CPA Exam: Financial Accounting and Reporting Study Plan

By Kenneth W. Boyd

The financial accounting and reporting (FAR) test on the CPA exam has the same format as the auditing test. You have 4 hours to answer 90 multiple-choice questions and 7 simulation questions. Fifteen of the multiple-choice questions and one of the simulation questions are pretest items, which don’t count toward your grade.

Test-preparation companies recommend that you spend 150 to 180 hours studying for the FAR test. This test requires the most hours of study. Following are some factors to consider in your study plan.

Understanding source documents

The FAR test includes questions on your ability to post accounting transactions. CPAs post transactions using source documents. Source documents are the original records that support an accounting transaction.

If you haven’t worked as an accountant, talk to someone working in the industry about source documents. People who work in accounting use source documents to post transactions all the time. Run down the types of transactions that your test-prep material mentions Ask your friend about the source documents he or she uses for each type of transaction.

Here are some common transactions and the source documents used to post the transactions:

  • Posting revenue (sales): Source documents include a copy of the invoice that was sent to the client. If the company sells a physical product, accountants typically require a shipping document. This document verifies that the product was shipped to the client. A CPA may also review a contract with the client or some sort of customer order form.

  • Writing a check for an expense: An accountant would need several documents before a check goes out to a vendor. Most firms use a purchase order form (P.O.). A P.O. is a formal request from an employee for a product or service. If you manufacture blue jeans, your factory manager may complete a P.O. for denim, a raw material used in production.

    After the purchase order is approved, an order is placed with the vendor. When the denim is received, the vendor includes a copy of the invoice and a packing slip. The packing slip lists what was actually shipped. An accountant agrees the information (price, number of items, and so on) among the purchase order, the order sent to vendor, the invoice, and the shipping document.

    If all the information agrees, a company official reviews the documents and writes the check for payment. Cash is reduced (credited) and an expense is posted (debited). In some cases, an expense is posted and an accounts payable balance is set up when the goods are received. When the company pays for the goods, accounts payable is debited (reduced), and cash is credited (reduced).

  • Increases and decreases to inventory: Purchases increase inventory. An order is placed with a vendor, and goods are received into inventory. Inventory is debited (increased) and crediting sets up an accounts payable balance.

    When a check is written for inventory, cash is reduced (credited) and accounts payable is reduced with a debit. Inventory, keep in mind, is an asset account. The inventory item doesn’t become an expense until it’s sold. When a sale is made, revenue or sales is increased. At the same time, inventory is reduced and cost of sales (an expense account) is increased.

Calculating answers correctly

The FAR test involves the most mathematical calculations. As you start to work practice questions, keep these tips in mind:

  • Write down each step. If you need to perform a calculation that requires several steps, write down those steps on your noteboard. Suppose you need to use the breakeven formula: Sales – Variable costs – Fixed costs = $0 profit. On your noteboard, write out the formula and fill in each amount. Label each number as dollars (use a dollar sign) or other appropriate units.

  • Organize your work. As you jot down notes to answer a question, write slowly enough so that you can read your handwriting. Label each calculation on your noteboard. If you use the breakeven formula in Question 30, write “30” next to your calculation and circle it.

  • Use algebra to fill in the blank. Often, a test question provides you with all the amounts in a formula except for one. You have to use algebra to solve for the missing amount. This type of question tests whether you know the required formula.

  • Review your calculations. Use any remaining test time to review as many of your answers as possible. That includes reviewing calculations.

Comparing cash and accrual basis accounting

To understand cash and accrual basis, you first need to know about the matching principle. This principle dictates that revenue should be recognized (posted to the financial statements) when it’s earned. Typically, a company recognizes revenue when it provides a product or service to a customer and presents the customer an invoice.

The matching principle states the revenue should be recognized when it’s earned, regardless of when the client payment is received.

Revenue should also be matched with the expenses incurred to produce the revenue. If you buy inventory in January to produce a good that is sold in March, the sale of January inventory is a cost of good sold (expense) balance that relates to the March revenue.

If the inventory item had a January cost of $50, that amount should be posted as cost of goods sold in March. In that way, the March financial statements recognize the revenue (sale) and the $50 cost of goods sold expense.

Accrual basis accounting applies the matching principle to accounting transactions. When you have a sale but no cash has been received, you post revenue and accounts receivable. The revenue isn’t related to the cash payment from the customer.

If you prepay six months of your company’s insurance premiums, you decrease (credit) cash and recognize (debit) prepaid insurance as an asset. No expense is recognized until the month of insurance coverage is over. At that point, prepaid insurance is reduced and insurance expense is recognized. In this case, expense recognition occurs after the cash is paid. Nearly all companies operate using accrual basis accounting.

Cash basis accounting recognizes revenues and expenses based on your checkbook (cash) activity. When a customer pays you, you recognize revenue. When you write a check, you post an expense. Cash basis accounting doesn’t apply the matching principle. Using the cash basis doesn’t match revenue with expenses, so it should be avoided to comply with generally accepted accounting principles (GAAP).