 Hello and welcome to this session in which we will go over this CPA exam simulation. This simulation I would say it's one of the most challenging simulations. For several reasons, the first one is this simulation indeed it simulate the real world. So it simulate a situation, a scenario that you as an entry level CPA staff you might see in the real world. Two, there's a lot of exhibits which it's not really that intimidating because usually each exhibit you'll have you can get an answer from each exhibit. Sometimes you might have to look at more than one exhibit which this this simulation will will involve. Also you're gonna have many adjustments and these adjustments they are all interrelated so if you mess up one adjustments it's gonna mess up the others. So that's why I believe it's a challenging so it's one of those the mother of all simulations. Nevertheless it's difficult I'm gonna show you how you would approach a simulation like this on the exam day. So I would say this is challenging I agree like if you said I got this simulation I was under time pressure it's challenging I would say yes I agree this is challenging but this could be more challenging for example in this simulation they don't ask you about the journal entries so they're gonna be asking you about adjustments and we should all know adjustments which is basically how to prepare adjusting entries in other words adjusting entries is fixing the account just the the number is not correct make sure it's the correct number. So let's go back and review our basic steps first as you take a look at it it's basically I have to do some computation it looks like adjustments now what type of adjustments I don't know I'm gonna have to look at each adjustment separately it looks like I need to adjust my revenues cost of sales general and administrative expenses research and development cost sales and marketing expense gain interest expense they might be correct they may not be correct so on and so forth what you do next is you okay so it's an adjustment don't open the exhibits yet there's a lot of exhibits just see what they are I have a summary of year five result I have a debt agreement memorandum I have an email regarding pine corporation sales contract I have an interest expense general ledger I have research and development expense account activity and I have additional information I have a lot and I have analytics definition if need be let's go ahead and get started in how you would solve this simulation before we proceed any further I have a public announcement about my company farhatlectures.com farhat accounting lectures is a supplemental educational tool that's gonna 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 first let's read it and see what we are being told to do now we have a we have a general idea but now we have to be specific and you have to be doing those real quick in the first two minutes you will do what you need to do what type of a simulation is it what am I being asked to do so we have oak corporation is preparing its financial statement as a year and December 31st year five review the above exhibits don't review anything yet to identify any adjustments required to the draft income statement for the year and the December 31st so now I know exactly what is the simulation about have an income statement they're giving me figures and they're telling me is this figure correct based on what we are told to adjust the draft income statement enter amount associated in column C enter increases to revenue and expenses as positive so increases are positive and decreases to revenues and expenses as negative enter decreases to gain as positive you have to be careful if it's again you have to decrease as positive and increases to gain as negative so when you have gains you have to be careful how we're dealing with this if no adjustments is needed then leave the associate column C blank if multiple adjustment affect the single financial statement line then enter the net amount in column C there's more than one adjustments you net them out adjustment might not be required in some rows within the draft income statement an amount in column D will calculate automatically thank you very much it means I don't have to worry about making a computational error now I'm ready to start the simulation the first questions I am being asked is revenue here's what you are told this is the drafted amount this is what we think revenue is right now 57,495 my our question to you is this does this number need adjustments or is this number correct adjusted at 57,495 how do you know whether it need adjustment or not now you go to the exhibit now when you go to the exhibit you have one two three four five six with the analytics seven exhibits so first thing you want to do is predict which exhibit am I am I gonna go to predict which one should you go to the debt agreement I will not open this one yet I will not open my interest expense yet I will not open research and development expense yet I will not I might definitely you'll always want to open the additional the additional information but I will definitely open email regarding pine corporation sales contract I really want to look at this because this is a sales contract and sales deals with revenue so I'm just walking you through my logic summary of year five result for segment beard I would also look at this I'm not it may not be related but because it's a summary of results they might have some revenue information so let me take a look at this one first I'm gonna take a look at this exhibit so this is for segment B we have revenues expenses transaction fee for disposal means we dispose this segment so this is what we know about the segment that was disposed pre-tax income income tax expense and net income I don't think this is helpful for my revenue okay but I know this now I know that segment B was disposed of let me take a look at email regarding pine corporation sales contract so it's basically an email from the senior accountant at oak company to the controller at oak company I spoke to the manager of the shipping department today and was told that the department shipped 20 000 product on December 31st