2010 AICPA newly released questions – regulation

2010 AICPA Newly Released Questions – Regulation Following are multiple choice questions recently released by the AICPA These questions were released by the AICPA with letter answers only Our editorial board has provided the accompanying explanation Please note that the AICPA generally releases questions that it does NOT intend to use again These questions and content may or may not be representative of questions you may see on any upcoming exams © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation What defense must an accountant establish to be absolved from civil liability under Section 18 of the Securities Exchange Act of 1934 for false or misleading statements made in reports or documents filed under the Act? a b c d Lack of gross negligence Exercise of due care Good faith and lack of knowledge of the statement's falsity Lack of privity with an injured party Solution: Choice "c" is correct Section 18 of the Securities Exchange Act of 1934 imposes civil liability on persons who intentionally make false statements in a registration statement or any other document required to be filed under the act Since the act proscribes only intentional misconduct, lack of intent to deceive is a defense Good faith and lack of knowledge of the statement's falsity would show that the false or misleading statement was not made with an intent to deceive Choice "a" is incorrect Lack of gross negligence sets the bar too high for the defense Gross negligence can be proved through reckless conduct Under section 18, liability cannot be imposed merely because the CPA acted recklessly Choice "b" is incorrect Due care is the standard for negligence It is a much higher standard of care than is required under section 18 Under section 18, a CPA need not prove that he or she was careful; only that he or she did not intentionally deceive Choice "d" is incorrect Privity (e.g., a contractual relationship) is not a requirement of a section 18 cause of action Therefore, lack of privity is not a defense © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation On December 1, Gem orally contracted with Mason for Mason to manage Gem's restaurant for one year starting the following January They agreed that Gem would pay Mason $40,000 and that Mason would be allowed to continue to work for Gem if "everything worked out." On June 1, Mason quit to take a better paying job, alleging that the contract violated the statute of frauds What will be the outcome of a suit by Gem for breach of contract? a b c d Gem will win because the contract was executory Gem will win because the contract was for services not goods Gem will lose because the contract could not be performed within one year Gem will lose because the contract required payment of more than $500 Solution: Choice "c" is correct As a general rule, under the statute of frauds, a contract that cannot be performed within one year from the time of its making is unenforceable absent proof of its material terms in a writing signed by the party being sued Here, the contract by its terms could not be performed within a year from the time it was made and Gem cannot prove the material terms of the contract through a writing signed by Mason Therefore, Gem would lose its breach of contract action Choice "a" is incorrect The statute of frauds requires proof of the material terms of certain contracts to be evidenced by a writing signed by the party being sued There is an exception to the statute if the contract has been executed Since the contract here is executory, the exception does not apply, so Gem will lose (not be able to enforce the contract) rather than win because the contract is executory Choice "b" is incorrect The statute of frauds applies to contract other than contracts for the sale of goods It applies to a service contract if by its terms it cannot be performed within a year Thus, the fact that the contract here is for services rather than goods is not a reason for Gem to win the law suit to enforce the agreement with Mason Gem will lose because the statute of frauds applies and Gem does not have a writing signed by Mason that sets out the material terms of the agreement Choice "d" is incorrect The $500 threshold is not relevant to the contract here That threshold applies to contracts for the sale of goods The contract here is for services What matters for service contracts is whether or not they can be performed within a year of their making If they cannot, such as the contract here, they are within the statute of frauds regardless of the price involved © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Which of the following bonds are an obligation of a surety? a b c d Convertible bonds Debenture bonds Municipal bonds Official bonds Solution: Choice "d" is correct An official bond is a type of surety bond Many states require public officials to obtain bonds from a surety for faithful performance of their duties Such bonds obligate a surety for all losses that the public official causes by negligence or nonperformance of required duties Choice "a" is incorrect