AUDITING AND ATTESTATION (AUD)

SAMPLE QUESTIONS

The following sample questions for the Auditing and Attestation (AUD) section of the CPA Exam have been provided
by Roger CPA Review.
View questions for the other sections of the exam.

QUESTION: Which organization developed the framework most commonly used by the auditing profession for
benchmarking internal controls of non-issuers?

a. The Committee of Sponsoring Organizations of the Treadway Commission

b. The Public Company Accounting Oversight Board

c. The Financial Reporting Council

d. The AICPA

ANSWER: Answer a is correct. In response to high profile cases involving fraudulent financial reporting, a group of
professional organizations and special interest groups involved in accounting formed the Committee of Sponsoring
Organizations of the Treadway Commission, known familiarly as COSO, to determine the causes. The outcome was
the development of a framework that has become the benchmark against which an entitys internal controls are
evaluated. The Public Company Accounting Oversight Board was established to oversee the audits of public
companies. The Financial Reporting Council promotes high quality corporate governance and reports for the United
Kingdom and Ireland. The AICPA, a member of COSO, is a professional organization established to advocate for and
protect the accounting profession.

QUESTION: As specified in Title II of the Sarbanes Oxley Act (SOX), which of the following non-audit services to
audit clients are not prohibited from being performed by a registered public accounting firm if the preapproved by the
audit committee and disclosed to the SEC?

a. Legal services or expert services unrelated to the audit.

b. Human resource services.

c. Internal audit outsourcing services.

d. Tax services.

ANSWER: Answer d is correct. According to SOX Title II, internal audit outsourcing services; management functions,
which include human resource services; and legal services and other expert services unrelated to the audit are all
prohibited. Provided they are preapproved by the audit committee and disclosed to the SEC, a CPA firm may provide
tax services to an audit client.
QUESTION: What is the most likely opportunity for theft or fraud by employees?

a. The belief that the theft is a common practice.

b. Needlessly complex transactions.

c. Access to assets that are easily traced.

d. Stock options that expire soon after the release of financial statements.

ANSWER: Answer (b) is correct. When transactions are complex, many individuals within the entity will not
understand the intricacies and, as a result, it becomes easier to deceive others, creating an opportunity to commit
fraud. Ineffective oversight by governance also creates an opportunity for individuals to commit fraud but does not
provide an incentive. A belief that the theft is a common practice is a rationalization, not an opportunity. Access that
are easily traced tend to result in apprehension and prosecution of the perpetrator of a theft, discouraging such theft.
Stock options are due to expire shortly after financial statements are issued create an incentive to overstate results in
order to increase the value of the options, but it does not provide an opportunity.

QUESTION: As part of its system of internal control, X Company requires that all sales orders received from
customers receive approval from the credit department before they are fulfilled. What type of control activity is this?

a. Physical control

b. Information processing control

c. Performance indicator

d. Segregation of duties

ANSWER: Answer (b) is correct. Requiring that sales orders be approved by the credit department before being
fulfilled is an example of an information processing control since it is designed to prevent certain information from
being processed, in the form of fulfilling a sales order, without adhering to a specific control, obtaining credit approval.
Physical controls are controls that limit the custody of resources to those with authority to have custody. Performance
indicators are benchmarks against which performance can be compared to identify potential problems. Segregation
of duties involves making certain that the same parties are not responsible for two or more of functions involving
authorization, custody of resources, recording of transactions, and reconciling recorded information to physical
assets.

QUESTION: According to professional standards, which of the following circumstances will impair a CPAs
independence?

a. A partner in the CPAs firm who works in another state and does no work for the client has a material indirect
financial interest in the client.

b. The CPA has a car loan with a financial institution client.

c. The CPAs nondependent stepchild has a material indirect financial interest in the client.

d. The client recently exceeded the 90-day limit for outstanding unpaid invoices due to the CPA.
ANSWER: Answer (c) is correct. A CPAs independence is impaired by any direct and any material indirect financial
interest in an attest client. A close relative, such as a nondependent stepchild, may have an immaterial direct financial
interest in a CPAs attest client but a material direct financial interest would impair independence. Independence rules
only apply to covered members, which include those working in the same office as the CPA performing the audit and
those who perform nonattest services for the client. A partner working in a different office and not providing nonattest
services for the attest client would not be a covered member. A CPA may have a car loan with a financial institution
client provided the terms are the same as would apply to other borrowers and the loan is not material to the CPA, the
way a home loan is likely to be. Independence would be impaired if audit fees are not paid within one year, but there
is no 90 day requirement.

QUESTION: According to Title II of the Sarbanes Oxley Act (SOX) of 2002, which of the following nonaudit services is
not prohibited from being performed for an audit client by a registered public accounting firm?

a. Bookkeeping services.

b. Appraisal or valuation services.

c. Internal audit services

d. Tax services.

ANSWER: Answer (d) is correct. With very few exceptions, Title II of Sarbanes-Oxley prohibits a registered public
accounting firm from performing any nonattest services for an attest client. One of the few exceptions is work related
to tax compliance, which may be performed if it is disclosed to the SEC and is pre-approved by the clients audit
committee after it determines that performing such services would not impair the accountants independence.

QUESTION: Which of the following assertions applies to an audit of inventory?

a. Occurrence

b. Classification

c. Cutoff

d. Completeness

ANSWER: Answer (d) is correct. Completeness is an assertion that applies to both classes of events and
transactions as well as to account balances. Assertions related to inventory, which represents an account balance,
include rights and obligations, allocation and valuation, existence, and completeness. Occurrence, classification, and
cutoff are assertions that relate to classes of events and transactions but not to account balances.

QUESTION: Audit documentation should enable an experienced auditor without direct knowledge about the client to
understand the procedures performed, the evidence obtained, and the conclusions reached by the auditor. Audit
documentation should include:

Audit Programs Documentation of Control Risk Client Representation Letter

 a. Yes Yes Yes

b. Yes No Yes

c. Yes Yes No

d. No Yes Yes

ANSWER: Answer (a) is correct. Audit programs provide documentation of procedures performed, documentation of
control risk provides information about conclusions drawn, and the client representation letter, which professional
standards require the auditor to obtain, provides information about the evidence obtained. All would be included in
audit documentation.

QUESTION: Which of the following would be considered corroborative evidence?

a. Checks, invoices, and contracts.

b. General and subsidiary ledgers.

c. Minutes from meetings of the board of directors.

d. Worksheets and spreadsheets supporting cost allocations.

ANSWER: Answer (c) is correct. Corroborative evidence, which supports the information derived from the accounting
records, includes minutes, confirmations, data about competitors, and information obtained by the auditor through
inquiry, observation, and inspection of documents. Checks, invoices, and contracts; general and subsidiary ledgers;
worksheets and spreadsheets supporting cost allocations, and computations, reconciliations and disclosures make
up the accounting records.

QUESTION: An auditor discovers several immaterial errors that the auditor determines do not, individually or in the
aggregate, cause the financial statements to be materially misstated. The auditor proposes adjusting entries to the
client, who refuses to correct the errors. Which of the following best summarizes the steps the auditor should take?

a. Document the errors and the conclusion that the financial statements are free from material misstatement.

b. Withdraw from the engagement because the clients refusal to correct the errors is a scope limitation.

c. Issue a qualified, except for opinion on the financial statements because the client refuses to correct the
errors.

d. Correct the errors on the clients behalf, and then issue the audit report.

ANSWER: Answer (c) is correct. There are a number of reasons a client may not wish to record adjustments, such as
when they had previously released preliminary financial information. When detected misstatements are not material,
either individually or in the aggregate, the auditor would not be precluded from issuing an unmodified report with an
unqualified opinion. Withdrawal would not be appropriate. The auditor would be required to document the errors and
the conclusion. The client, not the auditor, is responsible for the reporting entitys books and records and for recording
adjusting entries.

QUESTION: Which of the following financial ratios would be most useful to an auditor seeking information on a
companys ability to cover current obligations?

a. Earnings per share

b. Quick ratio

c. Gross profit margin

d. Sales to assets

ANSWER: Answer (b) is correct. The quick ratio, which is the ratio of current liquid assets to total current liabilities
provides information about the resources that are immediately available to cover current obligations. Earnings per
share provides information about the amount of net income earned per share. The gross profit margin indicates how
much sales generate toward covering expenses and profit. The ratio of sales to assets, the asset turnover ratio,
shows how efficiently assets are used to generate sales. None of these, with the exception of the quick ratio, provides
information about liquidity.

QUESTION: In a probability-proportional-to-size (PPS) sample with a sampling interval of $10,000, an auditor

discovered that a selected account receivable with a recorded amount of $12,000 had an audited amount of $11,000.
If this were the only misstatement discovered by the auditor, the projected misstatement of this sample would be

a. $1,000

b. $833

c. $960

d. $10,000

ANSWER: Answer (a) is correct. Under PPS sampling, an interval is determined by dividing the total value of the
population by the sample size. When an item is selected from an interval that has a value lower than the interval
amount, any error is measured as a percentage of the items value and that percentage is applied to the interval,
resulting in a larger error measurement. When the item has a value that is equal to or greater than the interval
amount, any error identified is assumed to be the projected misstatement without adjustment. With an interval of
$10,000 and a sample item with a greater recorded amount of $12,000, a $1,000 error would be considered the
projected misstatement.

QUESTION: X Company prepares a sales invoice, using a pre-printed sequentially numbered form, upon receipt of a
copy of a bill of lading from the shipping department indicating that goods have been shipped. An auditor wishes to
obtain evidence that all sales that that were recorded during the period actually occurred. Which of the following
procedures would likely be most effective for that purpose?

a. Trace entries from the sales journal to sales invoices and bills of lading.
 b. Trace a sample of receiving reports to the sales journal.

c. Trace a sample of sales invoices to bills of lading.

d. Trace a sample of bills of lading to the sales journal.

ANSWER: Answer (a) is correct. To obtain evidence as to the occurrence assertion, an auditor would trace a sample
from the accounting records to source documents to determine if each entry recorded is supported by evidence that a
sale occurred. This would be accomplished by tracing entries from the sales journal to source documents. Receiving
reports would relate to purchases, not sales. Tracing sales invoices to bills of lading would provide evidence that
those transactions for which sales invoices were prepared actually occurred, but would not indicate if all recorded
transactions actually occurred. Tracing a sample of bills of lading to the sales journal would provide evidence about
completeness, not occurrence.

QUESTION: An opportunity for fraud involving lapping of accounts receivable is more likely when which two duties
involving accounts receivable are not segregated?

a. Authorization and reconciliation.

b. Receipt of returned goods and recording.

c. Opening the mail and recording.

d. Recording and reconciliation.

