 Hello and welcome to the session in which we would look at a CPA simulation that could appear on the regulation section of the exam. The first thing you want to do when you look at a simulation is what type of simulation am I dealing with? If I scroll down a little, it looks like I have to do some computation. So it's a computational type of entry simulation. Second, what is the topic of the simulation? Because simulations don't exist by themselves. They cover a particular topic. In that topic, you need to know whether you are taking the multiple choice section or the simulation section. So let's take a look real quick. I mean, if I take a look here, I really don't know except I see Form 1120S. It looks like an S corporation. But let's read real quick. Falcon is a calendar year and S corporation. That's it. I'm dealing with an S corporation type of simulation. So I need to know a few things about S corporation. That's it. At this point, my confidence level should go up. I know my S corporation. I'm using Farhat lectures. My stress level should go down. My confidence level should go up. So let's go ahead and get started. Before we proceed any further, I have a public announcement about my company, Farhat Lectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead. Start your free trial today and answering the questions that we are that we are giving based on this scenario. So we have Falcon Inc as a calendar year S corporation owned equally by two shareholders, Jennifer and Marvin. Falcon reports its income and expenses on the accrual basis of accounting. Okay, they use accrual basis. Falcon has always been an S corporation and has no debt. That makes that makes our life much easier. Falcon's controller has provided for the completion of Falcon's year for 1120 S U.S. income tax return. A copy of the income statement as of year and December 31st, year four, and additional related information is provided in the exhibits above. So simply put, I am giving the income statement. I'm just going to take a look at it real quick. I'm not going to dive into it until I am ready to answer the questions. And I'm giving additional information. Let's take a look what the additional information are. It looks like the triple A account for the company, total distribution, year four, distributed equally, the tax basis of Jennifer, the tax basis of Marvin. That's all that's that's all I'm going to look at now. That's it. Now I'm going to dive into each question separately. So you have been asked to review the document and assist in the preparation of the 1120 for each item in column A, calculate the value and enter it in its associate cell in column B, enter income and gains as positive and losses and expenses as negative. If the answer is zero, enter zero. Great. First question. We need to compute Falcon's year, ordinary income and loss reported on form 1120s. Well, what does that mean? It means I need to compute the taxable, taxable business income, simply put business income that's taxable to the shareholder on form 1120s. How do I do that? Well, I have the income statement. Notice here, I have the income statement. I have the income statement, but this income statement is for financial reporting purposes. It's not for 1120. This income statement is for financial accounting purposes. Well, simply put, what they're asking me is to take this information and turn it into what? Turn it into 1120s. So let's do that. So what do you need to know when you are performing this computation? You need to know the rules. What goes on 1120s and what does not go on 1120s? Simply put, what type of revenues and what type of expenses I am dealing with in order to compute my 1120s. So we're going to go through it step by step to answer this question. Let me just put the calculator on the side so we can see the calculator as well as the computation at the same time. So starting with sales. Well, we're not giving anything. Well, it means the sales is sales for gap, which is this is the income statement and sales for tax cost of goods sold. Is cost of good sold deducted for tax purposes? Yes, unless there's something else is given to us, we deduct cost of goods sold. We have gross profit of 700,000. Good. Let's keep going. Can we deduct our salaries and wages on form 1120s? Of course, you're going to have employees, salaries and wages. Let me see if I can just put this calculator on the side so we can see what's going on at the same time. Give me one second. Yeah, this is better. Give me one moment here. Okay, this is way better. Let me see. Okay. Trying to make sure you can see the computation as I'm doing this. It's hard to, my screen is, my screen is a little bit small. Okay, that's fine. So we have gross income of 700,000 minus salaries and the, salaries and wages of 203 minus 203. That brings us to 497. So far, so good. Everything is the same. Repairs and maintenance. $10,000. Is this deductible? Yes, it is minus $10,000. That's deductible. Depreciation expense. Is this deductible? Do we have depreciation? Yes, we do. It's 8,000. Be careful here. This is the financial accounting financial statement. Let's see what you are told. You are told that the maker's depreciation was 20,000 for year four. Okay, so when you are computing your 1120, you don't use the depreciation for financial accounting purposes. You would use the depreciation for makers and you need to know this, that makers is the