A convertible bond is a corporate bond that may be converted into stock It has nothing to with the obligations of a surety Choice "b" is incorrect A debenture bond is simply an unsecured corporate bond It has nothing to with the obligations of a surety Choice "c" is incorrect A municipal bond is a bond issued by a city or other local government It has nothing to with the obligations of a surety © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation According to the Securities Act of 1933, which of the following statements is correct regarding an issuer of securities? a All securities issuers must provide potential investors with a prospectus containing specified information b An issuer is permitted to advertise an initial offering of securities only through distribution of the prospectus c All securities issuers must register the securities offering with the Securities and Exchange Commission (SEC) d If an issuer sells a security and fails to meet certain disclosure requirements, the purchaser may sell it back to the issuer and recover the price paid Solution: Choice "d" is correct A purchaser has a right to rescind under section 12 of the 1933 Act if the issuer fails to meet disclosure requirements Choice "a" is incorrect Under rule 506 of Regulation D, if only accredited investors invest, no prospectus need be given Choice "b" is incorrect Red herring prospectuses, tombstone ads, and oral offers also are permitted Choice "c" is incorrect Certain issuers (e.g., charities, banks) need to register © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation A calendar-year individual filed an income tax return on April This return can be amended no later than: a b c d Four months and 15 days after the end of the calendar year Ten months and 15 days after the end of the calendar year Three years, three months, and 15 days after the end of the calendar year Three years after the return was filed Solution: Rule: An individual may file an amended tax return (Form 1040X) within three (3) years of the date the original return was filed or within two (2) years of the date the tax was paid, whichever is later An original return filed early is considered filed on the due date of the return Choice "c" is correct In this question, the return was filed early (April 1), so the return is considered filed on April 15 There is no information on when the tax was paid, but it can be reasonably assumed that the tax was properly paid on April with the return So the latter of the two dates is three years The question that arises is "three years from when," and here the question falls somewhat short Three of the answers to this question are worded in terms of "the" calendar year These answers have to mean the prior calendar year Three years from April 15 (when the return was considered to be filed) would be three years, three months, and 15 days from the end of the prior calendar year Choice "a" is incorrect The date is not four months and 15 days after the end of the (prior) calendar year This answer ignores the three years It appears to be trying to trick candidates into thinking that April is four months However, that would mean that the last day that an amended return could be filed was the date of the filing of the original return Choice "b" is incorrect The date is not ten months and 15 days after the end of the (prior) calendar year Choice "d" is incorrect The date is not three years after the (original) return was filed This answer looks good at first glance, but note that the return was actually filed on April The Rule above considers an original return filed early to be filed on the due date of the return However, the answer says "after the return was filed" and not "after the return was considered to be filed." © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation In the absence of an election to adopt an annual accounting period, the required tax year for a partnership is: a b c d A tax year that results in the greatest aggregate deferral of income A calendar year A tax year of one or more partners with a more than 50% interest in profits and capital A tax year of a principal partner having a 10% or greater interest Solution: Rule: Per IRC Section 706(b), a partnership tax year must have the same taxable year as the common taxable year of the partners that, in the aggregate, have interest greater than 50%, which is determined based on the "testing day," the first day of the partnership's tax year (not considering the majority interest rule) Note: After a change is made to the "majority-interest" tax year end, the partnership does not have to change to another tax year for two years following the year of change Exceptions to the rule exist (1) If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership) (2) If the partnership is still unable to determine a tax year using the general rule or the first exception, then the tax year that causes the least aggregate deferral of income to the partners must be adopted Choice "c" is correct In the absence of election to adoption of an annual accounting period, the required tax year for a partnership