So you’re thinking about taking the Financial Accounting CLEP exam? Awesome! Here’s what you need to know.
The 75-question exam is designed to focus on the concepts and skills developed in a freshman, first-semester course. Basic, general topics such as debits and credits, the accounting equation, and the accounting cycle would be reviewed, as well as more advanced topics such as internal controls, valuation, and cash flows.
If you have some background in bookkeeping or basic accounting, you’ll probably just have to brush up on the more advanced portions of the test. If not, you’d better get pretty comfortable with the underlying concepts and theories. Accounting is not really difficult, but you won’t get it by memorizing. Understanding and internalizing is key!
The exam will be divided into five major chunks:
As with most of accounting, debits and credits are your friends. While they may be confusing for some, always remember that debit does not mean “increase” and credit does not mean “decrease” – they literally mean “left” and “right”. Keep in mind that assets and expenses are increased by debits, while liabilities, income, and capital are increased by credits.
You’ll want to understand the relationships between the income statement, balance sheet, and statement of cash flows and why they are all important in communicating the financial condition of the company. You should also be very comfortable with the U.S. generally accepted accounting principles (GAAP). Take note – while accounting principles are generally similar across the board, there is an alternative set of standards called the International Financial Reporting Standards (IFRS) which is common outside the United States. Be sure you’re reading up on U.S. GAAP!
This section would delve into the income statement – the one that measures how well a business operated in a certain period! Keep in mind that in most businesses, cost of goods sold (those directly related with sales) are different from operating expenses such as utilities, advertising, and rent. The difference between net revenues and cost of goods sold is what we call gross profit, while the difference between gross profit and operating expenses is the net profit.
You’ll also want to read up on irregular items and profitability analysis. In analyzing profitability, one of the most common measures used is return on sales. This is easy – just divide the net profit by the sales and you would get the percent value you need. Also: don’t forget that revenues and expenses are recorded when they are earned or accrued, not necessarily when they are received or paid! This is one of the generally accepted accounting principles – the matching principle.
Assets, liabilities, and equity – the three components of the accounting equation which also make up the balance sheet. Here, you’ll want to know more than how to keep both sides of the equation in check – knowledge about classification of accounts is important! Where do I classify patents, for example, or other forms of intellectual property? That would have to be a non-current asset because it is useful in the long term. Make sure you can make these calls with your eyes closed.
You should also be familiar with corporation speak such as preferred and common stock. Related to that, you should be aware that there are differences in how the balance sheet is presented based on the form of business organization. For instance, while the net profit of a sole proprietorship is commonly added to the owner’s capital account, the net profit of a corporation is added to a separate account called retained earnings. Capital contributions of the shareholders in the form of preferred and common stock are categorized in a distinct account.
Aside from this, being able to differentiate among liquidity, solvency, and activity and using them appropriately in analysis is a definite requirement. Here’s the gist:
Liquidity – the ability to pay short-term liabilities with current assets
Solvency – the ability to pay long-term liabilities with assets
Activity – the ability to effectively make use of assets to generate income
If you still have some time left, it would be good if you could brush up on some other conceptual topics. Read on how businesses implement internal controls in order to prevent cash leakages in the system. Consider how allowances are made for uncollectible accounts (bad debts) and how adjustments are made for long-term assets as well as the corresponding journal entries for the gains and losses for the sale of such.
This section can be quite tricky – especially because there are loose distinctions among operating, financing, and investing activities. But with enough practice doing the cash flow analysis using the indirect method, you’ll be a cash flow pro! Here’s a quick tip which holds true for the majority of accounts: current assets and current liabilities – operating, non-current liabilities and equity – financing, and non-current assets – investing. Pretty neat, right?
The topics under miscellaneous aren’t as important as those discussed above, but are worth getting a background of if you’re aiming for a near-perfect score! Oftentimes, companies also make investments in other companies or financial instruments which can generate additional income. Meanwhile, contingent liabilities refer to obligations a company might have because of some future event, such as a pending lawsuit or warranty claims from customers.
Correct Answer: B. $40, $40
Explanation: To compute for the depreciation through the straight-line depreciation method, we use the general formula (Purchase price – Salvage value) / Useful life. Plugging in the values, we get $280 (($2,500 – $100)/5 years) as the annual depreciation. To get the monthly value, we divide $280 by 12 months ($40). Therefore, the answer is $40. This would be true in both March and December because the depreciation expense does not change per month under straight-line depreciation. Meanwhile, it would be the accumulated depreciation account which would have a balance of $400.