depreciation. Therefore, I'm going to deduct $20,000. And this is basically part of your knowledge of Schedule M1, which will work another simulation about Schedule M1. But here, this is, I would say this is a comprehensive computation because they're asking you not only for the 1120S, they're asking you, do you know which items are deductible for tax purposes for the 1120S? Okay, for example, maker's depreciation is a tax depreciation. Okay, let's keep going. Charitable contribution, $5,000. It's deducted for GAP for financial accounting purposes. Would I deduct $5,000 of charitable contribution? Well, I hope you know charitable contribution is a separately stated item. In other words, it's going to be passed to the shareholders separately. Therefore, I don't deduct it when I'm preparing my 1120S. Payroll taxes, do I deduct my payroll taxes? Of course I deduct my payroll taxes. That's a business expense minus 18,000. Penalties and fines, penalties and fines, penalties and fines. Can I deduct penalties and fines for tax purposes? I hope you know this. That's not allowed. Therefore, I don't touch penalties and fines because they are not deductible for tax purposes. But I do have them deducted on my financial statement. That's fine. You can deduct them on your financial statement. You paid for them, but they are not deductible. The IRS, the government, it's not going to give you a deduction for incurring penalties and fines. They will be encouraging you to do so. Therefore, they will not allow it. Business insurance, of course business insurance is a legitimate business expense. Let's keep going. Other income, bank interest income of a thousand. Well, that's income. Well, that's great. Can you include interest income on your 1120S? And the answer is no. This is going to be a separately stated item. Simply put, the interest income, it's going to flow to Jennifer and Morvin. It's not added here. Capital loss on the sale of land. We have a capital loss. It reduced our income by 20,000 for financial accounting purposes. Can we use capital losses on schedule 1120S? And the answer is no. Capital losses are separately stated items, and those capital losses will flow to Jennifer and Morvin. And it's going to be equally 50-50. I'm basically done. Done with what I need to do. Therefore, my ordinary income for the 1120S is 440,000. So what was the deal here? What was the deal? The deal is, do you know your separately stated item and what goes on your schedule 1120S? I would say this is a comprehensive question here. This is like, it's involved a lot here. Okay. Now let's look at number three. Some of Vulcan's year four separately stated items of taxable income and deductible expenses to be reported on schedule 1120S, schedule K, shareholders pro rate, pro rata shares items. So here's what I'm going to tell you. If you don't get number two right, because you don't know your separately stated items, then you don't know your separately stated items. Therefore, you're going to fail number three. And we already identified our separately stated items. Let's go back and look at them one more time. Let's look at the income statement. And those were the charitable contribution separately stated items. You might be saying, how about depreciation? No, the depreciation is not separately stated items. There's a difference between gap depreciation and IRS depreciation, but it's not separately stated item. Charitable contribution it is. Is penalties and fines separately stated items? No, why not? Because even if they give it to you as separately stated items, there's nothing you can do with it. It's not deductible on a personal item. Therefore, it's not. So depreciation it is depreciation. Bank interest income is a thousand. So depreciation 8,000. That's basically an expense. Bank interest income is a revenue. Basically, it's income for the taxpayer. And we have capital loss of 20,000. So if we take 20,000, which is capital loss or 20,000 minus plus minus five, which is minus 25 plus one equal to 24,000, but that's 24,000 of expenses of losses or negative figures. So the separately stated items are total. Remember, because this is negative, I have to put negative 24,000, 24,000, which are what did I do? I netted the loss toward the business interest expense and the charitable contribution is basically a loss as an expense. It's a negative. It's a negative. Okay. Okay. So notice here, the penalties are fines are for late payment of payroll liabilities. It doesn't matter. You cannot deduct them. So notice, if you don't know your separately stated items, you'll be in trouble in this problem, which is if you don't know this, then you don't know anything about corporate S corporation for that matter. Non-deductible expenses. Yes, we know what non-deductible expenses. The non-deductible expenses are the penalties and fines that we incur on the payroll, which is negative. Whoops. Non-deductible expenses, negative 2,000. That's it. Now we're going to compute the company's accumulated adjustment account balance, which is here. Again, this, this, this simulation is quite involved. We need to compute the AAA account, the accumulated adjusted balance. Do you know how to compute the accumulated adjusted balance? Well, we are giving some information about this account. So let's take a look at the additional information here. We are giving the beginning balance of 100,000. This is the beginning AAA for Falcon