would be the tax year of one or more partners who have an aggregate of more than 50% interest in profits and capital, per the majority interest rule This is the BEST answer to the question Choice "a" is incorrect If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership) If the partnership is still unable to determine a tax year using the general rule or the first exception, then the tax year that causes the least (not the greatest) aggregate deferral of income to the partners must be adopted Choice "b" is incorrect A partnership may be able to avoid the rules above if it has a business purpose for selecting a different tax year and if this can be established with the IRS In this case, a calendar year (assuming it is not already required because it coincides with the general rule or the exceptions identified above) may be used Of course, while this answer may be correct in some circumstances, it is not the BEST answer to the question Choice "d" is incorrect If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership) Note that this is the second-best answer, but it only applies if answer option "c" is not available © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation In the current year Tatum exchanged farmland for an office building The farmland had a basis of $250,000, a fair market value (FMV) of $400,000, and was encumbered by a $120,000 mortgage The office building had an FMV of $350,000 and was encumbered by a $70,000 mortgage Each party assumed the other's mortgage What is the amount of Tatum's recognized gain? a b c d $0 $ 50,000 $100,000 $150,000 Solution: Rule: Per IRC Section 1031, non-recognition treatment is accorded to a like-kind exchange of property used in a trade or business "Like-kind" exchanges include exchanges of business property for business property, where like-kind is interpreted very broadly and refers to the nature or character of the property and not to its grade or quality Choice "b" is correct The exchange in this question qualifies for Section 1031 treatment since the exchange appears to be business property for business property However, the boot involved in the exchange (the mortgages) must be taken into account to determine the recognition or non-recognition of the gain realized on the exchange In this transaction, the total consideration received by Tatum is the FMV of the property received of $350,000 plus the mortgage of $120,000 that was assumed by the other party, for a total of $470,000 The adjusted basis of the property given up was $250,000, and there is also $70,000 of mortgage given up by the other party (and assumed by Tatum), for a total of $320,000 The realized gain is thus $470,000 – $320,000 = $150,000 The recognized gain will be the lesser of realized gain or net boot received The $120,000 of mortgage given up (and assumed by the other party) is treated as boot received, and the $70,000 of mortgage assumed is treated as boot given up The net is $50,000 of boot received The $50,000 of boot received is the recognized gain The treatment is somewhat the same as if cash/boot had been received in the transaction Choice "a" is incorrect Gain is recognized due to the net boot received Choice "c" is incorrect The $100,000 is the amount of realized gain being deferred, not the recognized gain Choice "d" is incorrect The $150,000 is the realized gain However, it is not the recognized gain © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Danielson invested $2,000,000 in DEC, a qualified small business corporation Six years later, Danielson sold all of the DEC stock for $16,000,000, and purchased an office building with the proceeds Danielson had not previously excluded any gain on the sale of small business stock What is Danielson's taxable gain after the exclusion? a b c d $0 $6,000,000 $7,000,000 $9,000,000 Solution: Rule: Per IRC Section 1202, a non-corporate taxpayer can exclude from gross income (and thus taxable income) 50% of any gain from the sale of exchange of qualified small business stock held for more than years There are all sorts of special rules including special rules for property acquired between 2009 and 2011, but the rule stated is the general rule Choice "c" is correct DEC is a qualified small business corporation and the stock has been held by Danielson for more than years Danielson is not a corporation The realized gain on the sale of the stock is $14,000,000 ($16,000,000 – $2,000,000) The amount of this gain that is excluded from gross income is 50% of the $14,000,000, or $7,000,000 That means that $7,000,000 of the gain is taxable Choice "a" is incorrect A percentage (normally 50%) of the gain from the sale of qualified small business corporation stock can be excluded from gross income by a non-corporate taxpayer Choice "b" is incorrect, per the above explanation Choice "d" is incorrect, per the above explanation © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Robbe, a cash basis single taxpayer, reported $50,000 of adjusted gross income last year and claimed itemized deductions of $5,500, consisting solely of $5,500 of state income taxes paid last