ANSWER: Answer (c) is correct. Lapping occurs when receipts are misappropriated, resulting in the overstatement of
one customers account. Subsequent collections are applied to the overstated account, moving the overstatement to
another account, with the action repeated such that the overstatement moves from one customers account to
another. To accomplish a lapping scheme, the same party would need access to the cash receipts in order to
misappropriate them, such as when the person is responsible for opening the mail, and the ability to affect the
recording of cash receipts so that subsequent receipts will be applied to the desired accounts. Being responsible for
authorization and reconciliation would enable a party to authorize a transaction and then, for example, write-off the
receivable as a result of a collusive relationship with the other party. The same would be true of someone responsible
for recording and reconciliation. Responsibility for receipt of returned goods and recording would enable a party to
misappropriate goods as they are returned without recording the return in the accounting records.

QUESTION: King Corporation often transfers funds from its general account into a special account that is used
exclusively to make debt payments. Near the end of the year, the company had the following transfers:

From General Account To Special Account

Amount Recorded in Books Recorded by Bank Recorded in Books Recorded by Bank

$35,000 12/29/13 1/2/14 12/31/13 12/31/13

$20,000 12/30/13 12/31/13 1/2/14 1/2/14

 $30,000 12/31/13 1/2/14 12/31/13 1/2/14

$40,000 1/2/14 1/4/14 12/31/13 1/3/14

Given the information above, choose the correct statement about Kings cash balance:

a. Cash is fairly stated.

b. Cash is overstated by $15,000.

c. Cash is overstated by $40,000.

d. Cash is overstated by $20,000.

ANSWER: Answer (d) is correct. The transfers made from the general account on 12/29/13 and 12/31/13 were
recorded by both the general account and the special account in 2013. The $20,000 transfer on 12/30/13 was
deducted from the general account in 2013, but was not added to the special account until 2014, resulting in an
understatement of $20,000. The $40,000 transfer on 1/2/14, however, was deducted from the general account in
2014, but was added to the special account in 2013, resulting in an overstatement of $40,000. As a result, cash is
overstated by the net amount of $20,000.

QUESTION: In testing managements rights and obligations assertion in relation to inventories, which of the following
procedures would the auditor most likely consider most reliable?

a. Review consignment agreements.

b. Vouch inventory counts to accounting records.

c. Trace inventory in accounting records to inventory counts.

d. Make inquiries and analyze inventory turnover to identify slow-moving or obsolete items.

ANSWER: Answer (a) is correct. Reviewing consignment agreements will provide the auditor with evidence as to
which inventory is owned and which is held on consignment, providing evidence relative to the clients rights to the
inventory. Vouching counts to accounting records will provide evidence about the completeness of the accounting
records as the test is designed to determine if all inventory is included in the reported amount. Tracing items in the
accounting records to counts will provide evidence that reported items exist. Identifying slow-moving and obsolete
inventory will provide evidence that supports the valuation of inventory.

QUESTION: An auditor observes new equipment while walking around a clients factory and vouches the new
equipment to schedules of property, plant, and equipment that support the information in the financial statements.
Which assertion is supported by the evidence obtained?

a. Existence.

b. Rights and obligations

c. Completeness
 d. Valuation and allocation

ANSWER: Answer (c) is correct. Vouching equipment that has been observed by the auditor to its inclusion in the
accounting records provides the auditor with evidence that the accounting records are complete and include all
equipment that the entity has. To support existence, the auditor will trace items from the records to observations. To
support rights and obligations, the auditor may look at purchase documents and insurance policies. To support
valuation and allocation, the auditor will likely look at purchase documents.

QUESTION: An auditor is recalculating depreciation on real property acquired during the year. Which of the following
documents will provide the most relevant information regarding a propertys depreciable base?

a. Deed

b. Bank confirmation of mortgage loan

c. Closing statement

d. Flood insurance policy

ANSWER: Answer (c) is correct. An assets depreciable basis is its cost less its salvage value. To calculate, or
recalculate, depreciation on an asset, the cost is necessary, which can be derived from the closing statement, which
is the document used in real estate and many other transactions to summarize the amounts or items being
exchanged between the parties, obligations being created or assumed, and costs being incurred that directly relate to
the transaction. A deed is a document of ownership but does not provide information about cost or salvage value. A
flood insurance policy provides evidence of ownership but not as to cost or salvage value.

QUESTION: An auditor is seeking evidence in an examination of bonds payable. Which of the following procedures
would the auditor likely perform?

a. Send confirmations to bondholders.

b. Trace assets purchased with bond proceeds to documentation for evidence of liens.

c. Evaluate reasonableness of interest expense in relation to bonds payable balances.

d. Perform analytical procedures relative to bond discount or premium.

ANSWER: Answer (c) is correct. By comparing interest expense to bonds payable balances, the auditor can
determine if interest is reasonable and investigate circumstances where it seems too low or high. The auditor would
not send confirmations to individual bondholders since bonds are easily transferrable. How bond proceeds are used
is not relevant to the audit of bonds payable. Since bond discount or premium is the difference between proceeds and
the face amount of the bond, the auditor will test the discount or premium by reviewing documentation related to the
bond issuance and recalculating amortization, as opposed to performing analytical procedures.

QUESTION: Identify the correct statement regarding analytical procedures used in a review conducted at the
conclusion of an audit.

a. The ultimate purpose of analytical procedures used in a review conducted at the conclusion of the audit is to
uncover fraud schemes that may have been missed previously during the audit.
 b. Typically, a junior member of the engagement team will perform the analytical procedures applied at the
conclusion of the audit because less precision is required.

c. If review analytical procedures suggest the presence of misstated account balances, the auditor may have
to perform additional substantive tests of details to satisfactorily complete the audit.

d. Analytical procedures used in the review near the conclusion of the audit are not required.

ANSWER: Answer (c) is correct. An auditor is required to perform analytical procedures near the end of an audit as
part of an overall review and are generally performed by a senior member of the audit engagement team. They are
performed after the auditor has already obtained sufficient appropriate audit evidence to support the information the
financial statements and are designed to assist the auditor in drawing an overall conclusion regarding the financial
statements. When the results of the procedures indicate that the financial statements may not be fairly presented, the
auditor may find it necessary to perform additional audit procedures.

QUESTION: Watt, CPA, concludes that, while ABC Co. has properly accounted for and disclosed certain significant
related party transactions, an emphasis-of-matter paragraph calling attention to these transactions should be added
after Watts opinion paragraph in the audit report. What should be included in the emphasis-of-matter paragraph?

a. A clear reference to the transactions and an indication that Watts audit opinion is not modified in light of
these transactions.

b. A detailed description of the transactions, a clear reference to the transactions, and an indication that Watts
audit opinion is not modified in light of these transactions.

c. A detailed description of the transactions and a clear reference to the transactions.

d. A detailed description of the transactions.

ANSWER: Answer (a) is correct. An emphasis-of-matter paragraph is used to draw attention to something that is
properly accounted for and disclosed in the financial statements. It is not necessary to repeat the details but rather to
clearly refer to the item and where it is presented and disclosed. In addition, since the item was properly accounted
for and disclosed, the auditor will make it clear that the opinion is not modified.

QUESTION: In a situation where there is a justified departure from a promulgated accounting principle that is
adequately disclosed, how will the auditor modify the standard report?

a. By modifying the Auditors Responsibility paragraph.

b. By adding an other-matter paragraph after the opinion paragraph.

c. By adding an emphasis-of-matter paragraph after the opinion paragraph.

d. By modifying the Managements Responsibility paragraph.

ANSWER: Answer (c) is correct. When a departure from a promulgated accounting principle is justified because
following the principle would result in misleading financial statements, the financial statements would be considered
fairly stated and the auditor would issue an unmodified opinion. The auditor will, however, draw attention to the
departure by including an emphasis-of-matter paragraph. Neither the auditors responsibilities nor managements
responsibilities are affected and neither paragraph would be modified. An other-matter paragraph is used to provide
information that is not required to be reported or disclosed in the financial statements that will enhance users
understandings of the audit or the audit report, not to draw attention to an item that is properly accounted for and
disclosed.

QUESTION: An auditor determines that, due to accounting errors, both a companys expenses and revenues are
materially understated, each by approximately the same amount. What is the auditors most likely course of action in
response to these findings?

a. Document these findings but take no further action because net income will still be correct.

b. Suggest adjusting entries to correct the understated expenses only.

c. Suggest adjusting entries to correct both the understated expenses and understated revenues.

d. Report the possible fraud scheme to the audit committee.

ANSWER: Answer (c) is correct. In drawing conclusions as to whether financial statements are fairly presented, the
auditor will consider known misstatements both individually and in the aggregate. The financial statements would be
considered materially misstated if a users judgment would be affected, whether the misstatement affected a
particular item or the entitys financial position or results of operations as a whole. As a result, the auditor will propose
adjustments to both revenues and expenses regardless of the fact that net income is not materially misstated. A
material misstatement may result from error or fraud and the auditor would only report such a misstatement to the
audit committee as a fraud scheme if there was reason to believe that it was a fraudulent misstatement.

QUESTION: Which procedure is an accountant not required to perform in an engagement to review the financial
statements of a client for which the accountant does not perform audits?

a. Testing small samples of transactions to ensure proper segregation of duties.

b. Inquiring of management who have responsibility for financial and accounting matters about their knowledge
of any fraud or suspected fraud affecting the entity.

c. Obtaining evidence that the interim financial information agrees or reconciles with the accounting records.

d. Obtaining a management representation letter.

ANSWER: Answer (a) is correct. When engaged to perform a review of the financial statements of a nonaudit client,
an accountant performs the same procedures as would be applied to annual financial statements. These include
reconciling the interim financial information to the accounting records and inquiring of management about their
knowledge of any fraud or suspected fraud affecting the entity. Consideration of internal control is required in a review
of the interim financial statements of an audit client and samples of transactions are only required during audits when
the auditor intends to rely on controls. An accountant must obtain a management representation letter before issuing
a review report.

FINANCIAL ACCOUNTING AND

REPORTING (FAR) SAMPLE QUESTIONS

The following sample questions for the Financial Accounting and Reporting (FAR) of the CPA Exam have been
provided by Roger CPA Review.
View questions for the other sections of the exam.

QUESTION: Consistency and feedback relate most closely to which two of the following accounting concepts,
respectively?

a. Predictive value and confirmatory value

b. Recognition and full disclosure

c. Conservatism and cost/benefit

d. Recognition and matching

ANSWER: Answer (a) is correct. Consistency is associated with predictive value since, when items are accounted for
consistently from one year to another, users can identify trends and use this information to anticipate what might be
expected to occur in the future. Feedback is associated with confirmatory value as feedback, such as actual results,
provides information as to the degree to which predictions made in the past were accurate. Recognition relates to
when items will appear on financial statements and full disclosure relates to the completeness of information
provided. Cost/benefit refers to the fact that an entity should not incur a cost to obtain or provide information which
exceeds the benefit of having that information.

