 under the session, this is Professor Farhad. In this session, we would look at an actual CPA simulation that's released by the AI CPA. Specifically, it covered the auditing concept. However, what's special about the simulation, this simulation, it's gonna illustrate why you need to take FAR before audit or before any other section. And I will show you why later on. As always, please connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1,600 plus accounting, auditing, finance and tax lectures. This is all the courses that I cover. If you like my lectures, please like them, share them, put them in the playlist, let the world know about them. If they're benefiting you, they might benefit other people as well. On my website, you'll have access to additional material such as notes, PowerPoint slides, true, false, multiple choice if you're studying for your CPA, 2000 plus CPA questions. I strongly suggest you visit my website. So let's take a look at this simulation. It's an auditing simulation. Again, I'm gonna mention that you're gonna see why I strongly suggest you sit for FAR before you sit for auditing. So first, let's read the instruction. So this is what the simulation would look like. So an engagement team is performing the audit of the financial statements of Griffin as of the year end December 31st, year seven. Task one, the senior accountant had identified three misstatements that have been carried forward into the summary of proposed adjustments. So they have three misstatement. Determine the impact of the identified misstatement on the financial ratios noted below. For each of the identified misstatement below indicate the impact on the financial ratio identified. In column D and E, select the impact if any on the misstatement on the financial ratio from the option list. Selection may be used once more than once or not at all. Consider each statements independently. This the information in the analytics definitions exhibit must be used for all financial ratios. So here the impact on current ratio. Hopefully we all know how to compute current ratio, current assets divided by current liabilities. But if you're not sure, which you should be sure when you go into the exam, you could look at analytics definitions and you could see that current ratio here is equal to current assets divided by current liabilities. They're giving us the profit margin ratio, which is net income divided by sales. So the gross profit margin, net income divided by sales or net sales. And you should know those ratios without even looking. So if you don't know what current assets and current liabilities are, you're gonna be in trouble on the exam day. Now frankly, I can answer these questions. I can finish task one, by not even looking at the debt restructuring email and by not looking at the audit work papers. All what they're asking you in task one, which is pretty simple and straightforward in my opinion, is we made those adjustments. We debited payroll expense, credited accrual payroll. What is the impact on the current ratio? Is it an increase, decrease or no impact? What is the impact on the profit margin? Increase, decrease or no impact. That's all what they're asking you. That's all what they are asking you. So I can answer these questions without looking at anything else and you should be able to do so as well. So notice, the simulation is pretty straightforward and easy. It may look a little bit intimidating, but task one is pretty straightforward. So let's take a look at the first adjustment. We debited payroll expense, we credited accrual payroll. What is the impact on the current ratio? So again, what's the current ratio? The current ratio is current assets divided by current liabilities. What happened is this? If you credited accrual payroll, you're gonna increase current liabilities. So simply put, here's what we're saying. Let me just show you the math real quick. I mean, you should be able to do this immediately, but I'll show you the math. You would say, if you have current assets of 10, current assets of 10, current liabilities of five, your ratio is two. And what's gonna happen when you credit accrued payroll, you're gonna add to the liabilities, let's assume one. As you add more to the liabilities, current ratio goes down. The current ratio goes down. So simply put, what's gonna happen is this. The current ratio will decrease. Why? Because you're increasing the liabilities. What's gonna happen to the profit margin? Well, the profit margin is net income divided by sales. What's gonna happen to net income? If you have more expenses, your net income will go down. Therefore, your profit margin will go down as well. So you have less profit per dollar because you have more expenses. They both decrease. So notice, it's, I mean, knowing the concepts, it should not take you that long, but I'm just explaining the concept because it's very important that you understand the concept because expenses going up, your debting expenses, your profit should go down, your profit margin should go down, okay? Let's take a look at the second entry. You