year Robbe's itemized deduction amount, which exceeded the standard deduction available to single taxpayers for last year by $1,150, was fully deductible and it was not subject to any limitations or phase-outs In the current year, Robbe received a $1,500 state tax refund relating to the prior year What is the proper treatment of the state tax refund? a b c d Include none of the refund in income in the current year Include $1,150 in income in the current year Include $1,500 in income in the current year Amend the prior-year's return and reduce the claimed itemized deductions for that year Solution: Rule: IRC Section 111 provides that gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax previously imposed (the tax benefit rule) Choice "b" is correct Under the tax benefit rule, an itemized deduction recovered in a subsequent year is included in income in the year recovered In this question, only $1,150 of the state income taxes was actually deducted as an itemized deduction last year The recovery is thus limited in the amount actually deducted (and not to the entire amount of the state tax refund) Choice "a" is incorrect The amount deducted, not $0, is included in income in the current year Choice "c" is incorrect The amount originally deducted, not necessarily the entire amount of the refund, is included in income in the current year Choice "d" is incorrect The amount deducted is included in income in the current year There is no necessity to amend the prior year's return 10 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation 41 Frey Corp has 1,000 shares of issued and outstanding common stock Frey's articles of incorporation permit a stockholder who owns 5% or more of the outstanding stock or who has owned the stock for longer than six months to inspect Frey's books and records Ace, who has owned 25 shares of Frey stock for four months, wants to inspect the books and records Under the Revised Model Business Corporation Act, which of the following statements is correct regarding Ace's right to inspect the books and records? a Ace must wait two months before being allowed to inspect the books and records b Ace must purchase an additional 25 shares of Frey stock before being allowed to inspect the books and records c Ace may, after giving five days written notice, inspect the books and records to determine the value of Frey stock d Ace may, after giving five days written notice, inspect the books and records to provide a list of Frey stockholders to Ace's broker Solution: Choice "c" is correct The Revised Model Business Corporation Act (RMBCA) provides that any shareholder may inspect a corporation's books and records on five days notice for a proper purpose, and this right may not be limited or abolished by the articles or bylaws Thus, Ace may inspect on five days notice Choice "a" is incorrect Despite the fact that Ace would have to wait two more months according to the bylaws (because Ace does not own 5% of the outstanding stock of Frey), he only must wait five days The RMBCA provides that a shareholder's inspection rights may not be limited or abolished in the articles or bylaws Choice "b" is incorrect Under the RMBCA, Ace need only provide five days notice and demonstrate a proper purpose to inspect There is no requirement in the RMBCA that Ace own at least 5% of the outstanding stock The provision in the articles requiring 5% ownership would be unenforceable because the RMBCA provides that the articles cannot limit or abolish a shareholder's inspection rights Choice "d" is incorrect Even if Ace had a right to inspect, inspection must be for a proper purpose Taking names for a mailing list for a purpose not unrelated to operation of the corporation is not a proper purpose 42 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation 42 Which of the following corporate shareholder rights is enforceable by means of a derivative suit? a b c d Compelling payment of properly declared dividends Enforcing access to corporate records Recovering damages from a third party Protecting preemptive rights Solution: Choice "c" is correct A derivative action is used when a corporation fails to enforce a right that it has against a third party; the shareholder brings suit on behalf of the corporation A suit against a third party to enforce the corporation's rights against the third party is an example of a corporate shareholder right enforceable by derivative suit Choices "a", "b", and "d" are incorrect All of the other choices are incorrect because they involve suits directly against the corporation rather than against a third party 43 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation 43 Toby invested $25,000 in a limited partnership with Connor and Blair Toby was a general partner in the limited partnership The partnership failed to pay Kelly $45,000 for services on behalf of the partnership Which of the following statements is generally correct regarding Toby's liability under the Revised Uniform Limited Partnership Act? a b c d Toby was liable for $25,000 because this was a limited partnership Toby was liable for zero because