QUESTION: Catastrophe Corp. has determined it is not a going concern, and will likely go bankrupt. Which basis of
accounting will Catastrophe adopt?

a. Tax basis

b. Remain with GAAP

c. Cash basis

d. Liquidation basis

ANSWER: Answer (d) is correct. When an entity has determined that it is not a going concern, which means that
there is substantial doubt that it will be able to meet its obligations as they become due for at least one year from the
date on which they issue their financial statements. Only when liquidation is imminent, which means the entity has
adopted a plan of liquidation or one is being imposed on it, will it switch to the liquidation basis of accounting.
Whether or not an entity is a going concern is not a factor as to whether or not it will apply the tax or cash basis of
accounting.

QUESTION: Under U.S. GAAP, which of the following would be included in accumulated other comprehensive
income as a component of stockholders equity on the balance sheet? Assume no fair value election for reporting
investments.

I. Unrealized fair value gains or losses on held-to-maturity investments

II. Foreign currency translation adjustments

 III. Certain gains and losses on derivative financial instruments designated as fair value hedges.

a. III only.

b. I and III only.

c. II only.

d. I, II, and III.

ANSWER: Answer (c) is correct. Items reported in other comprehensive income and reported in the aggregate in
accumulated other comprehensive income, a component of stockholders equity, include unrealized gains and losses
on available for sale securities, adjustments to a pension asset or liability resulting from the difference between the
projected benefit obligation and the fair value of plan assets, translation adjustments resulting from the consolidation
of foreign subsidiaries, and changes in the value of derivatives designated as cash flow hedges. Held to maturity
securities are reported at amortized cost, not fair value, and unrealized gains and losses are not recognized.
Changes in the value of fair value hedges are reported in income, not other comprehensive income.

QUESTION: A company reports the following information as of December 31:

Sales revenue $350,000

Cost of goods sold $150,000

Operating expenses $110,000

Foreign currency translation gain $ 25,000

Ignoring income taxes, what amount should the company report as comprehensive income as of December 31?

a. $90,000

b. $125,000

c. $150,000

d. $115,000

ANSWER: Answer (d) is correct. Comprehensive income includes net income plus other comprehensive income
(OCI); or all changes in equity during a period except those resulting from investments by owners and distributions to
owners. The companys net income includes sales revenues of $350,000 minus costs of goods sold of $150,000
minus operating expenses of $110,000, for a net amount of $90,000. Other comprehensive income (OCI) includes the
foreign currency translation gain of $25,000. Therefore, comprehensive income equals $115,000 ($90,000 +
$25,000).
QUESTION: When applying the revenue test to determine if a segment is a reportable segment, the segments
revenues are compared to the total for the entity. Which of the following revenue items should be included in the
revenue calculation?

I. Sales to unaffiliated customers

II. Interest earned from loans to other segments

III. Intersegment sales of products

a. I, II, and III

b. I and III only

c. I and II only

d. I only

ANSWER: Answer (b) is correct. In evaluating whether or not a business segment is a reportable segment, an entity
will compare the segments revenues to total revenues of all segments. Revenues include sales to unaffiliated
customers and to other segments. It does not, however, include interest earned, which is a form of other income but
not revenues.

QUESTION: Capsule Corp. reported the following in 2014:

Beginning retained earnings $260,000

Ending retained earnings $290,000

Cash dividends declared $90,000

Beginning accumulated other comprehensive income $20,000

Ending accumulated other comprehensive income $15,000

What was Capstones comprehensive income for 2014?

a. $125,000

b. $55,000

c. $115,000

d. $65,000
ANSWER: Answer (c) is correct. Comprehensive income is equal to net income plus other comprehensive income
(OCI). Ending retained earnings of $290,000 consists of beginning retained earnings of $260,000 plus net income
and minus dividends of $90,000. Beginning retained earnings reduced by dividends gives a balance of $170,000,
requiring net income of $120,000 to give an ending balance of $290,000. Ending accumulated other comprehensive
(AOCI) of $115,000 equals beginning AOCI of $120,000 plus OCI. As a result, OCI is equal to the reduction in AOCI
of $5,000 and comprehensive income is $120,000 - $5,000 or $115,000.

QUESTION: Misk, Inc. received from a customer a one year, $750,000 note bearing annual interest of 9%. After
holding the note for six months, Misk discounted the note at National Bank at an effective interest rate of 12%. What
amount of cash did Mick receive from the bank?

a. $700,950

b. $719,400

c. $780,713

d. $768,450

ANSWER: Answer (d) is correct. Misk will first calculate the maturity value of the note, which will be the face value of
$750,000 plus one years interest at 9% or $67,500. Since the note is being discounted after 6 months, the bank will
receive $817,500 after six months. The discount will be $817,500 X 12% X 6/12 or $49,050. As a result, Misk will
receive $817,500 - $49,050 or $768,450 from the bank.

QUESTION: When the allowance method of recognizing uncollectible accounts is used, which of the following
statements is true regarding the impact a collection of an account previously written off would have on Accounts
Receivable and Allowance for Doubtful Accounts balances?

a. Accounts Receivable would not change and Allowance for Doubtful Accounts would decrease.

b. Accounts Receivable would not change and Allowance for Doubtful Accounts would increase.

c. Accounts Receivable would increase and Allowance for Doubtful Accounts would decrease.

d. Accounts Receivable would increase and Allowance for Doubtful Accounts would not change.

ANSWER: Answer (b) is correct. The recovery of a receivable that was previously written off is recognized by first
reversing the entry to write it off with an increase to the allowance account and an increase in Accounts Receivable.
The collection is recorded with an increase in Cash and a decrease to Accounts Receivable. The net effect is an
increase in the allowance account and an increase in Cash with no change to Accounts Receivable.

QUESTION: Which of the following inventory valuation methods produce(s) the same dollar amount as the balance in
ending inventory under both periodic and perpetual inventory systems?

FIFO LIFO
 a. Yes Yes

b. No Yes

c. Yes No

d. No No

ANSWER: Answer (c) is correct. Since FIFO assumes that ending inventory consists of the most recent purchases,
the FIFO cost flow assumption leads to the same ending inventory balance under both the perpetual and periodic
systems. Under the LIFO cost flow assumption, the most recent goods purchased are assumed to be sold while older
inventory is assumed to remain on hand. When using the periodic method under LIFO, it is assumed that all sales
occur at the end of the period and are taken from the latest purchases. Since goods cannot be sold before they are
purchased, the perpetual method will require that early sales be charged against the most recent purchases as of the
date of sale and will lead to a different ending inventory balance.

QUESTION: West Co. recorded the following inventory information during the month of February:

Units Unit Cost Total Cost Units on Hand

Balance on 2/1 800 $2 $1,600 800

Purchased on 2/8 1,000 $3 $3,000 1,800

Sold on 2/14 1,500 300

Purchased on 2/17 2,000 $1 $2,000 2,300

Sold on 2/23 1,600 700

Purchased on 2/28 800 $4 $3,200 1,500

West uses the LIFO method to cost inventory. What amount should West report as inventory at the end of February
under each of the following methods of recording inventory?

a. Perpetual: $3,700, Periodic: $4,200

 b. Perpetual: $4,200, Periodic: $3,700

c. Perpetual: $3,700, Periodic: $3,700

d. Perpetual: $4,200, Periodic: $4,200

ANSWER: Answer (b) is correct. Under the perpetual method, purchases and sales are recognized as they occur. As
a result, the sale of 1,500 units on 2/14 would consist of the 1,000 units purchased on 2/8 and 500 of those in
beginning inventory, leaving 300 from beginning inventory. The 1,600 units sold on 2/23 all would have come from the
2,000 purchased on 2/17, leaving 400 of those unites in ending inventory. As a result, ending inventory would consist
of 300 from beginning inventory at $2, or $600, 400 from the purchase on 2/17 at $1, or $400, and the 800 purchased
on 2/28 at $4, or $3,200 for a total of $4,200. Under the periodic method, it is assumed that all sales occurred at the
end of the period. As a result, the total sales of 3,100 units would have included the 800 purchased on 2/28, the 2,000
purchased on 2/17, and 300 of those purchased on 2/8. Ending inventory would consist of the 800 units in beginning
inventory at $2 per unit, or $1,600, and the 700 remaining from the purchase on 2/8 at $3 per unit, or $2,100, for a
total of $3,700.

QUESTION: Pair Co. sells one product and uses the last-in, first-out (LIFO) method to determine inventory cost.
Information for the month of January 2014 follows:

Units Unit Cost

Beginning inventory, 1/1/14 3,000 $4.70

Purchases, 3/4/14 8,000 $3.90

Sales 7,500

Pair has determined that at January 31, 20X4, the replacement cost of its inventory was $4 per unit and the net
realizable value was $4.90 per unit. Pairs normal profit margin is $1 per unit. Pair applies the lower of cost of or
market rule to total inventory and records any resulting loss. At January 31, 20X4, what should be the net carrying
amount of Pairs inventory?

a. $16,050

b. $13,650

c. $14,000

d. $17,050

ANSWER: Answer (c) is correct. Under LIFO, it is assumed that the 7,500 units sold were all from the purchases on
3/4/14, leaving ending inventory of 3,000 units from beginning inventory, at a cost of $4.70 each or $14,100, and 500
units remaining from the purchase of 3/4 at $3.90 each or $1,950, for a total cost of $16,050. Market is replacement
cost of $4 per unit since it is between the ceiling, the net realizable value of $4.90, and the floor, the net realizable
value minus a normal profit, or $3.90. At $4 per unit, total market is $14,000, which will be the carrying amount of
inventory.
QUESTION: Canterbury Co. issues a discounted, non-interest-bearing note in exchange for borrowed funds. Choose
whether the cash received will be higher or lower than the face value of the note, and whether the effective annual
interest rate will be higher or lower than the discount rate:

Cash Received vs. Face Value of Note Effective Rate vs. Discount Rate

a. Higher Lower

b. Lower Higher

c. Higher Lower

d. Lower Higher

ANSWER: Answer (b) is correct. When a note is discounted, the issuer will receive the maturity value, which will be
the face amount when the note is noninterest bearing, reduced by the discount. As a result, cash received will be
lower than the face value of the note. The amount of the discount will be the discount rate multiplied by the maturity
value and adjusted for the length of time until the note matures. Upon repayment, the effective rate paid will be higher
than the discount rate. A $1,000 noninterest bearing note, for example, maturing in one year that is discounted at
10% will result in cash received of $1,000 - $100 or $900. At maturity, the borrower remits the $1,000 to the lender,
which is repayment of the $900 received plus the $100 discount. A cost of $100 to borrow $900 for one year would
indicate an effective rate in excess of 11%, higher than the 10% discount rate.