debit the depreciation expense 125, credited accumulated depreciation 125. What is the impact on the current ratio? Well, what's the current ratio? Current ratio is current assets divided by current liabilities. So what did this adjustment do to the current ratio? Nada, nothing. You increased an expense, which is not a current asset or a current liability. You increased accumulated depreciation, not a current asset, not a current liability. The impact on current ratio, no impact. What about the impact on the profit margin? Notice, it should be the same thing as the previous answer. Notice in the previous question, you debited payroll expense and your profit margin went down. In this problem, you debited depreciation expense, your profit margin is gonna go down as well. Why? Because your expenses went up. When your expenses goes up, your net income goes down. When your net income goes down, your profit margin decreases. Okay, let's take a look at the third adjustment. Debit, you should be happy if you get a simulation like this. You're gonna debit prepaid insurance and you're gonna credit reduce insurance expense. So what happened when you debit prepaid expense? When you debit prepaid expense, prepaid expense is a current asset. So if you increase current assets, it's gonna increase your current ratio because you're increasing the numerator. Therefore, this will increase and you are crediting insurance expense. When you credit expenses, you reduce expenses. When you reduce your expenses, your profit goes up as well as your profit margin. So your profit margin goes up. Now notice, this simulation is given to you in an auditing exam. How do I know this? That's what the AI CPA released. They released the simulation. So notice, it's an auditing exam but it's practically financial accounting. All these concepts are from adjustments and ratios you would learn in financial accounting. You would learn also in BEC. But the point is if you don't know how the adjustments affect the financial statements which in turn affect the ratios, you're gonna be so confused in these simulation. But if you went through the FAR section and you know how these adjustments in which how did they affect the financial statements? Literally, this should take you this first simulation task one, two minutes, no more than two minutes. That's it, all right? So we're done with the first task simulation. Let's look at task two. And notice, I didn't even look at the exhibits. So I was in sort of, I mean, I looked at the analytics definition but I didn't have to and you shouldn't have to. If you don't know what current assets is before going into the exam, I'm sorry, if you don't know what current ratio and profit margin, well, you're gonna be in trouble, okay? Task two, task two reads, the engagement manager had requested that the summary of proposed audit adjustment, adjustments started by the senior accountant be updated for any additional misstatement identified. Use the information in the exhibits above. So that's what they ask you to do now to determine the adjustment journal entries required. Each adjusting entry can be entered in any of the three responses table below. So there are three adjustment entries that we need to do to prepare each required journal entry, click the cell in the account name column and select the appropriate account maybe used once or not at all for a journal entry. So we have, you have a bunch of accounts so you don't have to type it. Enter the corresponding debit and the amount associated column, all amount will automatically run at the nearest dollar. Not all rows in the table might be needed to complete each journal entry. So some journal entries might need two, some might need three. So that's what they're telling you that's what they're giving you three. So they, you know, not to confuse you but to, you know, you might need three, three adjusting entries but there's nothing given to us. I have to look, I have to look into the exhibits now. So I have this exhibit here about the debt restructuring and it's basically an email from the audit manager firm to the senior auditor firm, to the senior auditor. So from the manager to the person that's working on the audit. February 3rd, year eight, which is this is after the year end because we're auditing year seven. Debt restructuring with Compass Bank. So there's a debt restructuring thing. The debt senior auditor. And this is basically, this is how it happens in the real world. This is like a real world example. Griffin has refinanced its credit facility. I reviewed the executed loan agreement dated December 28th, year seven. So they, they, they finished the agreement by the end of the year. The maturity of the loan was extended from September 30th, year eight to December 31st, year 14. The entire 3.4 million balance of the loan was classified as current assets as December 31st, year seven. The loan principle is payable with quarterly installment of 225. The first quarterly payment is due March 8th. Please determine the impact on the December 31st, year seven financial statement. Again, this