for the company. Total distribution is 30,000. That's fine. And we are giving the basis of Jennifer and Marvin, but here we're looking at the AAA account. So AAA account, there are certain items that, you know, affect the AAA account. What are they? Like ordinary income, separately stated items, you know, separately stated items. Even non-deductible items will affect the AAA, because the non-deductible, they would reduce your AAA. Although they're not deductible, like fines and penalties. Nevertheless, they affect your AAA. You have less, $2,000 less in fines and penalties, it's going to reduce it. So how do we compute the AAA item? Well, let me pull my calculator and start to go over, go over this information. Again, notice in this exercise, this is a difficult simulation. In a sense, it's not difficult in terms of knowledge. It's difficult because it's everything is connected. So if you get one thing wrong, especially the first question, and you don't know how to answer the first question, it's going to carry over. So starting with the AAA, we have $100,000, the beginning balance, that's giving to us. The ordinary business income for the company was $440,000. We computed, that's the first thing we computed, that's going to increase our AAA. We're up to 540. Now, the separately stated, the separately stated item, we said they're negative 24,000, that those would reduce the AAA. They would reduce the AAA account. You need to know this. Whoops, too many zeros, minus 24. Even the penalties and fines, they will affect the AAA because they did indeed reduce your ability, reduced your earnings. Okay, it's not deductible. That's a different story that your AAA is similar to your retained earning. It reduces your ability to pay dividend. It reduces your earning, negative 2,000. Then also the company made a distribution of 30,000, that's going to also reduce your AAA. All in all, your AAA end up to be 484. What is AAA? It's your beginning balance of the AAA plus any income minus any separately stated item, or sometimes plus some separately stated item, minus any non-deductible expenses minus shareholder distribution. Basically the retained earning, beginning balance plus net income minus withdrawal equal to ending retained earning. Same concept, not same concept, but the AAA computation. You have to know it. You have to know it in details, which is again, for half lectures, I cover this. I have lectures explanation about this. You want to make sure you know this inside out. Now we want to compute the Jennifer, a Jennifer's shareholder basis as of the end of the year. Well, Jennifer, okay, let's take a look at Jennifer. We are giving some information here about Jennifer. Jennifer basis starting at, starting at 60,000, right here. It's given to you the basis. Again, how do you compute the basis? Well, you need to know how to compute the basis inside out. There are certain items that increase the basis, certain items that decrease the basis. How do we do so? Well, we're going to start with 60,000. Well, 60,000 is the beginning basis. The company made 440,000 in ordinary income. What is the share of Jennifer? Jennifer is 50% owner. Therefore, we're going to increase her basis by the ordinary income of her share, which is 220,000. That's done. Also, we reported 24,000 in separately stated items as deductible expenses. What is Jennifer? What is Jennifer's share? 50% of that. But that's going to be a minus 12,000 because those are expenses. Those are not income. 268. Also, we reported 2,000 of non-deductible expenses. Would that be part of the basis? Yes, they would reduce the basis. But 2,000 Jennifer's share is only 1,000. Remember, this is like the K1. So everything is pro rata. And what's the percentage here? 50% for Jennifer. We're not done yet. We made a distribution of $30,000 and distributed equally. What is Jennifer's share of that? 15,000. And how is that going to affect her basis? It's going to, if you're getting your money back, you're reducing your basis, minus 15,000 with the basis. And that's going to give Jennifer everything all said and done, a basis of 200 and ending basis of 252,000. Well, can I turn this into a multiple choice? It will be, it will be a difficult multiple choice. If this, if this was a multiple choice, if I asked you to compute Jennifer's basis, giving you this information here, you know, giving you the income statement, tell you to compute the Jennifer's basis, you have to go through ordinary income. You have to know which one is separately and not separately stay random. It will be a long multiple choice. But nevertheless, it's a multiple choice. This simulation is comprehensive as corporation as corporation. And it's understandable. If you don't know your S corporation items, how to compute ordinary income separately stated items, you should not be sitting for the exam. And this is where four half lectures can help you. I can help you understand S corporation inside out. That's what you want to, that's how you face any simulation knowing the topics inside out will help you resolve any simulation because you don't know how they're going to give you the information. If you know the topic, you will do your best then at least you have the key. The knowledge is the key to solve the simulation. If you are not competent with that knowledge, then you can't, you can't do it. I'm always here for you. Good luck, study hard, and of course, stay safe.