QUESTION: Candy Co. exchanged inventory with Dandy Co. in a transaction that lacks commercial substance. Both
Candys and Dandys inventory had fair values that exceeded their costs by 30%. Since Dandys inventory was more
valuable, however, Candy paid Dandy cash to compensate for the difference. Who, if anyone, will recognize a gain on
the exchange?

a. Candy only

b. Dandy only

c. Both Candy and Dandy

d. Neither Candy nor Dandy

ANSWER: Answer (b) is correct. In an exchange that lacks commercial substance involving like and unlike assets,
such as cash, only the party receiving the unlike assets will recognize a gain. Since Candy paid cash to Dandy to
compensate for a difference in the values of the inventory exchanged, only Dandy will recognize a gain on the
exchange.
QUESTION: Which of the following statements is correct regarding donated assets?

a. Donated assets are not recorded on a companys balance sheet if the donor requests that the gift remain
anonymous.

b. Donated assets are recorded at historical cost on a companys balance sheet.

c. Under GAAP the donation of an asset will result in a credit to either revenue or gain.

d. Under GAAP no gain can be recorded on a donated asset until and unless it is sold to a third party.

ANSWER: Answer (c) is correct. When assets are received in a nonreciprocal transfer, under which neither equity
nor other assets are exchanged, the entity will recognize the assets at their fair values and recognize the total fair
value of assets received as a form of nonoperating income.

QUESTION: X Company purchased a patent on January 3, 20X4 from Y Company for $145,000. An attorney drew up
the contract between X & Y at a total cost of $15,000, which was split equally by the parties. The patent had a
carrying value of $90,000 on Ys books. X expects to be able to benefit from the patent for 10 years, after which it is
expected to be of little to no value.
What will be the carrying value of the patent on X Companys December 31, 20X5 balance sheet?

a. $160,000

b. $152,500

c. $128,000

d. $122,000

ANSWER: Answer (d) is correct. X Company will recognize the patent at its cost of $145,000 plus of the attorneys
fee of $15,000, or $7,500, for a total of $152,500. It will be amortized over the expected useful life of 10 years at the
rate of $15,250 per year. As of December 31, 20X5, after X held the patent for 2 years, accumulated amortization will
be $15,250 x 2 or $30,500 and the carrying value of the patent will be $152,500 - $30,500 or $122,000.

QUESTION: A company reacquired some of its own stock to be held as treasury stock and used for its employees
401K plan. In their statement of cash flows how would this cash outflow be reported?

a. Under operating activities.

b. Either under operating activities or financing activities.

c. Under financing activities.

d. Either under investing activities or financing activities.

ANSWER: Answer (c) is correct. When a company reacquires its own stock it is consider treasury stock and is
reported under financing activities on the statement of cash flows.
QUESTION: Very early in 20X3, while developing software for sale to others, after achieving technological feasibility
but before the commencement of commercial production, X Company incurred $320,000 to produce product masters
and to test the software. X Company estimated that the software will be sold for a total of 10 years. After nearly a full
year of selling, X had revenues from software sales of $120,000 in 20X3. Sales in future periods are expected to
amount to $680,000. Costs associated with producing and packaging the software approximate 10% of revenues.
What portion, if any, of the $320,000 will be recognized in income in 20X3?

a. $48,000

b. $32,000

c. $0

d. $320,000

ANSWER: Answer (a) is correct. Costs incurred after reaching technological feasibility but before commercial
production, such as the production of product masters, are capitalized and amortized. The amount of amortization will
be the greater amount when calculated under both the straight-line method and the volume of output approach.
Under straight-line, amortization will be 10% of $320,000 or $32,000. Under the volume of output approach the ratio
of current sales, $120,000, to the total of current and estimated future sales, $120,000 + $680,000 or $800,000, is
multiplied by the $320,000 carrying value of the amortizable costs to determine amortization of , $120,000/$800,000 x
$320,000 = $48,000. Since it is larger, $48,000 will be the amount of amortization in 20X3. In addition, X will
determine if the carrying value of the software exceeds its net realizable value from future sales. Future sales are
expected to be $680,000. With costs of only 10% or $68,000, the remaining $612,000 exceeds the carrying value of
the software indicating no need for further amortization.

QUESTION: At year end, Mayce Co. held investments with the intent of selling them in the near term. The
investments consisted of $300,000, 9%, seven-year bonds, purchased for $278,000, and equity securities purchased
for $75,000. At year end, the bonds were selling on the open market for $320,000 and the equity securities had a
market value of $90,000. What amount should Mayce report as trading securities in its year-end balance sheet?

a. $410,000

b. $395,000

c. $390,000

d. $373,000

ANSWER: Answer (a) is correct. Investments in trading securities are reported at their fair values as of the balance
sheet date. Since Mayce intends to sell both the bonds and the equity securities in the near term, both are trading
securities and the amount at which they will be reported on the balance sheet is their fair values of $320,000 and
$90,000 for total of $410,000.

QUESTION: OK Co. uses the equity method to account for its January 1, 20X4 purchase of FDL Inc.s common
stock. On January 1, 20X4, the fair values of FDLs FIFO inventory and plant exceeded their carrying amounts. How
do these excesses of fair values over carrying amounts affect OKs reported equity in FDLs 20X4 earnings?

Inventory excess Plant excess

 a. Decrease Decrease

b. Decrease No effect

c. Increase Increase

d. Increase No effect

ANSWER: Answer (a) is correct. Under the equity method, the investor adjusts the portion of the investees income
recognized to account for differences between the book values of the investees assets and liabilities and their fair
values. Under FIFO, it is assumed that inventory on hand is sold first and, if the fair value is greater than the carrying
value, the difference increases cost of sales, decreasing the investees income. Likewise, if the fair value of plant
assets is greater than the carrying value, the difference will be allocated over the assets depreciable life, increasing
depreciation expense and further reducing the investees income. The investor will then recognize a proportionate
amount of the investees adjusted income.

QUESTION: Identify the correct statement(s) regarding stock warrants:

I. Additional paid-in capital is credited when a company issues warrants to existing shareholders to purchase
unissued stock at a given exercise price.

II. A companys net income decreases upon the exercise of stock warrants issued to shareholders.

III. The expiration of stock warrants has no effect on equity accounts.

a. I and II only.

b. III only.

c. I and III only.

d. I only.

ANSWER: Answer (b) is correct. When stock warrants are issued, such as when bonds are issued with detachable
stock purchase warrants, any proceeds allocated to them is recorded in additional paid-in capital. If issued to existing
shareholders, however, there are no proceeds and additional paid-in capital is not affected. If the warrants are
exercised, the proceeds will be recorded in common stock and additional paid-in capital, with no effect on income. If
they expire without being exercised, however, no entry is made.

QUESTION: For the year ended December 31, 2015, Pering Co. reported pretax financial income of $550,000. Its
current tax expense was $144,000. Pering reported a difference between pretax financial statement income and
taxable income. This difference is due to accelerated depreciation for income tax purposes. Perings effective income
tax rate is 30% and Pering made estimated tax payments during 2015 of $75,000. What amount did Paring report as
taxable income for 2015?
 a. 405,000

b. 480,000

c. 475,000

d. 550,000

ANSWER: Answer (b) is correct. Current tax expense is calculated by multiplying taxable income by the tax rate.
Therefore, taxable income is calculated by dividing current tax expense of $144,000 by the tax rate of 30%. Taxable
income for 2015 is $480,000.

QUESTION: On December 31, 2016, Blue Co. leased a new machine from Green Co. with the following pertinent
information:

Lease term 5 years

Annual rental payable at beginning of each year $55,000

Useful life of machine 7 years

Blues incremental borrowing rate 12%

Implicit interest rate in lease (known by Blue) 10%

Present value of annuity of $1 in advance for 5 periods at

10% 4.17

12% 4.04

There is no bargain purchase option but title transfers to Blue Co. at the end of the lease. The cost of the machine on
Greens accounting records is $294,500. At the beginning of the lease term, Blue Co. should record a lease liability of

a. $294,500

b. $222,200

c. $229,350

d. $0
ANSWER: Answer (c) is correct. Since title will transfer to the lessee at the end of the lease this is a capital lease. A
lease obligation will be recognized in an amount equal to the present value of the minimum lease payments using the
rate implicit in the lease since it is known to the lessee and lower than the lessees incremental borrowing rate. As a
result, the lease obligation will be $55,000 x 4.17 or $229,350.

QUESTION: Green Co. had net cash provided by operating activities of $209,000; net cash used by investing
activities of $354,000; and cash provided by financing activities of $190,000. Greens cash balance was $36,500 on
January 1. During the year, there was a sale of equipment that resulted in a gain of $7,200 and proceeds of $55,000
were received from the sale. What was Greens cash balance at the end of the year?

a. $45,000

b. $55,000

c. $81,500

d. $88,700

ANSWER: Answer (c) is correct. Since cash provided by operating activities is $209,000, cash used by investing
activities is $354,000, and cash provided by financing activities is $190,000, the net increase in cash for the period is
$209,000 - $354,000 + $190,000 or $45,000. This is added to the beginning cash balance of $36,500 to give an
ending cash balance of $81,500. The proceeds from the sale of equipment would already be included in cash flows
from investing activities and the gain on sale would have been eliminated in measuring cash flows from operating
activities.

REGULATION (REG) SAMPLE

QUESTIONS

The following are actual retired questions from the Regulation (REG) section of the CPA Exam.
The answers are provided by Roger CPA Review.
View questions for the other sections of the exam.

QUESTION: In Year 1, Gardner used funds earmarked for use in Gardners business to make a personal loan to
Carson. In Year 3, Carson declared bankruptcy, having paid off only $500 of the loan at that time. In Year 1, Gardner
purchased equipment for use in Gardners business. In Year 3, Gardner sold the equipment at a $5,000 loss. In
January of Year 3, Gardner received shares of stock as a gift from Smith; the shares had been purchased by Smith in
Year 1. In November of Year 3, Gardner sold the property for a $5,000 gain.
Which of the above transactions will Gardner report as a long-term capital gain or loss for Year 3?

i. The bad debt write-off

ii. The sale of equipment

iii. The sale of shares

A. II and III only.

 B. None of the above.

C. I only.

D. III only.

ANSWER: D. The uncollectibility of a personal loan represents a nonbusiness bad debt, which is treated as a short-
term capital loss, regardless of the holding period. Depreciable business property held longer than one year is
Section 1231 property and losses on sale are treated as ordinary, not capital losses. Shares received by gift will
retain donors holding period and basis. Since the shares had been purchased by the donor more than 1 year before
their sale, the result would be a long-term capital loss.