is a proof. This is a proof of my claim, what I said earlier, taken far before taken audit is very important. Why? Because this topic, what do you need to understand here? I mean, I can see this, I can see this same simulation on a far section exam. What is it testing? It's testing your knowledge about refinancing current maturities, like current maturities of debt. So you have a debt on the books, but the company refinanced the debt. What do you have to do when you refinance the debt? Well, when you refinance the debt, you have to determine the long-term and the short-term component. So let me show you on a picture or on a graph, what am I looking at here? So here's what happened. They had a loan that was due. So the company had a loan. So this is year seven. And on year seven, they have a loan on their balance sheet, 3.4 million, which was a current liability. Now, what happened is few days, few days, few days before the year end, which is December 28th. What they did, they refinanced and they extended this loan. They basically refinanced it. They turned it into, they went from year eight to year 14. So it's no longer current liabilities. It's a long-term liability. That's one thing. That's one thing. And it happened right before year end. So it's definitely the 3.4 should be reclassified. But how do we reclassify it? Now, remember, the loan is 3.4 million, 3.4 million. Now, remember, every long-term debt, this is listed as current liability now. Every long-term debt, if it's long-term, remember the long-term debt will have to be broken into a current and long-term portion. What does that mean? It means this 3.4 million, some of it, it's gonna be current and some of it, it's gonna be long-term because it was refinanced. And what we are told, the agreement is we're gonna pay principle of 225 every quarter. So simply put, we're gonna pay 225, 225, 225, and another 225 in year eight. This is for each quarter. What does that mean? It means we're gonna be making four payments of 225,000. Simply put, that's a total of 900,000. Simply put, of the 3.4 million, 900,000 would be still current liability, which is the whole thing is current liability. And the remainder of 900,000 is current, the remainder of 2.5 million will have to be long-term. What does that mean? It means take out of the current section, okay? Debit current liabilities, 2.5 million and turn it into long-term debt, 2.5 million. This is what we are doing. So we had a loan of 3.4 million, we had a loan of 3.4 million, but it was refinanced because it was refinanced. Now it turned into long-term debt. Remember, every long-term debt has a current portion in the long-term portion, okay? So we go back here and what we need to do, we need to debit current portion of long-term debt, which is we need to reduce current portion of long-term debt, 2.5 million. Why 2.5 million? Because that's gonna be long-term and we are gonna turn it into long-term debt, long-term debt. Sometime it's called long-term debt net of current portion, not net of current portion. That was the AICPL put it long-term debt net of the current portion, but that's fine. And that's gonna be 2.5 million. Once again, this exact simulation, I don't see why not it can be given on the FAR section of the exam. I don't see why not, there's no reason not to. That's why you wanna take FAR before you take audit, okay? So I'm done with this first exhibit. I have audit working paper, so I have other information. Be careful about the date, be careful about everything when you're looking at these exhibits. We have Gryffing, prepared by staff accountant year eight, which is right after year end. Service revenue reviewed by senior auditor two to year eight. And this is as of December 31st, year seven, the information. The ascertain whether service revenue recognized during December year seven is complete and accurate and all material respected in relation to the financial statement taken is also, this is the purpose of this exhibit or of this test. 12th to year seven, we have the customer name, we have the amount, we have a tick mark A, we have the date 12, 4, we have the customer name, we have the amount, we have the tick mark. And notice all these transactions happen in December because there might be some concern with them. So you need to know what the tick mark is, what did they mean by A, what did they mean by C. So let's take a look at the tick mark. Per review of contract invoice and service record, we recalculated the amount of the revenue earned and verify that the revenue was recognized in the correct period. This is what A is. When we have a C tick mark, per review of the contract and service record, service was finalized and invoice as December 31st, year seven, per review of general ledger detail, the receivable balance where it was recorded in the unbuilt receivable at year end, hold on. So here, this $50,000, so after we looked at the contract and service record and the invoice, the receivable was recorded in the unbuilt receivable at year end. Well, hold on a second. If it's a legitimate sale, legitimate