principle of conservatism. When making a judgment, an accountant should choose the more conservative approach:
For income-statement issues, a conservative approach recognizes expenses immediately and delays the recognition of revenue. Those steps reduce net income, which is considered a conservative approach.
A conservative approach to the balance sheet is to avoid overstating the value of assets, such as inventory and equipment. When in doubt, the accountant should choose a lower asset value. The balance sheet should also avoid understating liabilities.
If an accountant applies the principle of conservatism, he or she avoids presenting financial statements that are overly optimistic.
The conservative principle is applied to inventory using the lower of cost or market (LCM) guideline, where the term market refers to the current replacement cost of the inventory. Following this guideline ensures that the value of inventory isn’t overstated.
The FAR exam also tests your knowledge of gross profit and how that concept relates to the formula for ending inventory. Consider these two formulas:
Gross profit = Sales – Cost of goods sold (Note: Gross profit can also be calculated as a percentage of the sales price.)
Ending inventory = Beginning inventory + Purchases – Cost of goods sold
A typical CPA test question will ask you to use the gross profit formula to compute cost of goods sold. After you have cost of goods sold, you’ll have to complete the ending inventory formula.
Fixed assets
Fixed assets are in the long-term asset category. Several related concepts frequently appear on the FAR test.
Accountants create a company policy to determine whether costs are capitalized. Capitalization means that the cost of the item will be posted as an asset. If the spending creates a resource that will be used over the long term to generate revenue, accountants create a new asset in the financial statements. If the company decides that the spending will not create an asset, the cost is expensed.
Most fixed assets depreciate. Depreciation is an estimated amount. It’s the original cost expensed over the life of the asset. The term is also defined as the decline in value of an asset due to the passage of time. The two definitions can be connected. Assets are defined as any resource you use to generate revenue in your business.
Accountants assign each asset a useful life. The useful life is the period of time when the asset can be used to generate revenue. At the end of the useful life, the asset may or may not have further value to the company. The end of the useful life may also mean that the asset is fully depreciated.
Salvage value represents the value of an asset when it is fully depreciated. If you can sell the asset after you use it, any cash received is considered salvage value. You can relate salvage value to the trade-in value a car dealer offers you when you trade in your car and buy another one.
Depreciation of fixed assets represents an expense to a business. As the asset depreciates, the accountant debits (increases) depreciation expense and credits (increases) accumulated depreciation. Accumulated depreciation is a contra-asset account: It’s posted to the fixed assets section of the balance sheet, but it’s increased by crediting. The accumulated depreciation account reduces the fixed asset’s value.
Future value and present value
Accountants need to plan the cash flows needed to purchase fixed assets. Depending on the cost, a business may need to set aside dollars for several years to fund the purchase of an expensive asset. To keep planning simple, company management may prefer to invest a specific amount each year to fund the purchase.
The FAR test may ask you to compute the annual deposit needed to accumulate a certain amount of dollars by a future date. The test question will provide you with a table of future-value factors. To select the right factor, you need to know the difference between these terms:
The future value of a single sum versus the future value of an annuity: A single sum means that one amount is invested, whereas an annuity represents an amount invested each year.
Ordinary annuity versus an annuity due or annuity in advance: An annuity due or annuity in advance assumes that the dollars are invested at the beginning for a period (month or year). The ordinary annuity assumes that dollars are invested at the end of each period.
Present value analysis takes amounts to be paid or received in the future and discounts the value of each payment into present-day dollars. The discounting uses some type of percentage rate. The FAR test may refer to the rate as an interest rate, discount rate, or required rate of return.
Keep in mind that the rate provided in the question is the rate you use to discount the payments. (Note: For a future value calculation, the FAR test may also use interest rate or required rate of return.)
Intangible assets
Companies may have other assets that are intangible — that is, they aren’t physical assets. Accountants also define intangible assets as nonmonetary assets. Patents, copyrights, and trademarks are classified as intangible assets.
Leasing assets
Many companies lease assets instead of buying them. The party who owns the asset and leases it is the lessor, and the party who leases the assets and makes payments is the lessee.
The FAR test covers two types of leases. An operating lease is a lease that’s comparable to the lease you take out on a car. The lessor records the lease payments as rental revenue, and the lessee posts the payments as rental expense. No asset is created.
The test also covers direct financing leases, or capital leases. In this case, the lessor creates an asset when the lease agreement is set up. Accountants view direct financing leases as similar to an installment agreement to purchase an asset.
Nonmonetary exchanges
A nonmonetary exchange (NME) occurs when a business exchanges one asset for another. This transaction may take place without any cash. In other cases, although cash changes hands, the cash is only a fraction of the value of the assets exchanged. On the FAR test, you commonly see NME questions in which cash is exchanged along with assets. The cash in the exchange is referred to as boot.
To account for an NME, you need to determine whether the transaction has commercial substance. A transaction has commercial substance if a company’s expected cash flows will change as a result of the transaction.
As you study NME questions, make sure you determine whether or not the transaction has commercial substance.
Investments
Companies include investments in the asset section of the balance sheet. Businesses hold both common stock and debt issued by other companies as investments.
The issuer of a bond pays the entire interest due to the current owner, regardless of how long the current owner has owned the bond. This creates an issue when a bond is sold from one investor to another between interest dates.
That issue is called accrued interest. Accrued interest is the dollar amount of interest the buyer owes the seller when a bond is purchased. To calculate that interest, a test question may ask you to count the number of days in a given period.
Valuing certain investments
Your financial accounting and reporting (FAR) test may include two methods of valuing investments: the cost adjusted for fair value method and the equity method:
Cost adjusted for value method: This method starts with the cost of your investment. The value of your investment increases as the market value increases. Market declines reduce the value of the investment. Each month of year, you verify the market value of the investment and then adjust the investment’s value in your accounting records.
Equity method: The equity method also starts with your investment’s original cost. However, no adjustments are made for changes in the market value of the investment.