QUESTION: Quanti Co., a calendar-year taxpayer, purchased small tools for $5,000 on December 21, 20X14,
representing the companys only purchase of tangible personal property that took place during 20X14. On its 20X14
tax return, how many months of MACRS depreciation may Quanti Co. claim on the tools?

A. One-and-a-half months

B. One month

C. Six months

D. None

ANSWER: A. In most cases, MACRS involves applying the half-year convention under which assets are amortized
for year in the year of acquisition and in the year of disposal. When an entity acquires at least 40 percent of its
depreciable and amortizable assets in the final three months of the year, the mid-quarter convention is applied under
which depreciation is calculated only for of the last quarter of the year, or 1 months.

QUESTION: Hanks home is burglarized on December 22, 20X14. Personal property with a fair market value of
$40,000 and an adjusted basis to Hank of $25,000 is stolen. Hank paid an independent appraiser $700 on December
29 to determine the fair market value of the property at the time of the break-in. Hanks homeowners insurance policy
leads him to believe he is entitled to receive $15,000 in reimbursement for the event, but no settlement has been
made with the insurance company by year-end. Hanks AGI in 20X14 is $30,000. How much may Hank deduct from
AGI as a result of these facts on his 20X14 tax return? Assume Hank itemizes and assume there has still been no
settlement with the insurance company at the time of filing.

A. $7,000

B. $21,900

C. $6,900

D. $22,000

ANSWER: A. Theft and casualty losses are deductible to the extent that they exceed both $100 and 10% of AGI. The
loss is measured by the lesser of the reduction in fair value of the property as a result of the casualty or the excess of
the basis in the property over its fair value after the loss. Since the reduction in fair value from $40,000 to $0 exceeds
the excess of the basis of $25,000 over the new fair value of $0, the lower loss, $25,000, will be used. This will be
reduced by the $15,000 in insurance proceeds to which the taxpayer is entitled, giving a net amount of $10,000. This
is reduced by $100 and by 10 percent of AGI, or $3,000, for a net amount of $6,900. The $700 appraisal fee is also
deductible as a miscellaneous expense. The amount is reduced by 2 percent of AGI, or $600, for a net deduction of
$100. As a result, total deductions from this theft will be $6,900 + $100 or $7,000.

QUESTION: Regarding the tax treatment of a businesss research and experimental (R&E) expenditures, which of
the following statements is true?

A. A common reason for electing tax deferral of such expenses is the expectation of lower tax rates in the
future.

B. Expenses associated with the acquisition of land upon which a purpose-built R&E facility is constructed are
considered R&E expenditures for tax purposes.

C. Companies generally prefer to expense R&E costs immediately, but may elect instead to defer and amortize
such costs over a minimum of 60 months.

D. Companies may elect to immediately expense R&E costs incurred in the first applicable taxable year and all
future years through an appropriate filing with the IRS.

ANSWER: C. A taxpayer generally elects to deduct R&E costs in the period occurred. The election, if made in the
first tax year in which R&E expenditures are incurred, requires no filing with the IRS. Such an election is binding for
the current and future periods unless a change is approved by the IRS. As an alternative, the taxpayer may file an
election to defer and amortize R & E expenditures over a period that does not exceed 60 months. One reason
companies will defer and amortize R&E costs is the anticipation of higher, not lower, tax rates in the future. For tax
purposes, costs incurred in acquiring land or depreciable property are not considered R&E expenditures, though later
depreciation expense in relation to such property could qualify.

QUESTION: Identify the correct statement below regarding the Domestic Production Activities Deduction (DPAD).

A. Qualified Production Activities Income (QPAI) is calculated by applying a percentage to net income from an
IRS rate table based on specific criteria.

B. The DPAD cannot exceed attributable W-2 wages paid.

C. A sole proprietorship cannot claim the DPAD, but a partnership or S corporation with more than one
shareholder can.

D. Taxable income for the purposes of calculating or amending the DPAD includes any net operating loss
(NOL) deduction, such as an NOL carryforward or NOL carryback.

ANSWER: D. A DPAD is allowed to taxpayers that have Qualified Production Activities Income (QPAI); AGI or taxable
income, as appropriate for the taxpayer; and W-2 wages paid to employees engaged in the production of the QPAI.
The amount of the deduction is not determined using a rate table; it is 9% of the lesser of QPAI or taxable income,
subject to a limit of 50% of attributable W-2 wages paid. Sole proprietorships, partnerships, and S corporations all
may take advantage of the DPAD. For purposes of calculating the DPAD, taxable income does not include a
deduction for the DPAD but does include net operating losses.

QUESTION: Kudzu, Clemmons and Clancy form KCC Partnership with the following contributions:
 Partner Contribution Adjusted Basis Fair Market Value

Kudzu Land $52,000 $50,000

Kudzu Services N/A $ 5,000

Clemmons Property $30,000 $40,000

Clancy Property $25,000 $30,000

What amount of taxable income to Kudzu results from the formation of KCC?

A. $5,000

B. $0

C. $7,000

D. $2,000

ANSWER: A. When cash or property is contributed to a partnership in exchange for a partnership interest, the
transaction is not taxed and the tax bases and holding periods remain unchanged. Services contributed in exchange
for a partnership interest, however, are taxed at their fair market value, $5,000 in this case.

QUESTION: Identify the correct statement below regarding similarities and differences of corporate and individual
taxation.

A. If long-term capital losses exceed their allowable yearly offset to ordinary income, both individuals and
corporations may carry forward the losses and claim them as long-term capital losses in future years,
subject to certain limitations for corporations.

B. Both individuals and corporations can utilize the like-kind exchange provisions of Code Section 1031.

C. Both individuals and corporations must distinguish between deductions for and deductions from in
calculating taxable income.

D. Corporations can claim the Domestic Production Activities Deduction (DPAD), but individuals cannot.

ANSWER: B. Section 1031 of the Internal Revenue Code relates to exchanges of property for similar property in
like-kind exchanges and applies to corporations and individuals. An individual may carry forward nondeductible
capital losses and they retain their character as being long-term or short-term. A corporation may carry nondeductible
losses back 3 and forward up to 5 years with all carrybacks and carryforwards treated as short-term. While a
corporation does not distinguish between deductions for and deductions from taxable income, these distinctions are
important to an individual due to the different limitations placed on various income and deduction items. The
Domestic Productions Activities Deduction is available to both individual and corporate taxpayers.
QUESTION: Harold gives one share of stock in Harold Corp., an S Corp, to each the following individuals:

His nephew

His son

His adopted step-daughter

His grandson

His cousin

What is the minimum number of additional S-Corp shareholders under Code Section 1361 that will result from this
distribution of stock?

A. Three.

B. Four.

C. Two.

D. Five.

ANSWER: C. For purposes of determining that there are no more than 100 shareholders of an S corporation,
shareholders that are directly related, going up to six generations, may be treated as a single taxpayer. As a result,
Harolds son, adopted step-daughter, and grandson may all be considered the same as Harold and will not result in
any additional shareholders. Harolds nephew and cousin will each be an additional shareholder, indicating an
addition of two.

QUESTION: Identify which of the following would be a separately stated item on Schedule K-1 of an S Corporations
Form 1120S:

i. Salaries paid to employees who are not shareholders.

ii. Salaries paid to officers who are shareholders.

iii. Collectibles gain or loss.

A. III only.

B. None of the above.

C. II and III only.

D. All of the above.

ANSWER: A. Separately stated items on Schedule K-1 of an S corporation include those items that receive special
tax treatment such as being taxed at specific rates or being subject to various limitations. Salaries paid to employees,
whether or not they are shareholders or officers, are ordinary business expenses and do not receive special tax
treatment. As a result, neither would be a separately stated item. Gains and losses on collectibles are treated as long-
term capital gains and losses, which do require special treatment and would be separately stated items.

QUESTION: Zunilda is 77-year-old individual with an AGI of $25,000 in 2014. She began living in a nursing home in
2014 upon the recommendation of her primary care physician in order to receive medical care for a specific condition.
She had the following unreimbursed expenses in 2014:

Expense Amount

Nursing home health care costs $5,000

Nursing home meal and lodging costs 8,000

Prescription drugs 1,500

As a result of these unreimbursed expenses, how much may Zunilda deduct from AGI on her 2014 tax return?
Assume Zunilda elects to itemize deductions.

A. $12,000

B. $4,000

C. $12,625

D. $4,625

ANSWER: C. The $1,500 cost of prescription drugs and the $5,000 of nursing home health care costs would be
included in Zunildas medical expenses. When a taxpayer resides in a nursing home due to needed medical care, as
is the case, the cost of meals and lodging are also included, resulting in total medical expenses of $14,500.
Taxpayers who are 65 or older reduce medical expenses by 7.5% of AGI to determine the deductible amount. As a
result, Zunilda may deduct $14,500 7.5% x $25,000 ($1,875) for a deduction of $12,625.

QUESTION: In Year 1 Jorge buys a home for $200,000, making a down payment of $40,000 and taking out a loan
from the bank for $160,000 to finance the balance. In Year 5 the remaining loan balance is $130,000 while the home
has increased in value to $270,000. Jorge refinances with a loan company that agrees to lend 125% of the value of
the home, or $337,500, using $130,000 to repay the bank loan and providing $207,500 in cash. Jorge immediately
spends $10,000 of the cash on a lavish vacation to the Bahamas, and $20,000 to pay down credit cards. How much
of the $337,500 home equity loan balance is allowable for calculating the home mortgage interest deduction on
Jorges Year 5 tax return?

A. $240,000

B. $230,000
 C. $270,000

D. $220,000

ANSWER: B. Home mortgage interest on acquisition indebtedness, or on loans that replace acquisition
indebtedness, up to $1,000,000, and interest on home equity loans up to $100,000 may be deducted as long as the
total debt does not exceed the fair value of the residence. The use of the proceeds of a home equity loan does not
affect the deductibility of the interest. Upon refinancing, $130,000 of the new loan would be considered a
replacement of acquisition indebtedness, with the remainder considered a home equity loan. As a result, Jorge could
deduct interest on $130,000 + $100,000 or $230,000 since it does not exceed the fair value of the property.

QUESTION: On office building owned by Milo was destroyed by Hurricane Mel on September 25, 20X14. On October
2, 20X14 the President of the United States declared the area where the office building was located a federal disaster
area. Milo received settlement of his insurance claim for the destruction of his building on January 2, 20X15. In order
to qualify for nonrecognition of gain on this involuntary conversion, what is the last date for Milo to acquire qualified
replacement property?