this was a partnership debt, not a personal debt Toby was liable for $45,000 because Toby was a general partner Toby was liable for $15,000 because this was a limited partnership Solution: Choice "c" is correct Toby was a general partner General partners in a limited partnership are personally liable for all obligations of the partnership If the partnership does not pay Kelley, Toby will be liable for the amount owed Choices "a", "b", and "d" are incorrect, based on the above explanation 44 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation AICPA Released Simulation Directions 45 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Situation Alaska, Inc is an accrual-basis C corporation that was incorporated on January 1, year At the end of year 2, the corporation is considering converting to an S corporation Alaska is required to determine its accumulated earnings and profits prior to conversion The company has already calculated book net income, taxable income, and prior-year accumulated earnings and profits, and is now attempting to calculate the company’s current earnings and profits 46 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation E and P Determination For purposes of this task, assume that all items of income and expense have been properly reported by Alaska on Form 1120, U.S Corporation Income Tax Return, for the appropriate years Starting with taxable income as a benchmark, indicate the effect of each of the following items in the calculation of current-year earnings and profits by placing a check in the correct column next to each item Be sure a column is checked for each item Definition of Corporate Earnings and Profits: Although similar in many respects and in concept, corporate earnings and profits (E&P) are not exactly the same as retained earnings Earnings and profits is calculated according to the rules of federal income taxation, and retained earnings is calculated according to Generally Accepted Accounting Principles (GAAP) For example, while non-taxable dividends reduce retained earnings, they have no effect on E&P The calculation of E&P is critical to the tax impact of corporate distributions, and the calculation of E&P (both the current and prior accumulated amounts) is required in the preparation of the corporate income tax return [Note that the adjustments applied to the starting amount of corporate taxable income can be always positive, always negative, or either positive or negative Note also that those differences may be temporary or permanent in nature, and they follow the rules discussed in the textbook in the section that presents the corporate Schedule M-1.] The determination of E&P is also critical to evaluating the ability of the corporation to pay dividends Thus, any items that have not been reflected in the corpoartion’s taxable income but may have an impact on the corporation’s ability to pay dividends must be included in the calculation of E&P 47 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Current Earnings and Profits General Calculation Corporate taxable income [postive or negative taxable income] Common E&P Adjustments [negative or positive] *: Always a negative adjustment / ^: Always a positive adjustment Federal income tax expense* Non-deductible penalties, fines, political contributions, etc.* Officer life insurance premiums [corporation is the beneficiary]* Expenses for production of tax-exempt income* Non-deductible charitable contributions* Non-deductible capital losses* Losses and gains that have different effects on taxable income vs E&P Changes in the cash surrender value of certain life insurance policies Excess depreciation for E&P over that for regular income tax Installment income method adjustments Completed contract income vs %-of-completion income adjustments Amortization of intangible drilling costs adjustments Refunds of federal income tax paid^ Tax-exempt income^ NOL deductions^ Life insurance proceeds where corporation is the beneficiary^ Dividends received deduction used to calculate regular taxable income^ Carryovers of capital losses that impacted taxable income^ Carryovers of charitable contributions that impacted taxable income^ Non-taxable cancellation of debt not used to reduce basis of property^ = Current Earnings and Profits (E&P) 48 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Explanations: Unrealized losses (and unrealized gains) represent changes in value of securities held but not yet sold These unrealized gains and losses are not recognized for tax purposes They have no effect on regular taxable income, stockholders’ equity, or E&P Federal income taxes accrued and paid is an expense item that will reduce stockholders’ equity Although it is not allowed as a tax deduction, it will reduce E&P (a negative adjustment) For purposes of E&P, a corporation will treat gain from an installment sale as if the installment method were not used This means that the entire profit will enter E&P in the year of the sale Therefore, gain on a prior year installment sale recognized in the current year must be subtracted from taxable income (thus reducing