Correct Answer: A. Cannot be determined
Explanation: In the given example, the cost of goods sold cannot be determined. One may hastily answer that the cost of goods sold would be $500 ($1,000 – $500). While this is indeed a possible outcome in real life, we cannot be sure because the amount for Purchases was not given in the problem. With a value for the Purchases account, the cost of goods sold could be even higher than $500.
Correct Answer: A. Contra revenue and debit
Explanation: Since sales discounts are deductions to sales or revenues, it will be considered as a contra revenue account. Moreover, since the normal balance of revenues is credit (revenues are increased by credits), the normal balance of sales discounts would be the opposite – debit.
Correct Answer: C. Cost of goods sold would be understated, gross income would be overstated
Explanation: An overstatement in the ending inventory would reduce cost of goods sold, causing it to be understated. Meanwhile, since gross income is the difference between sales and cost of goods sold, it would be overstated.
Correct Answer: B. Cost of goods sold would be understated, gross income would be overstated
Explanation: An overstatement in the ending inventory would reduce cost of goods sold, causing it to be understated. Meanwhile, since gross income is the difference between sales and cost of goods sold, it would be overstated.
Correct Answer: C. Depreciation
Explanation: Depreciation is a non-cash expense – you don't actually spend cash month after month because your equipment and other fixed assets lose their value. This is why depreciation is added back to the net income in order to accurately depict cash flows from operating activities.
Correct Answer: C. Goods in transit with terms FOB Destination
Explanation: Goods which have the terms FOB Destination are only recognized as inventory from the buyer's perspective once it is received by the buyer, not when it is still in transit. This is because FOB Destination means that the buyer is free from the responsibility of the goods until it reaches his or her hands. Therefore, it is not yet recognized as inventory in the buyer's books.
Correct Answer: C. Increase in revenue of $75, no increase in operating expenses
Explanation: Since TLT Merchandising was only able to sell 5 bouquets, the revenue would only increase by $75 ($15 selling price x 5 bouquets). Meanwhile, there is no increase in operating expenses because the $10/bouquet cost would be classified under cost of goods sold since it is directly related with the revenues generated. The cost of goods sold should increase by $50 ($10 purchase price x 5 bouquets sold).
Correct Answer: B. Operating activity
Explanation: Typically, accounts payable are incurred whenever we make a purchase from a supplier on account. This type of transaction is associated with the daily operations of a company, and is therefore classified as an operating activity. Alternatively, we can analyze this transaction through the shortcut we have explained above. Since accounts payable is a current liability, we can conclude that it is an operating activity.
Correct Answer: D. Ownership of the owner and ownership of the business
Explanation: The accounting entity or separate entity concept is one of the generally accepted accounting principles (GAAP). It states that whatever the owner owns (or owes) is apart and distinct from whatever the company owns (or owes). Therefore, in accounting, personal expenses such as the rent of the owner's house should not be considered as an operating expense in the books of the company. Whenever the owner would use company funds for personal use, it should be instead be recorded as a withdrawal from the owner's capital account.
Correct Answer: A. When the office supplies are used
Explanation: Using the asset method, when supplies and similar items are bought, they are first recorded as an asset as opposed to an expense. Therefore, an expense is not recorded when the office supplies are paid, neither when they are received or bought. An adjusting entry is to be made by the company (usually at the end of the month, period, or year) when the office supplies are used. Only then would the office supplies that are used be considered as an expense. This would be reflected in the income statement. Meanwhile, the office supplies still unused would remain as an asset.
While quite short on the study side of things, the official CLEP book is the go-to final practice test. Since this is the only official practice test available, I normally use it as my final spot check before taking the test.
REA offers a great combination of CLEP study tips, exam study materials, and detailed practice tests. This book functions well as the central pillar of a strong CLEP prep strategy, with resources like the Official CLEP Study Guide (above) providing a great final practice test at the end.
The website looks like it was made before the internet, but it’s legitimately the single most useful study guide I’ve found yet. Basically it’s a series of flashcards that help you study in a fast paced and fun way.