A. December 31, 20X18

B. October 2, 20X18

C. December 31, 20X19

D. January 2, 20X19

ANSWER: C. In order to avoid being taxed on a gain resulting from an involuntary conversion, the property subject to
the conversion must be replaced within a specified time, measured from the end of the calendar year in which the
proceeds are received. In general, the period is 2 years, but it is 3 years when the involuntary conversion results from
government condemnation or eminent domain and is extended to 4 years when the loss is in connection with a
declared federal disaster area. Since Milo received the recovery on January 2, 20X15, the property would have to be
replaced within 4 years from the end of 20X15 or by December 31, 20X19.

QUESTION: Claire is a self-employed individual who owns and runs Claires Creations, LLC. In 20X14 she had
$225,000 in net self-employment earnings, including a deduction for 50% of self-employment tax, prior to any Keogh
deduction. Claire has a defined contribution, stock bonus Keogh plan. What is the highest deductible Keogh
contribution Claire can make for the 20X14 tax year? Assume no excess contribution carryover from prior years.

A. $56,250

B. $225,000

C. $52,000

D. $45,000

ANSWER: D. The deductible contribution to a Keogh plan by a self-employed taxpayer is limited to 25% of income
from self-employment after subtracting the contribution. If Claire has income from self- employment of $225,000
before subtracting the contribution, and if we call the contribution amount X, the equation becomes X = 25%
($225,000 X). Multiplying both sides of the equation by 4 will give 4X = $225,000 X, or 5X = $225,000 and X =
$225,000/5 or $45,000. This would give taxable income of $180,000 and a contribution equal to 25% of that amount.
QUESTION: Delius Corp. has outstanding 1,000 5% bonds, issued in Year 1 at their face value of $1,000 each, which
are currently selling at $1,150 each. In Year 3 Delius Corp. reaches an agreement with its bondholders to issue 100
shares of stock for each bond instead of paying off the bonds at the maturity date. The stock has a fair market value
of $18 per share. As a result of the above, what recognized gain must Deliuss bondholders, now shareholders, report
in Year 3?

A. $650,000 long-term capital gain

B. $800,000 long-term capital gain

C. $650,000 dividend

D. $0

ANSWER: D. An exchange of bonds for stock is a Type E reorganization, which is a recapitalization designed to
change the capital structure of a single corporation. In a corporate reorganization, a security holder will not recognize
a gain or loss when the stock or securities of a corporation that is involved in the reorganization are exchanged solely
for stock or securities in the same corporation or another one that is part of the reorganization. Since the previous
bondholders are receiving solely stock in exchange for their bonds, no gain or loss would be recognized.

QUESTION: Which of the following generates a permanent difference between book and taxable income?

i. The Domestic Activities Production Activities Deduction (DPAD)

ii. Section 179 bonus depreciation

iii. Tax credits

iv. II only.

A. I, II, and III.

B. I only.

C. I and III only.

ANSWER: D. In reconciling book income to taxable income on Schedule M-1, all differences between book and tax
income are identified. Temporary differences are those that will ultimately be the same for tax and book purposes but
in different periods, such as bonus depreciation, taken in the year of acquisition for tax and spread out over the life of
the asset for book purposes. Permanent differences are items that are deductible or taxable for tax purposes but not
for book purposes, or vice versa. This would include the DPAD, which is deductible for tax purposes but is not an
expense for financial reporting purposes, and tax credits, which are reductions in tax as a result of the operation of
tax law but do not represent either income or expense for financial reporting purposes.

QUESTION: Which of the following situations will result in a tax preparers penalty?

i. At a clients insistence, the preparer takes and properly discloses a tax position which does not meet the
reasonable basis standard.
 ii. The preparer discloses a clients personally identifying information to outside parties in order to permit the
electronic preparation and submission of the clients return.

iii. The preparer provides his Preparer Tax Identification Number but fails to sign a clients tax return.

A. II only.

B. I, II, and III.

C. I only.

D. I and III only.

ANSWER: D. A tax preparer will incur a penalty for an understatement of a tax liability as a result of a tax position
that lacks substantial authority and is not disclosed or a position that has no reasonable basis supporting it,
regardless of whether or not it is disclosed. A preparer will also be penalized for failing to sign a return. Although a
preparer will generally be penalized for disclosing confidential information obtained through the preparation of a
return, there will be no penalty if the information is provided to permit the electronic preparation or submission of the
taxpayers return.

QUESTION: In 20X14 Colossus Corporation incurred net capital losses in the amount of $25,000. Colossus had the
following net capital gains in the previous five years:
20X13 - $7,000
20X12 - $2,000
20X11 - $5,000
20X10 - $4,000
20X09 - $3,000
How much of the 20X14 capital loss may Colossus carry over to 20X15?

A. $0

B. $8,000

C. $11,000

D. $1,000

ANSWER: C. A corporation may not deduct a capital loss. Instead, it may be carried back to any or all of the
preceding three years to be offset against previously taxable capital gains with the remainder carried forward for up to
5 years. Colossus will carry $7,000 back to 20X13, $2,000 to 20X12, and $5,000 to 20X11 for a total carryback of
$14,000. The remaining $11,000 will be carried forward to 20X15.

QUESTION: On March 1 of the current year Reiter, an individual, sold an office building for $300,000 that had an
adjusted basis of $220,000, resulting in a gain of $80,000. Reiter had purchased the building for $260,000 on April 1
of the previous year, and $30,000 of the total depreciation taken took advantage of a special tax incentive program
Reiter qualified for. How should Reiter report this gain on the current year tax return?

A. $80,000 ordinary gain

 B. $30,000 ordinary gain and $50,000 long-term capital gain

C. $50,000 ordinary gain and $30,000 long-term capital gain

D. $40,000 ordinary gain and $40,000 short-term capital gain

ANSWER: D. Depreciable real property is section 1250 property subject to recapture of excess depreciation. Since
the building was held for less than 1 year, all depreciation taken, $40,000, would be considered excess depreciation
and would be recaptured, resulting in ordinary income of $40,000. The remainder of the gain would be a short-term
capital gain due to a holding period of less than 1 year.

QUESTION: In Year 7 Standard Corp., a C corporation, sold Section 1250 property for $600,000 that had an adjusted
basis of $550,000, resulting in a $50,000 gain. The property had cost Standard $720,000 when purchased in Year 1,
and $170,000 of accelerated depreciation had been taken. Had straight- line depreciation been used, depreciation
would have been $100,000. How should Standard report the gain on its Year 7 tax return?

A. $20,588 ordinary gain and $29,417 long-term capital gain

B. $28,824 ordinary gain and $41,176 long-term capital gain

C. $70,000 ordinary gain

D. $50,000 ordinary gain

ANSWER: D. When section 1250 property that has been held for more than 1 year is sold at a gain, excess
depreciation is recaptured, resulting in an ordinary gain with the remainder, if any, recognized as long-term capital
gain. Excess depreciation for a C corporation consists of the difference between the amount taken using an
accelerated method and the amount that would have been allowed under straight-line, $170,000 - $100,000 or
$70,000, plus 20% of the amount allowed under straight-line, $100,000 x 20% or $20,000 for a tot6al of $90,000.
Since this exceeds the amount of the gain, the entire $50,000 gain would be ordinary.

QUESTION: Mary gives Joanne a gift of land worth $80,000. The lands original cost to Mary was $30,000. As a
result of the transfer, Mary paid a gift tax of $12,000. What is Joannes basis in the land? Assume an annual gift
exclusion of $14,000.

A. $39,091

B. $30,000

C. $42,000

D. $37,500

ANSWER: A. A donees basis in an appreciated gift is equal to the donors basis plus gift tax paid with respect to the
gifts appreciation. The amount of gift tax added is the amount of tax paid, $12,000, multiplied by the ratio of the net
appreciation in the value of the gift, $50,000, to the amount of the gift, which is calculated after eliminating the annual
gift exclusion, $80,000 - $14,000 or $66,000. As a result, the amount of gift tax that will be added to the donors basis
of $30,000 will be $12,000 x ($50,000/$66,000) or $9,091 and the basis will be $39,091.
QUESTION: On November 1, 20X13, Ruth gave Helen a gift of stock worth $15,000. Ruth had purchased the stock
on February 1, 20X13 for $17,000. Helen sold the stock to an unrelated party on November 1, 20X14 for $17,700.
What is the amount and character of Helens gain or loss upon the sale?

A. $700 short-term capital gain

B. $2,700 short-term capital gain

C. $700 long-term capital gain

D. $2,700 long-term capital gain

ANSWER: C. When property received by gift has a fair value that is lower than its basis on the date of the gift, the
basis for determining gain or loss is determined using the sales price. If the sales price is lower than the fair value at
the date of gift, that amount is used to calculate the loss and the holding period is calculated from the date of the gift.
If the sales price exceeds the donors basis, the donors basis is used to calculate the gain and the donors holding
period is included. Since the property was sold for $17,700, which exceeds the donors $17,000 basis, a gain of $700
would be recognized. The holding period would extend from Ruths date of acquisition, 2/1/X13, to the date of sale,
11/1/X14, which is greater than a year. Helen will recognize a $700 long term capital gain.

QUESTION: Ravi, a prosperous businessman, owns devalued property its basis to him exceeds its fair market
value (FMV), which is $600,000. He would like to give the property to his daughter, Ritu, but is unsure about the tax
consequences to Ritu depending on the timing of the gift. Should he give it as a gift now, or leave it to her in his will?
Why? Assume it is highly unlikely the FMV will have risen to the level of Ravis basis by the time of Ravis death.

A. Give as gift now, because devalued property will be subject to step-down basis when given as part of the
estate, but will benefit from dual basis if given as a gift during the givers lifetime.

B. Leave in will, because giving devalued property as part of an estate leads to better tax consequences for the
beneficiaries due to the annual exclusion rules.

C. Give as gift now, because receiving devalued property during the givers lifetime leads to better tax
consequences for the recipient due to the annual exclusion rules.

D. Leave in will, because devalued property will benefit from step-up basis when given as part of the estate, but
will be subject to the dual basis rules if given as a gift during the givers lifetime.

ANSWER: A. If Ritu inherits the property from Ravi, her basis will be the fair value at the date of death, or six months
after the date of death if the alternate valuation date is elected, which is presumed to be lower than Ravis basis. A
sale would result in a gain equal to the difference between the sales price and that amount. If Ritu receives the
property as a gift, since it is worth less than Ravis basis on the date of the gift, her basis will be Ravis basis if sold at
a gain and the fair value at the date of the gift if sold at a loss. As a result, Ritu will only have a taxable gain if the
property is sold for more than Ravis basis, making a gift the more advantageous way for her to receive the property.