year five we received confirmation from the common carrier that pine received all 20 000 on january second year sex that's a great based on this information and the email below I recorded the following journal entry a count receivable 400 I debit at the counter receivable credited sales debit at cost of goods sold credited inventory this is what the controller says now from the controller back to the senior accountant while working on the year end close please consider the following new customer contract detail oak enter into a contract with a new customer to produce and deliver 20 000 product for pine yes we did deliver those the transaction price will be 450 which is this is exactly what we recorded the shipping terms are FOB destination this is the key to this answer now if you don't know what FOB destination is so this whole email this whole intimidated section relies whether you know what's FOB destination versus FOB shipping so if this sale was FOB destination destination means you don't record the sale until the customer received the product in other words when it went when this sale is in transit the company did not did not did not complete the sale yet so here's what we did we shipped December 5th year 5 the customer received that January 2nd year 6 what does that mean it means this entry here belongs to year 6 does not belong to year 5 what does that mean it means I have to take out of revenue 450 000 I just know this I have to take out of revenue 450 000 and obviously we're gonna see later obviously you're gonna have to take out of a counter receivable 450 000 as well and also and if you notice here since I have this one open if you look at cost also we have to take out of cost because we also recorded the related cost 350 000 so simply put we just find out the first two adjustments which is all based on your understanding of what your understanding of at FOB shipping FOB destination I will not do it yet I want to look at additional information just to make sure I did not I did not miss something the following provides information for oak the secured overnight financing rate effective tax rate I'm just reading this real quick this is on October 26 oak sold segment B okay major line of business that presents strategic shift in the company's operation and and recognize a pre-tax gain of 300 000 project A relates to the development of new product that oak expect to launch in the second nothing that about this revenue and cost now and look I didn't even open the other exhibits if you want to open them like that interest research to feel better but I think I will go with reducing my revenue by 450 said if you reduce means negative for revenues and expenses and reducing my cost by 350 and what I just did I just finished the first two adjustments it again I'm going to repeat myself one more time it all depends on one thing only and that's your understanding of FOB shipping now also I reduced my in I increased my inventory why am I mentioning this because at the end I'm going to have to compute return on sales and I'm just going to tell you what the how we computed this so remember I I reduced my inventory I'm going to go back and increase my inventory by 350 when the when when I make the adjustment okay so so basically from a journal entry as I told you they did not ask you to prepare the journal entries we'll have to reverse this entry so we'll debit revenue credit account receivable and by debiting revenue reduced revenue we reduce account receivable and we increase inventory and credit reduce cost of goods sold now we are done with this good that's really good we have general administrative expenses the number is 6,814,500 dollars and we are being asked is this a correct amount and if not what should be the journal entry should we add more expenses should we reduce expenses that's what we are being told to do okay so I don't see the general ledger for a general and administrative expenses well for now if I'm looking at this I really don't know what to do because I don't see anything about general and administrative I see research and development so I'm going to I'm going to switch to research and development and it says 2,304,000 now why am I doing this because if I'm if I'm gonna try to tell you what what should you look for I don't know what you should look for for the general administrative expenses let's take a look at the research and development expense because it's given at 2,304,000 so I'm going to look at the detail of the general ledger I'm going to go over this they're giving me a figure they're giving me a figure and they're telling me this is what we have and this figure should match the first thing you want to know is this is why this is important for the real world notice the closing balance for this general ledger research and development expense activity so this is the R&D expense activity well it shows 2,304,000 you're going to go back here on the income statement it should match 2,304,000 now it must be there could be something wrong here because they're telling me they're asking me to look into it so I'm gonna you're gonna have to look into each account separately now to find out if there's anything unusual engineering costs to develop specification for prototype project A well yeah this is this sounds like research and development cost material consumed to develop prototype A okay that's fine we're looking at project A because they told us something in the additional information about product A market research to evaluate potential sales price okay let's stop right here what do we know about R&D do we include market research well R&D is not included in market research what does that mean it means this 215,000 should not belong here why because market research is not research and development market research is basically it's market it's a marketing expense therefore I know from this amount I have to take out 215,000 why because it doesn't belong there it's not research and development third party contract services provided to test prototype A this sounds like research and development on product A recognition of year five salaries for R&D personnel yes R&D research and development