receivable, why is it built in the unbuilt receivable? It should be built in the receivable if everything is good. So notice the first thing we notice is tick mark C. We have a problem here. I'm sorry, tick mark, yes, C. No, I'm sorry, tick mark B. I apologize, this was tick mark. Yeah, tick mark B, where's tick mark B? Tick mark B is right here, chestnut. Chestnut. Chestnut, what we're saying about chestnuts, I should have just went through the record first because let's go back to globe. I'm sorry, let's go back to globe. This way we'll go through the customer's globe. Tick mark C, per review of the $50,000 contract and invoice, service was for the period December 15th, year seven, through January 14th, year eight, and should be recognized equally between year seven and year eight based on the contract of the terms. Okay, this is this customer globe. What does that mean? For globe, we have $50,000 of revenue. When we looked at the details of it, based on the tick mark, they're saying, we'll hold on a second. This $50,000, half of it should be counted in 2007 and the other half should be counted in 2008. What does that mean? It means we need an adjusting entry. What does that adjust the entry for? Is to take out out of this revenue, 25,000, take it out out of revenue, okay? Take it out of revenue because we received the money, we have the contract, but we're gonna complete the work, some of it in year seven, some of it in year two, year eight, not year two, the following year. What does that mean? It means debit revenue. We have to reduce revenue. We have to reduce revenue by 25,000 because we have to split the $50,000 revenue between the two and credit some liability. Let's see what liability are we given here. Contract liability, just some sort of unearned revenue of 25,000. What did we do? We backed out of revenue. So this C, this tick mark C, it tells us, look, this $50,000, some of it is earned in year seven, some of it is earned in year eight, okay? Tick mark A, we don't have to worry about tick mark A because they said everything is recognized in the current period. Tick mark B, let's look at tick mark B. Per review of our contract and service record, service was finalized and invoiced as of December 31st, year seven. Per review of the ledger detail, the receivable balance was recorded in the unbuilt receivable at year end. So here's what we did. The 75,000 was properly recorded in the proper period. All the evidence supported a sale. However, it was not recorded in the account receivable. It was recorded in an account called unbuilt service revenue. It should be in the receivable. What does that mean? It means I have to put it in the receivable. Therefore, I have to debit my receivable, I have to debit my receivable, 75,000, and I have to credit it was put in unbuilt revenue, unbuilt receivable, 75,000. So I fixed that error. And I believe those are the three errors. I don't have to keep on going because I only have three journal entries. I identified them and look what the tick mark is. Tick mark means agreed amount to general ledger balance and F means amount foot without exception. Now, why is this simulation? The why would this simulation be challenging for some students? If you work in the real world, if you're an auditor, this would be like a piece of cake. It should not be easy if you are a staff auditor. If you work in tax or if you were never a staff auditor or if you never work in public accounting, this looks a little bit intimidating. Why? Because you don't see those exhibits when you take your college courses. Maybe I go over one or two examples for the whole semester, but students don't look at this. Actually, I do give actually a complete project in my auditing course. So you get familiar with this, but most colleges and universities don't give project that you have to deal with exhibits and audit work papers. So that's why it's challenging. That's one thing. Because it's from the real world, stuff that you will see from the real world, but it's easy concept. Now, the other thing that's challenging about this CPA simulation is most of the questions are from far topics. Do you know how to prepare adjusting entries? That's what they're doing, really. You prepared one, two, those are really adjusting entries. That's all what they are. So that's why far is important to complete before you complete auditing. So hopefully, if this simulation did anything, if you have not set for your exam, complete far before you complete any other section. That's always, that's always my advice. And how can I help you with all this process? How can I help you? Well, I would like to remind you that I have my website. And on my website, I have additional resources for FAR, for audit, for intermediate accounting, auditing courses, so on and so forth, auditing, attestation, intermediate accounting, finance, tax, you name it, all the CPA exam. Go ahead, subscribe, join, solve additional questions. I'm here to help you, use all your resources. You're gonna study for your exam once, do it good. And I'm always here to help. Good luck.