QUESTION: Identify the correct statement concerning issues of estate taxes, gift taxes, and family tax planning.

A. A gift for a minor child, distributable to the child upon the childs 18th birthday, is a taxable gift to the extent
that it exceeds a present value of $14,000.

B. Upon the death of one its owners, a property owned in joint tenancy automatically goes to the survivors and
bypasses the estate of the decedent.
 C. Gifts given in contemplation of marriage, such as an engagement ring to a fiance, are excludable from
taxable gifts so long as the marriage occurs no later than sometime within the following tax year.

D. Income in respect of a decedent, includable on the fiduciary income tax return, is excluded from the
valuation of the gross estate of the decedent.

ANSWER: B. Joint tenancy is the ownership of property by two or more persons with each having an undivided
interest in the property. This gives joint tenants the right of survivorship indicating that, upon the death of a joint
tenant, that tenants share in the property reverts to the other joint tenants, not to the deceaseds estate. Only a
present interest, which is an unrestricted right to the immediate use of the gift, is subject to the annual exclusion. A
gift distributable upon a childs future birthday is a future interest and is fully taxable. While gifts to a donors spouse
are not subject to gift tax, there is no exclusion for gifts in contemplation of marriage, such as an engagement ring.
The gross estate of a decedent includes income in respect of the decedent, which is a receivable to the estate,
despite the fact that it is also includable on the fiduciary income tax return.

QUESTION: Identify the correct statement regarding portability of a deceased spouses unused lifetime exclusion
amount.

A. It can be granted via an amended tax return of the surviving spouse.

B. It permits the surviving spouse to apply the decedents unused exclusion amount to the surviving spouses
own transfers during life, but not at death.

C. It is granted via an election on the decedents fiduciary income tax return.

D. It can be elected only through a timely filing of a Form 706.

ANSWER: D. Portability refers to the ability of a surviving spouse to take advantage of any unused portion of their
deceased spouses unified estate and gift tax credit. To take advantage of this, the estate is required to file an estate
tax return on form 706. It may not be granted by filing an amended tax return for the surviving spouse. The credit may
be applied to gifts given during the surviving spouses lifetime with the remainder applied to the surviving spouses
estate. It may not be claimed on the decedents fiduciary income tax return filed on form 1041.

BUSINESS ENVIRONMENT AND

CONCEPTS (BEC) SAMPLE QUESTIONS

The following are actual retired questions from the Business Environment and Concepts (BEC) Section of the CPA
Exam.
The answers are provided by Kaplan Schweser.
View questions for the other sections of the exam.

QUESTION: What is the backup facility that can be up and running at a short notice called?

1. VAN.

2. Remote site.
 3. Cold site.

4. Hot site.

ANSWER: The correct answer is D. A hot site is a backup facility that can be up and running at a short notice. A cold
site is a backup facility that can be up and running at a considerable effort. VAN stands for Value Added Network and
is not a backup facility. Remote site is not specific about the speed of availability.

QUESTION: The application processing phase where the master file is updated is called:

1. audit trail.

2. edit routine.

3. data capture.

4. master file maintenance.

ANSWER: The correct answer is D. Master file maintenance involves updating the master file with new
transaction(s). Data capture is the phase where data is recorded. Edit routine is validation of (previously) input data.
Audit trail is an authentication control to verify integrity of transactions.

QUESTION: Which of the following factors would cause the demand curve for a given product to increase (shift to the
right)?

1. Changes in the price of the given product.

2. Decrease in consumer income.

3. Increase in the price of a substitute product.

4. Increase in the price of a complimentary product.

ANSWER: The correct answer is C. An increase in the price of a substitute product would cause the demand curve
for a given product to increase (shift to the right).

QUESTION: The purpose of a flexible budget is to:

1. reduce the total time in preparing the annual budget.

2. compare actual and budgeted results at virtually any level of production.

3. eliminate cyclical fluctuations in production reports by ignoring variable costs.

4. allow management some latitude in meeting goals.

ANSWER: The correct answer is B. This is the definition of a flexible budget. Compared to a static budget, which
shows only one level of production, the flexible budget shows budgeted costs and revenues for any level of
production. As levels of production change, the costs and revenues will change as well. The flexible budget provides
that information. Variance analysis is made more meaningful with flexible budgets.

QUESTION: Spoilage occurring during a manufacturing process can be considered normal or abnormal. The proper
accounting for each of these costs is:

NormalAbnormal
A
ProductPeriod
.
B.ProductProduct
C.Period Product
D
Period Period
.
ANSWER: The correct answer is A. Normal spoilage is product deterioration expected to occur, especially in
manufacturing, even under the best of conditions. Abnormal spoilage is spoilage beyond the normal spoilage rate.
Normal spoilage is a product cost while abnormal spoilage is a period cost. The cost of normal spoilage is "absorbed"
by the surviving units while the abnormal spoilage loss is recognized immediately; that is, in the current period.

QUESTION: The Public Company Accounting Oversight Board (PCAOB) was created by which of the following?

1. Securities and Exchange Commission.

2. Sarbanes-Oxley Act of 2002.

3. Financial Accounting Standards Board.

4. Institute of Certified Public Accountants.

ANSWER: The correct answer is B. The Sarbanes-Oxley Act of 2002 created the PCAOB.

QUESTION: The Committee of Sponsoring Organizations of the Treadway Commission (COSO) internal control
framework consists of five interrelated components including control activities. Which of the following is NOT an
example of a control activity?

1. Risk assessment.

2. Segregation of duties.

3. Security of assets.

4. Performance reviews.
ANSWER: The correct answer is A. Control activities include authorizations, performance reviews, security of assets,
application controls, and segregation of duties. Risk assessment is one of the five interrelated components.

QUESTION: All of the following are risks of e-commerce EXCEPT:

1. Applicability.

2. Data integrity.

3. Processing integrity.

4. Security and authenticity.

ANSWER: A) Risks of e-commerce include security and authenticity, processing integrity, data integrity, and privacy.

QUESTION: What does a credit balance in a direct-labor efficiency variance account indicate?

1. Actual total direct-labor costs incurred were less than standard direct-labor costs allowed for the units
produced.

2. The standard hours allowed for the units produced were greater than actual direct-labor hours used.

3. The number of units produced was less than the number of units budgeted for the period.

4. The average wage rate paid to direct labor employees was less than the standard rate.

ANSWER: B) A credit balance indicates a favorable variance, with standard hours allowed being greater than actual
hours used.

QUESTION: Nile Co.s cost allocation and product costing procedures follow activity-based costing principles.
Activities have been identified and classified as being either value-adding or nonvalue-adding as to each product.
Which of the following activities, used in Niles production process, is nonvalue-adding?

1. Raw materials storage activity.

2. Design engineering activity.

3. Heat treatment activity.

4. Drill press activity.

ANSWER: A) In the production process, storing raw materials until they are needed represents a non-value added
step, whereas engineering, heat treatment or drilling represents improving the product. In addition, storage requires
handling costs, cost of holding inventory, possible breakage or misappropriation, while inventory simply waits for use
at a later time.
QUESTION: In an income statement prepared as an internal report using the direct (variable) costing method, fixed
selling and administrative expenses would:

1. Be used in the computation of the contribution margin.

2. Be used in the computation of operating income but not in the computation of the contribution margin.

3. Be treated the same as variable selling and administrative expenses.

4. Not be used.

ANSWER: B) Under the direct or variable costing method, variable costs are deducted from revenue to determine
contribution margin, and all fixed costs (manufacturing, selling, general and administrative) are then deducted to
obtain net income or income from operations.
The contribution margin is calculated in two steps:

1. Revenue less variable cost of goods sold = Contribution margin: manufacturing

2. Contribution margin: manufacturing less other variable costs (S, G & A) = Contribution margin: final

QUESTION: Jago Co. has 2 products that use the same manufacturing facilities and cannot be subcontracted. Each
product has sufficient orders to utilize the entire manufacturing capacity. For short-run profit maximization, Jago
should manufacture the product with the:

1. Lower total manufacturing costs for the manufacturing capacity.

2. Lower total variable manufacturing costs for the manufacturing capacity.

3. Greater gross profit per hour of manufacturing capacity.

4. Greater contribution margin per hour of manufacturing capacity.

ANSWER: D) As both products can utilize full capacity, the greatest profit will result from the greatest contribution
margin (selling price - variable costs) for capacity. Fixed costs are irrelevant as they are not affected by the decision.

QUESTION: Which of the following statements about capital budgeting evaluation methods is FALSE?
 1. NPV does not take the profit of an investment into account since it concentrates on a projects effect on the
value of the firm.

2. The IRR and NPV will never disagree about whether or not a project is acceptable.

3. The IRR and NPV methods both incorporate the firms WACC.

4. The IRR can be defined as the discount rate that results in a project having an NPV equal to zero.

ANSWER: A) NPV does measure the effect of an investment on the value of the firm and does so by discounting
future cash flows by the WACC. If the return of the project is greater than the WACC the NPV will be positive.
Therefore, the return is greater than the cost and the project is profitable.

QUESTION: Residual income is income:

1. from which dividends are deducted.

2. from which an imputed interest charge for invested capital is deducted.

3. to which dividends are added.

4. to which an imputed interest charge for invested capital is added.

ANSWER: B) An investment's residual income is the accounting income from the investment less an allowance for a
return on investment (invested capital).

QUESTION: Which of the following is least likely an assumption of linear regression?

1. The residuals are normally distributed.

2. There is a linear relation between the dependent and independent variables.

3. The independent variable is correlated with the residuals.

4. The variance of the residuals is constant.

ANSWER: C) The assumption is that the independent variable is uncorrelated with the residuals.

QUESTION: What is the market conversion price of a convertible security?

1. the price that an investor pays for the common stock if the convertible bond is purchased and then
converted into the stock.
 2. the price that an investor pays for the common stock in the market.

3. the value of the embedded call option.

4. the value of the security if it is converted immediately.

ANSWER: A) The market conversion price, or conversion parity price, is the price that the convertible bondholder
would effectively pay for the stock if she bought the bond and immediately converted it. market conversion price =
market price of convertible bond conversion ratio.

QUESTION: If the Federal Reserve (Fed) wanted to increase the money supply, it would:

1. lower the discount rate.

2. lower the required reserve ratio.

3. buy government securities.

4. any or all of these.

ANSWER: D) Expansionary monetary policy involves reducing reserve requirements, purchasing additional
government securities, and/or lowering the discount rate.

QUESTION: A bank is considering building a branch on a piece of property it already owns. Which of the following
cash flows should NOT be considered in the capital budgeting analysis?