E&P) This is because it is included in the current year’s taxable income but was already included in E&P in the original year of the sale The nondeductible portion of meals and entertainement (50% of the total meals and entertainment expense) is a valid expense that will reduce both stockholder’s equity and E&P Because this is the portion that was not deductible in determining regular taxable income, it must be subtracted from taxable income in determining E&P The amount of state income tax expense that relates to the corporate taxable income for the year is the amount that is deducted from regular tax as income tax expense The difference in the amount paid and the expense is accrued and reported on the balance sheet (i.e., either a taxes receivable or a taxes payable account is created) Thus, the amount of the state refund from a prior year received in the current year is a reduction to the amount reported I the prior year as “taxes receivable” on the balance sheet Thus, there is no effect on corporate income or E&P As presented above, the expense related to premiums on life insurance of an officer when the corporation is the beneficiary is not deductible (i.e., it is a negative adjustment for E&P), and the related proceeds from the collection on that type of life insurance policy are not taxable (i.e., they are a postive adjustment for E&P purposes) Under GAAP, changes in the cash surrender value of a life insurance policy run through the income statement and either increase or decrease the ability of the corporation to pay dividends (i.e., they increase or decrease equity) However, just as the premiums are not deductible and the proceeds not taxable, neither are the changes in the cash surrender value of life insurance reportable for tax purposes Thus, the increase in cash surrender value of life insurance policies owned by the company is not taxable and is not part of taxable income; however, it must be included as a positive adjustment in the calculation of E&P (i.e., an addition to taxable income and an increase to E&P) 49 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Distribution In year 4, Alaska is still a C corporation Accumulated earnings and profits at the end of year were $61,000 Current earnings and profits for year are $24,000 During year 4, Alaska made two distributions on the dates indicated in column A of the table below Allocate the distributions indicated in column B among columns C, D, and E Round all answers to the nearest dollar Distribution dates Distribution amounts Current E&P Accumulated E&P at 12/31/year Excess distribution 3/31/year 58,000 15,297 42,703 9/30/year 33,000 8,703 18,297 6,000 Totals 91,000 24,000 61,000 6,000 Explanation: Corporate distributions are first applied to current E&P, then to accumulated E&P, then to return of capital, and, then, if any excess remains, it is classified as excess distributions and reported as capital gain distributions (taxable income) by the shareholder Distributions within the year are allocated based on the ratio of each distribution to the total distribution Note that the allocation of the excess distribution to return of capital and capital gain distributions depends on the stock basis of the shareholder (refer to the next section of this simulation) Current E&P o 3/31/Year 4: $15,297 The $24,000 current E&P is allocated between the two distributions based on the ratio of each distribution to the total distribution, which is $91,000 $15,297 = 24,000 X (58,000 / 91,000) o 9/30/Year 4: $8,703 The $24,000 current E&P is allocated between the two distributions based on the ratio of each distribution to the total distribution, which is $91,000 $8,703 = 24,000 X (33,000 / 91,000) Accumulated E&P at 12/31/Year and Excess Distribution 3/31/year 4: $42,703 and $0 The total distribution of $58,000 at 3/31/year 4, is below the total of current and accumulated E&P of $85,000 (24,000 + 61,000) Therefore, there is no excess distribution associated with this The remaining $42,703 ($58,000 50 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation total distribution – $15,297 [calculated above as the distribution from current E&P]) is allocated to accumulated E&P 9/30/Year 4: $18,297 and $6,000 This distribution represents an excess distribution of $6,000 The total available E&P from above is $85,000, and this distribution of $33,000 results in total distributions for the year in the amount of $91,000 [$58,000 + $33,000] Thus, $6,000 is a distribution in excess of E&P The remaining amount of $18,297 ($33,000 total distribution – $8,703 [distribution from current E&P per above] – $6,000 excess distribution) is allocated to accumulated E&P 51 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Underwood, a 20% shareholder in Alaska, has a stock basis of $700 at the beginning of year Complete the following table to indicate the characterization of the Alaska distributions to Underwood during year Round all answers to the nearest dollar Underwood's total distribution 18,200 Dividend income 17,000 Return of capital 700 Capital gain 500 Explanations: Underwood’s Total