salaries are research and development recognition of year five corporate accounting and salaries and finance salaries hold on a second I have 183,000 included with these expenses there are these this sounds like a general and administrative expenses hold on a second so what do I need to do here I have two reclassification to make I need to take out the 215,000 out of the market market research because this is not research it's basically marketing cost and I have to take out 183,000 out of corporate accounting and it doesn't belong there it doesn't belong there that belong in research in development simply put the 183,000 belongs to general and administrative so I have to do what I have to add 183,000 in this column because I have to now I figure it out because look if you were trying to do your general administrative and looking at the statements you would be you would have been spinning your wheels so just I moved to research and development because I had the general ledger for it now I know sales and marketing also I need to add to this the 215,000 I need to add that this 215,000 so what I did is I took them out from where I took them out from research and development it means I have to reduce research and development by the total which is if I add them up they're up to 398,000 and simply put this is called a reclassification entry reclassification means I'm going to be debiting salaries and marketing expense debiting general and administrative expense and crediting research and development expense so the expenses were in the wrong place not a big deal at all like this is a simple like if I gave you this in a this will be too easy for a multiple choice why is this challenging because you have to look for it but if you know what you are looking for it's not difficult at all so it's easy but it's it it will be too too easy if I put this question in a multiple choice I hope this makes sense now gain on disposal gain on disposal I had a gain on disposal 300,000 what that what did I dispose of gain on disposal well if you look you remember only when we look when I looked at summary year five segment B I was told that I disposed of this segment okay that's fine I dispose of this segment that's that's great but I was told under the additional information if you look at the additional information I was told under the additional information or somewhere that actually in the additional information that the segment represent a major strategic shift in the company's operation what does that mean this is a discontinued operation when you see the word major strategic shift it's strategic shift and the company's operation it means I'm not dealing with the gain with the sale of an asset I'm I'm dealing with the disposal of a of a whole segment okay so this is so this 300,000 should not be there it should be under discontinued operation and I do have discontinued operation here if you notice here in column in in this row row 17 I have a gain on discontinued operation again what does that mean it means this game should not be here so if this game should not be here what do I need to do I need to take it out of here because it's again it's a negative I have to offset it with a positive so I have to take the gain out why because it's not a sale of a division I did not sell a division I did not sell a division I dispose of a whole segment so it has to be under discontinued operation so if I added 300,000 what do I have to do the gain has to go somewhere else the gain has to go under discontinued operation and remember this discontinued operation the gain has to be put as negative so what I just did I also did another reclassification entry what is the reclassification entry debiting this gain basically I debited the gain here and I credited discontinued operation the gain here the gain uh the gain on discontinued operation the gain on discontinued operation so I'm done with that let's see what else do I have left now I'm going to be looking at interest expense the interest expense you are giving is 356,250 and the question is is this number correct now how do I know whether this number correct or not well now I'm going to go to my interest general ledger detail and it should show 356,250 because it should match 356,250 356,250 okay great now you examine when you have it those general ledger you examine how did we come up with this figure we have a semi interest payment of 187,500 then another semi interest accrual payment of 168,750 this is what we have as a result we have total interest expense of 356,250 now the question is do you think this is correct or incorrect if it's correct you don't do anything how do you know whether this amount is correct or not well first I need to take a look at my debt agreement because I need to know what that do I have and how did they come up with this computation how did they come up with this computation well let's take a look the following summarizes the key terms of the debt agreement entered by oak and the national bank the agreement we borrowed 10 million dollar semi annual principal payment of a million beginning on july 1st year five that's that's the deal of july 1st year five variable interest so it's not a fixed interest the variable interest it's the secure overnight rate as quoted at the beginning of each of each semi annual period plus 2.5 so what's your interest rate your interest rate is the SOFR which is it's a variable SOFR plus 2.5 this is how much interest you will need to record every six months principal and interest payment are due july 1st maturity january 1st national bank oak is is the first and only lender so that's the only debt we are dealing with simply put we have a 10 million dollar debt we made a principal payment july 1st so basically we have to now we have to do is we have to see if they computed the interest expense correctly well to compute the interest expense we have to know the interest rate well we are told it's SOFR plus 2.5 and notice in this exhibit in this question i'm looking at more than one exhibit so notice that's why i said this is a challenging one because i have to look at more than one exhibit so i'm gonna have to go to the additional