1. The $100,000 spent to determine whether there are any environmental issues regarding the property.

2. The $50,000 the firm will forgo in lost revenue from the sale of the property if the company decides to build.

3. The several hundred customers that will switch from alternative branches to the new branch if the bank
makes the investment.

4. The shipping and installation charges the bank must spend to get equipment in the new branch.

ANSWER: A. The $100,000 spent on an environmental analysis is a sunk cost and should not be considered in the
analysis. The $50,000 lost from the sale of the property is an opportunity cost and should be considered. The
transferred customers result in cash flows that are externalities/cannibalization for the bank and must be considered.
Also, the shipping and installation charges are added to the depreciable basis and are counted.

QUESTION: All else equal, which of the following will help decrease a companys total debt to equity ratio?

1. Buying treasury stock.

 2. Paying cash dividends to stockholders.

3. Converting long-term debt to short-term debt.

4. Lowering the dividend payout ratio.

ANSWER: D. Buying treasury stock and paying cash dividends will decrease stockholders equity, and thus increase
the debt/equity ratio. Converting long-term debt to short-term will have no effect on total debt or stockholders equity.
Lowering dividend payout ratio will increase retained earnings, thus increasing stockholders equity and decreasing
the debt/equity ratio.

QUESTION: If the exchange rate value of the euro goes from $0.95 to $1.10, then the euro has:

1. appreciated and the Dutch will find U.S. goods more expensive.

2. depreciated and the Dutch will find U.S. goods cheaper.

3. appreciated and the Dutch will find U.S. goods cheaper.

4. depreciated and the Dutch will find U.S. goods more expensive.

ANSWER: C. appreciated and the Dutch will find U.S. goods cheaper.
An exchange rate is a ratio that describes how many units of one currency you can buy per unit of another currency.
The numerator will be in the currency in which the quote is made and the denominator is the other unit of the
currency you are comparing. A currency appreciates when it rises in value relative to another foreign currency.
Likewise, a currency depreciates when it falls in value relative to another foreign currency. An appreciation in value of
a currency makes that countrys goods more expensive to residents of other countries. The depreciation of the value
of a currency makes a countrys goods more attractive to foreign buyers.

QUESTION: Which of the following statements concerning the relationship of the quantity demanded or supplied with
price is(are) correct?

I. The quantity supplied varies inversely with price.

II. The quantity demanded varies directly with price.

1. I only.

2. II only.

3. Both I and II.

4. Neither I nor II.

ANSWER: Neither I nor II.

The quantity supplied varies directly with price and the quantity demanded varies indirectly with price. Answer (a) is
not correct because the quantity supplied varies directly with price. Answer (b) is not correct because the quantity
demanded varies indirectly with price. Answer (c) is not correct because the quantity supplied varies directly with
price and the quantity demanded varies indirectly with price.

QUESTION: The following information pertains to Roe Co.s manufacturing operations:

Standard direct labor hours per unit 2

Actual direct labor hour 10,500
Number of units produced 5,000
Standard variable overhead per standard direct labor
$3
hour
Actual variable overhead $28,000

Roes unfavorable overhead efficiency variance was:

1. $0.

2. $1,500.

3. $2,000.

4. $3,500.

ANSWER: B. $1,500.
Overhead is generally applied based upon direct labor hours. The unfavorable overhead efficiency variance
represents the number of actual hours required over the number of standard labor hours allowed for that level of
output, multiplied by the standard variable overhead rate. Based on Roes operations, the unfavorable overhead
efficiency for the 5,000 units produced is $1,500;

Hours allowed (5,000 units 2

10,000
hrs/unit)
Actual hours 10,500
Excess hours over standard 500
Standard rate $3
Variance $1,500

QUESTION: In an income statement prepared as an internal report, total fixed costs normally would be shown
separately under:

Absorption costingVariable costing

A. No No
B. No Yes
C. Yes Yes
D. Yes No
ANSWER: B. No; Yes
Under the direct or variable costing method, variable costs are deducted from sales revenue to determine contribution
margin and all fixed costs (overhead, selling, general and administrative) are then deducted to obtain net income or
income from operations. The contribution margin is calculated in two steps:

Sales revenue less (variable) cost of goods sold = Contribution margin: manufacturing.

Contribution margin: manufacturing less other variable costs (S, G & A) = Contribution margin: final.

Under the absorption costing method, each cost classification (cost of goods sold, selling, general and administrative,
etc.) includes both its fixed cost and variable cost components.

QUESTION: An investor owns stock and is concerned that prices may fall in the future. Which strategy could help to
hedge against adverse market conditions?

1. Buy a futures contract.

2. Buy a futures contract.

3. Buy a put option.

4. Buy a call option.

ANSWER: C. Buy a put option.

Buying a call, buying a futures contract, or buying a forward gives the investor the chance to buy more stock.
However, neither of these strategies provides a way to hedge the existing equity position. A put option provides the
opportunity to sell the stock.

QUESTION: For a given year, a companys economic value added measure (EVA is a registered trademark of Stern
Stewart & Co.) will be positive if the:

1. firm has a net operating profit after tax greater than the market value of the debt capital employed.

2. firms MVA is positive.

3. earns a return greater than its cost of capital.

4. firm has a net operating profit after tax greater than the book value of the capital employed.

ANSWER: C. firm earns a return greater than its cost of capital.

EVA is positive when a company earns a rate of return greater than its cost of capital. EVA is a financial performance
measure that attempts to calculate true economic profit. The formula is net operating profit after tax reduced by a
measure of the cost of all capital of the firm. Its focus is on maximizing shareholder wealth.
Market value added (MVA) is the difference between the market value of a company and the capital contributed by
investors (both bondholders and shareholders). Higher MVA is better than lower MVA. A high MVA company is one
that has created substantial wealth for its shareholders.
QUESTION: A bank is considering building a branch on a piece of property it already owns. Which of the following
cash flows should not be considered in the capital budgeting analysis? The:

1. $50,000 the firm will forgo in lost revenue from the sale of the property if the company decides to build.

2. $100,000 spent to determine whether there are any environmental issues regarding the property.

3. several hundred customers that will switch from alternative branches to the new branch if the bank makes
the investment.

4. shipping and installation charges the bank must spend to get equipment in the new branch.

ANSWER: B. $100,000 spent to determine whether there are any environmental issues regarding the property.
The $100,000 spent on an environmental analysis is a sunk cost and should not be considered in the analysis. The
$50,000 lost from the sale of the property is an opportunity cost and should be considered. The transferred customers
result in cash flows that are externalities/cannibalization for the bank and must be considered. Also, the shipping and
installation charges are added to the depreciable basis and must be included.

QUESTION: Short-term interest rates are:

1. generally lower than long-term rates.

2. generally higher than long-term rates.

3. lower than long-term rates during periods of high inflation only.

4. not significantly related to long-term rates.

ANSWER: A. generally lower than long-term rates.

Short-term interest rates are generally lower than long-term interest rates. This is due to the higher interest rate risk
and yield-curve risk associated with an increased time to maturity. Answer D is incorrect because short-term interest
rates are related to long-term rates.

QUESTION: On December 31, year 7, North Park Co. collected a receivable due from a major customer. Which of
the following ratios would be increased by this transaction?

1. Current ratio.

2. Receivable turnover ratio.

3. Quick ratio.

4. Inventory turnover ratio.

ANSWER: Receivable turnover ratio.

Accounts receivable turnover = sales/average accounts receivable

Collection of accounts receivable would reduce the accounts receivable balance and resulting average accounts
receivable. This reduction in the denominator of the AR turnover ratio would result in an increase in the fraction
calculation.

The current ratio is current assets/current liabilities and the quick ratio is (cash + receivables)/current liabilities. For
both calculations, the collection of the receivable would result in a $0 net effect (as AR decreased, cash increased).

The inventory turnover ratios is COGS/average inventories which is not affected by the collection of the receivable.

QUESTION: The partners of College Assoc., a general partnership, decided to dissolve the partnership and agreed
that none of the partners would continue to use the partnership name. Under the Revised Uniform Partnership Act,
which of the following events will occur on dissolution of the partnership?

Each partners Each partners

existing liability apparent authority
would be dischargedwould continue
A. Yes Yes
B. Yes No
C. No Yes
D. No No

ANSWER: C. No; Yes

Partners are agents of the partnership and each other. Thus, agency rules apply. If a partnership dissolves, partners
must give actual notice to old customers and published notice to new ones. Failure of a partner to give proper notice
would give a partner apparent authority to act on behalf of the partnership with customers who were unaware of the
dissolution. Although dissolution would discharge a partners actual authority, it does not discharge a partners
apparent authority. Additionally, a dissociated partner remains liable for pre-dissolution obligations. Only Answer (c)
reflects that a partners liability is not automatically discharged by dissolution and that apparent authority would
continue.

QUESTION: The corporate veil is most likely to be pierced and the shareholders held personally liable if:

1. the corporation has elected S corporation status under the Internal Revenue Code.

2. an ultra vires act has been committed.

3. a partnership incorporates its business solely to limit the liability of its partners.

4. the shareholders have commingled their personal funds with those of the corporation.

ANSWER: D. the shareholders have commingled their personal funds with those of the corporation.
A stockholder may be held personally liable for corporate debts (piercing the corporate veil). Specifically this may be
done by a showing of fraud, undercapitalization of the corporation, and commingling of corporate and personal funds
by the stockholder. Thus, the corporate veil may be pierced if the stockholder commingled their personal funds with
those of the corporation. Choosing S corporation status, commission of an ultra vires act, and incorporation to obtain
limited personal liability are all insufficient grounds to pierce the corporate veil.

QUESTION: An accounting information system (AIS) must include certain source documents in order to control
purchasing and accounts payable. For a manufacturing organization, the best set of documents should include:

1. purchase requisitions, purchase orders, inventory reports of goods needed, and vendor invoices.

2. purchase orders, receiving reports, and inventory reports of goods needed.

3. purchase orders, receiving reports, and vendor invoices.

4. purchase requisitions, purchase orders, receiving reports, and vendor invoices.

ANSWER: D. purchase requisitions, purchase orders, receiving reports, and vendor invoices.
The AIS functions include ensuring an entitys resources are protected and accurately documented in a reliable
manner. For a manufacturing organization, the transaction cycle should be controlled and documented to protect the
reliability of the process. The purchase requisition is evidence that some user needs the goods. The purchase order
specifies the price and quantity authorized by the purchasing department. The receiving report is evidence of the
quantity actually received. The vendor invoice is evidence of the vendors request to be paid for the specified quantity
(which should be matched with the receiving report and purchase order) and price (which should be matched with the
purchase order).