Ch9. CPA Exam High-Frequency Error Analysis — Common Mistakes and Traps

Financial Reporting — Common Errors

① Contingent liability vs. contingent asset
   → Contingent liability: probable + reasonably estimable → ACCRUE
   → Contingent asset: virtually certain → accrue;
     probable (not virtually certain) → disclose in footnotes only

② PP&E impairment test (ASC 360)
   → Recoverability test uses UNDISCOUNTED future cash flows
   → Measurement uses fair value (NOT undiscounted)
   → Common mistake: using fair value for the recoverability test
   → Impairment write-downs are NOT reversed under US GAAP

③ Financial asset classification (ASC 320 / ASC 326)
   → HTM / AFS / Trading — three categories for debt securities
   → Equity securities (ASC 321): generally measured at fair value
     through net income (no AFS/HTM option for equity)
   → AFS unrealized gains/losses → OCI (not net income)

④ PP&E — No revaluation model under US GAAP
   → US GAAP: cost model only
   → Common confusion: IFRS IAS 16 allows revaluation
   → Revaluation surplus (OCI under IFRS) does NOT exist in US GAAP

⑤ Lease accounting (ASC 842)
   → ALL leases ≥ 12 months → recognize ROU asset and lease liability
     for BOTH operating and finance leases
   → Short-term lease exemption: ≤ 12 months at commencement
   → Low-value asset exemption does not exist under US GAAP
     (it exists under IFRS 16 for underlying assets ≤ ~$5,000)

Cost and Managerial Accounting — Common Errors

⑥ Contribution margin = Sales − Variable costs
   (NOT sales minus fixed costs)
   Common mistake: subtracting total costs instead of variable costs

⑦ BEP formula:
   BEP (units) = Fixed costs ÷ CM per unit
   Common mistake: using total costs in denominator instead of CM

⑧ Standard cost variances: price vs. efficiency
   → Price/rate variance: (Actual price − Standard price) × Actual quantity
   → Efficiency/usage variance: (Actual qty − Standard qty) × Standard price
   → Common mistake: swapping the price and quantity bases

⑨ Absorption vs. variable costing income:
   → Production > sales → absorption income HIGHER
     (fixed OH deferred in ending inventory)
   → Production < sales → variable costing income HIGHER
   → Common mistake: reversing the direction

⑩ ABC — assign indirect costs via activity cost drivers
   → NOT a single plant-wide overhead rate
   → Each activity pool has its own cost driver (machine hours,
     setups, inspection hours, etc.)

Tax Accounting — Common Errors

⑪ Permanent vs. temporary book-tax differences
   → Permanent (fines, municipal bond interest, DRD) → no deferred tax
   → Temporary (depreciation timing, warranty accruals) → DTA or DTL

⑫ Sales and use tax
   → No federal sales tax in the US
   → Economic nexus (Wayfair): remote sellers must collect if
     >$100,000 sales or >200 transactions in a state
   → Use tax: buyer self-remits when seller does not collect

⑬ Zero-rate equivalent vs. exemption
   → In the US sales tax context, "exempt" means no tax + no refund
   → Manufacturing exemptions function similarly to zero-rating
     but there is no credit/refund mechanism built into US sales tax

⑭ Individual income sources — classification
   → Capital gains held >12 months: long-term preferred rates (0/15/20%)
   → Capital gains held ≤12 months: ordinary income rates (10–37%)
   → Qualified dividends: same preferential rates as LTCG

⑮ Federal income tax rate brackets
   → 7 brackets: 10%, 12%, 22%, 24%, 32%, 35%, 37%
   → The marginal rate applies only to income IN that bracket
   → Common mistake: applying the highest marginal rate to ALL income

Auditing and Accounting Standards — Common Errors

⑯ Four audit opinion types
   → Unmodified (clean) / Qualified / Adverse / Disclaimer
   → Adverse ≠ Disclaimer:
     Adverse: auditor SAW the statements → materially misstated
     Disclaimer: auditor COULD NOT obtain sufficient evidence

⑰ Auditor independence
   → Both independence in fact (mental) AND independence in
     appearance are required (AICPA Code; PCAOB Rule 3520)

⑱ Materiality
   → Quantitative threshold + qualitative consideration
   → A small dollar amount may be material due to its nature
     (e.g., fraud; affects compliance with covenants)

⑲ Internal control components (COSO Framework)
   → Control Environment, Risk Assessment, Control Activities,
     Information and Communication, Monitoring
   → Five components, NOT four

⑳ Consolidated financial statements
    → Consolidate all entities where the parent has CONTROL
      (voting interest model: >50% voting; or VIE model: primary beneficiary)
    → Intercompany transactions (sales, loans, dividends) fully eliminated
    → Non-controlling interest (NCI) presented in equity section

Key Concept Cards

Contingent Liability = Probable + Estimable → Accrue ★★★★★ : Probable but not estimable + reasonably possible → footnote only. Remote → nothing. Memory hook: probable + estimable = accrue; otherwise = disclose

Four Audit Opinion Types ★★★★★ : Unmodified (clean), Qualified (except for), Adverse (not fairly presented), Disclaimer (no opinion). Memory hook: clean → qualified → adverse → disclaimer

Zero-Rate vs. Exempt (Sales Tax Context) ★★★★☆ : US sales tax has no VAT-style credit mechanism. Exempt sales = no tax; manufacturing exemptions reduce cascading but no refund of prior-stage tax. Memory hook: US sales tax: exempt = no tax, no refund mechanism

Practice Quiz

Q. What is the difference between an Adverse Opinion and a Disclaimer of Opinion?

An Adverse Opinion is issued when the auditor has obtained sufficient evidence and concludes that the financial statements are materially AND pervasively misstated — “we looked and it’s wrong.” A Disclaimer of Opinion is issued when the auditor could not obtain sufficient appropriate audit evidence (scope limitation is pervasive) — “we couldn’t look.” Both are extreme opinions, but they arise from opposite circumstances: adverse = misstatement; disclaimer = inability to audit.

Q. Why must intercompany transactions be eliminated in consolidated financial statements?

From the perspective of the consolidated economic entity, intercompany transactions (e.g., a parent selling inventory to a subsidiary) are internal transfers, not arm’s-length transactions with outside parties. Including them would overstate revenues, expenses, assets, and liabilities at the group level. Unrealized intercompany profits (on inventory still held within the group) must also be eliminated, as those profits have not been realized through a transaction with an unrelated third party.