information so i know the loan amount is 10 million i know how they come up with the interest expense now i need to take a look at the additional information and under additional information i see that from this SOFR was 1.25 january 1st and it changed july 1st to 1.5 so what's my interest rate for the first six months my interest rate for the first six months is 1.25 plus 2.5 that's how that's what the deal is so what do i do as what do i do at this point i would say okay if that's the case what i'm gonna do is this i'm gonna have a 10 million i started with a 10 million with a 10 million dollar loan and i'm gonna multiply this by what did we say we say um let me see let me move this 1.25 plus 1.25 plus 2.5 so the interest rate the first six month is 3.75 so i'm gonna take 10 million dollars you would use your calculator and multiply it by 0.0 375 that's the rate for the whole year 375 000 and this is only for six month i'm gonna multiply this by 0.5 and for the first six month my interest expense is 187 500 now what do you do go to the interest expense uh general ledger to see if indeed they computed this amount correctly let's go back to the interest expense general ledger and notice here they computed the interest expense correctly 187 000 187 500 dollars so notice the first six month we see it's correct now we need to compute the remaining six month the remaining six month okay how do we compute the remaining six month remember after after the first six month we paid down a million dollar now we need to know what was the sofa rate sofa rate was 1.5 it means for the remaining the next six month the rate was 1.5 plus 2.5 which is four percent let's go back now and compute our debt so the the next six month we are at four million dollars and the interest rate is four percent which is 1.5 the sofa plus 2.5 that's the deal so we're paying four percent so i'm going to take nine million times four percent and this should be 360 000 this is for the whole year times 0.5 for half a year so if i take 360 000 times 0.5 the interest expense for the next 12 month it should be six month it should be 180 000 well let's see is it 180 000 let's see my interest expense my interest expense here they computed it as 168 750 so what's the difference 168 750 the the difference is 11 250 what does that mean it means this number is not correct i computed the first six month correct the second six month it was incorrect i have to increase my interest expense the difference is 11 250 difference between 168 750 and what i computed 180 okay good but notice here i i have to agree i have to agree like this this the reason it's challenging again if i give you this in a multiple choice tell you compute the interest expense it's very easy but when you have to look in the debt agreement then you have to look in the additional information then do the computation and compare to the interest expense general ledger this is where it takes time and this is where your knowledge so notice here in a multiple choice to compute this interest expense fixed entry i would say it's easy to do what here you have to know where to look for the information so i have to increase my interest expense by 11 250 and i just fixed my interest expense i just fixed my interest expense now what i have to do i have to compute my income tax either income tax expense or income tax benefit what do i do i just have to adjust the number right now it's 339050 and when it comes to income tax expense i have to know my tax rate and i believe under the additional information i was told the effective tax rate is 20 so i know the effective tax rate is 20 so what i have to do i have to take a look at all the adjustments that i made and which is basically computed them or since this is a great thing they computed all of this for you they computed the to change for 11 250 and what do i have to do i have to multiply this by 20 because i have to adjust because this number is based on income from continuing operation of 1695250 multiplied by 20 you get this if you made additional adjustments for 11 250 what do you have to do you have multiplied by point 20 and you have to put it as negative 82 250 and i just fixed my income tax expense which is 256800 okay now let's take a look at income gain on discontinued operation the gain on discontinued operation we oh sorry i put the gain on discontinued operation in the wrong place it's 300 000 here the gain on discontinued operation sorry so okay the gain on discontinued operation has to be 300 000 okay now what do we need to know about discontinued operation remember we have a gain and how do we report the gain on discontinued operation we always report the gain on discontinued operation net of tax because we have a gain of 300 000 we have to pay 20% tax again the losses are also reported net of tax again this is another concept separate concept that you need to know for this simulation so if i have a gain of 300 000 i have to pay 20% taxes on it my taxes it's going to go up by 60 000 my taxes will go up by 60 000 so the income tax expense on this will have to go up by 60 000 60 000 60 000 and now my net my net profit from this from this discontinued operation is again the gain is negative this is a gain again you have to be careful in this simulation because you have to be careful about the pluses and the minuses so the gain is 300 000 the gain is 300 000 then i have to pay 60 000 and taxes the net gain is 240 the net gain is 240 because i have had to pay taxes on this and then the computed net income is 89 000 is 89 000 again i'm not the the adjustment overall adjustment is 89 000 i have to reduce it overall it's one million three hundred eleven thousand two hundred this is the new net income the new net income so notice i had i had i had to go through several adjustments let's review them real quick kind of just kind of put everything under control i would say revenues and expenses were pretty straightforward the reclassification expenses as long as you know how to read the general ledger just you know you know certain things don't be long in the rnd you reclassify them not bad gain on disposal as long as you understand that selling uh segment