Distribution: $18,200 Total distributions from above are $91,000 Underwood is a 20% shareholder Thus, the total distribution is $18,200 ($91,000 X 20%) Dividend Income: $17,000 According to the first chart, $85,000 of the total distributions of $91,000 represent current and accumulated E&P The remaining $6,000 is classified as excess distributions All distributions will be considerd to be taxable dividends to the extent of this ratio Dividend income is $17,000 ($18,200 X $85,000 / $91,000) Return of Capital: $700 The remaining excess distribution of $1,200 ($18,200 – $17,000) is considered to be a return of capital to the extent of basis in the stock The basis is given to be $700, so that amount is return of capital Capital Gain: $500 The portion of the excess distribution that exceeds stock basis is taxable as a capital gain Stock basis is $700, so the capital gain is $500 ($1,200 – $700) 52 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Communication Alaska’s controller, who has no tax background, was reviewing the corporate income tax return and does not understand why taxable income, as reported on the return, does not agree to net income before tax, as reported on the financial statements Prepare a memo to the controller explaining the purpose of Schedule M-1, Reconciliation of Income (Loss) per Books with Income per Return, and provide an explanation for two items that would most likely appear on a corporation’s Schedule M-1 Type your communication in the response area below the horizontal line using the word processor provided REMINDER: Your response will be graded for both technical content and writing skills Technical content will be evaluated for information that is helpful to the intended reader and clearly relevant to the issue Writing skills will be evaluated for development, organization, and the appropriate expression of ideas in professional correspondence Use a standard business memo or letter format with a clear beginning, middle, and end Do not convey information in the form of a table, bullet point list, or other abbreviated presentation 53 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Explanation: Generally, taxable income will not agree to net income before taxes on the Income Statement The reason for this is that the financial statements are prepared under the rules of Generally Accepted Accounting Principles (GAAP) and the tax return is prepared using tax law This can result in differences in revenue, expenses, or both A Schedule M-1 is prepared with the Federal Income Tax Return, Form 1120, of the company This purpose of this schedule is to provide a reconciliation between taxable income on the tax return and book income on the Income Statement The schedule begins with book income and ends with income for tax purposes Let’s look at a couple of common examples that may cause differences between book income and taxable income and, thus, be included on the Schedule M-1 54 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Depreciation on the income statement is based on GAAP depreciation rules However, tax depreciation is typically based on the Modified Accelerated Cost Recovery System (MACRS) This will lead to timing differences between book income and taxable income, and the difference will be reported on the Schedule M-1 as either a positive or a negative adjustment, depending on the depreciation schedules for all of the company’s assets Another common example is interest revenue from municipal bonds This interest is reported as revenue and included in the Income Statement under the rules of GAAP However, this interest is tax-exempt under the Internal Revenue Code and is not included in taxable income Thus, to reconcile book income to income per the tax return, a negative adjustment (i.e., a subtraction from book income) is necessary to be reported on the Schdeule M-1 I am hopeful that this information has aided in your understanding of how the GAAP income statement reconciles with the taxable income on the tax return Should you have any additional questions or require further clarification, please not hesitate to contact me Sincerely, CPA Exam Candidate 55 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation Research/Authoritative Literature Alaska, Inc uses MACRS for income tax purposes However, MACRS is not allowed in determining the company’s current and accumulated earnings and profits Which code section and subsection provides guidance on the effect of depreciation on earnings and profits? IRC 312 (k) Keywords: “Depreciation Effect Earnings and Profits” 56 © 2010 DeVry/Becker Educational Development Corp All rights reserved ... explanation 44 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation AICPA Released Simulation Directions 45 © 2010 DeVry/Becker... remaining $42,703 ($58,000 50 © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation total distribution – $15,297 [calculated above... nothing to with the obligations of a surety © 2010 DeVry/Becker Educational Development Corp All rights reserved 2010 AICPA Newly Released Questions – Regulation According to the Securities Act