CPA Exam: Business Environment and Concepts Study Plan - dummies

CPA Exam: Business Environment and Concepts Study Plan

By Kenneth W. Boyd

The business environment and concepts (BEC) test has a different structure from the other three tests. For the 3-hour BEC test, you find 72 multiple-choice questions (with 12 pretest items). The remainder of the test consists of three written communication questions, including one pretest item.

Eighty to 90 percent of this test requires knowledge and understanding of BEC concepts. The remaining 10 to 20 percent of the exam is written communication.

BEC topics are similar to what a business major would see in undergraduate coursework. This test includes economics and financial-analysis topics.

Test-preparation companies recommend that you spend 80 to 110 hours studying for the BEC test.

Working with currency risk

Currency risk may be the most difficult subject on the entire CPA exam. Currency risk is the risk that a firm will incur a loss when it exchanges one type of currency for another. Companies that operate in more than one country have exposure to currency risk.

To prevent big swings in currency conversions, companies hedge currency conversion rates. A hedge is set up when a company pays a fee to lock in a specific currency conversion rate for a specific period of time. Reliable might pay a fee to ensure the 1 dollar converts into 2 pounds and that the conversion rate remains in place for three months.

By using a hedge, Reliable knows how many pounds that English plant will receive when it converts $1,000,000.

Handling financial ratios and formulas

The BEC test covers financial ratios and formulas. Typically, you can use flashcards to write down the information covered on the test and memorize them. One way to study financial ratios and formulas is to make sure you understand some key terms.

Liquidity refers to a company’s ability to generate enough cash flow to meet its short-term (current) obligations. The balance sheet separates assets and liabilities into short-term and long-term classifications. For the CPA exam, “current” means 12 months or less. You can use that definition for current, unless a test question tells you otherwise.

Current assets are those assets that are in cash or that will be converted to cash within 12 months. Current assets include accounts receivable. Companies expect receivables to be paid in cash within 12 months. If not, the receivable should be written off as uncollectable.

In the same way, inventory is a current asset. A business expects inventory to be sold (and converted into cash) within a year. If not, the inventory is obsolete and should be written off as an expense.

Current liabilities are those debts that a firm expects to pay within a year. This category includes accounts payable and wages payable. The current portion of long-term liabilities is also a current liability. If you have to repay $100,000 in principal on a loan within a year, that $100,000 is categorized as a current liability.

Solvency is a firm’s ability to generate enough cash to operate over the long term. For the CPA exam, long-term is considered more than a year. A long-term debt, for example, is a liability that is due in more than year.

A good starting point for understanding financial ratios and formulas is to define liquidity and solvency. Now consider some of the more frequently tested items:

  • Working capital: Working capital is defined as current assets less current liabilities. To maintain liquidity, a company wants to have at least 1 dollar of current assets for every dollar of current liabilities. In other words, a firm wants current assets to be greater than current liabilities.

  • Current ratio: This ratio is current assets divided by current liabilities. The ratio expresses the working-capital amounts as a ratio. A company wants a ratio greater than 1. The amount in the numerator of the fraction (current assets) should be equal to or greater than the denominator amount (current liabilities). A ratio of at least 1 means the current assets are greater than current liabilities.

  • Inventory conversion period (or inventory turnover): Several ratios on the BEC test address how quickly companies collect cash. The faster a company can collect cash, the less cash it needs to operate each month. The inventory conversion period ratio explains the average time it takes for a firm to sell its inventory.

    If a company can sell inventory quickly, it can collect cash on the sales faster. This ratio is average inventory divided by sales per day. If a business has $100,000 in inventory, on average, and sells $2,000 of inventory per day, the inventory conversion period is $100,000 divided by $2,000, or 50 days. Average inventory is calculated as follows:

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  • Receivables conversion period (or receivable turnover): This ratio defines how long it takes to collect accounts receivable. The ratio is average receivables divided by credit sales per day. Credit sales aren’t paid in cash, so they’re posted to accounts receivable.

    Suppose a business has $200,000 in receivables, on average, and sells $10,000 of goods on credit per day. This receivable conversion period is $200,000 divided by $10,000, or 20 days. Average receivables is calculated as follows:

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Segregating duties

The BEC test includes questions about internal controls. Internal controls are policies and procedures created by company management. The controls exist to protect company assets and other resources from theft. Internal controls also ensure that the business complies with regulatory requirements. These controls also help the company generate financial statements that are free of misstatement. This topic is also tested on the auditing (AUD) test.

One frequently tested internal control is segregation of duties. This concept states that if management spreads out certain duties among different employees, the risk of asset theft is lower.

Where possible, management should assign the following duties to three different employees:

  • Custody of assets: Physical custody over assets includes keeping the company checkbook or having keys to the company equipment building.

  • Authority over assets: A manager with the ability to sign checks has authority to move cash. Writing a check moves cash from the company to the payee on the check. The individual with physical custody of the checkbook shouldn’t also have the ability to sign checks.

  • Recordkeeping for assets: Accountants are record keepers. An accountant shouldn’t have physical custody of any company assets or the authority to sign a check. When it comes to cash, the accountant should be responsible for reconciling the bank account and posting accounting transactions.

Obviously, keeping the duties segregated is tougher in a small business with fewer employees.