b was discontinued operation you need to take this one out and put it with the gain on discontinued operation and you have to be reported net of tax so far so good interest expense i would say was a little bit like we had to be careful with interest expense was a little bit like you have to look at three different places so that's fine uh income tax benefit was the result if you got all of them right you will get this right and the rest is that's it so if just the reason i'm summarizing this is to make sure you you don't get you don't get overwhelmed again on it's easier said than done on the exam day of course it's gonna be you're gonna be under more pressure but the point is is to be prepared and stay calm under pressure that's the whole that's the reason i'm going over this to tell you that if you know where to look it's easy if you know where to look it's easy now i'm gonna they're giving us the balance sheet for year four year five the balance sheet for year four they're asking us what's the net effect of adjustments well what's the net if you remember i told you the net effect on the assets we are going to do what uh we are going to uh remove remove the account receivable and increase the inventory removing the account receivable was 450 adding the inventory was 350 so the net is a reduction of 100 000 from the asset side so this is going to be the adjustment to the assets the net adjustments the rest the rest were affecting the expenses reclassification then the liabilities remember we had to increase expense adjustment we had to increase interest expense adjustment which is again what do you do you debit expense you credit a liability also we had an adjustment for income tax expense our income tax expense again income tax expense income tax liability income tax expense was a reduction okay so notice here you have to understand the the effect okay so this is so expenses went down um expense i'm sorry expenses went up with the interest expense and remember you have to you have to understand the corresponding credit or debit when you're dealing with expenses the corresponding debit or credit is a liability so here income tax expense went up liabilities went up here income tax expense went down liabilities went down so you have to be netting those liabilities liability up 11 000 liability down 82 250 then here we also had an income tax expense for the discontinued operation again if income tax expense went up it means a liability went up so we have two liabilities up one liabilities down we net them if we net them it will be 11 000 so negative 11 000 on the liabilities this is the effect on the liability give me one second here i'll close this so if you net them it's negative 11 000 and this is the effect on the liability so now we have the adjusted the adjusted assets the adjusted liabilities here they're asking us to compute return on asset notice this is a long long long long uh simulation i would take a look at my analytics definition it should be they should be return on asset i'll just take a look at it and see what you know what their what formulas they're using just because since we are this since this is given to you you want to take a look at it return on asset is net income which we already computed net income and hopefully we computed net income correctly divided by average total asset now you have to be careful you have to use the average total asset what is the average total asset well the average total asset is year four plus year five because two years two years let me go back to the two years because they're given us year four and year five the average of the two years so year four plus year five divided by two year four plus asset that's only we're looking at assets year four plus year five divided by two and net income is net income which is 1,311,200 so if you take 1,311,200 divided by and if you find the average, the average is going to be 45 million and the answer will be 2.91%, 2.91%. Once again I know you're going to say well this is easier, sad and done. Yes, as I mentioned at the beginning, this is not for the weak-hearted individual but this is the point. The point is to make you strong in dealing with those CPA simulations. This is the whole purpose of it. So the key is stay calm, stay calm, no work to look for the information and notice when I looked at just the whole point of this is when I was looking at gender and administrative, you could have been spinning your wheels. So I just skipped over R&D because I saw the R&D and within the R&D I need to find out there is something wrong with the R&D which has allowed me to do the reclassification. So just kind of sometimes skip over something, come back later, don't panic, always look for the additional information and the key is knowledge. The key is knowledge. If you don't know FOB shipping, FOB destination, that's a simple concept. You will get the simulation all wrong because you could not adjust revenues properly. If you don't know what discontinued operation is and discontinued operation is reported net of tax, you'll get this one wrong. Those are the two key to this simulation. If you don't know how to compute your interest expense, you should not be taking the CPA exam. That's another key factor. And the most important one and the least amount that the students familiar with is know how to read general ledger. Because no college course, I mean I do teach it, far had lectures teach it. But no college course show you how to read the general ledger for a company. In my courses when I teach financial accounting I show you how to read the general ledger which is and also how to read the special ledgers. So that's why the key here is to know how to read those. Otherwise, it's difficult because this is a real, if you're a CPA, when I was in practice, you have to do this. This is part of your daily routine. And that's why somebody who's been in practice for two to three years, this will be an easy simulation, bring it on for you. Practice, practice, practice. I'm always here for you. Look at additional simulations. Of course, look at far had lectures, look at additional resources. Good luck, study hard and of course, stay safe.