oh and welcome to the session this is
Professor for hat and this session we
would look at an introduction to the
third taxed asset and the third tax
liability this topic gives students a
lot of problems especially in
intermediate accounting or and on the
CPA exam I'm here to help you I'm gonna
demystify this topic this is an
introductory topic so please make sure
to take notes and you should be good to
go before we start this one I remind you
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additional practices multiple-choice
questions and if you're studying for
your CPA exam 2000 plus CPA questions so
in this session what we're going to go
over is accounting fundamentals for
accounting for income taxes this topic
is quite challenging for a lot of
students so the strategy is to listen to
the lecture listen to the lecture then
after the lecture you're gonna have to
work multiple choice questions make sure
toward the multiple choice questions
because without working the multiple
choice questions it's not gonna be very
helpful for you because you need to
practice what you have learned if you
don't practice what you have learned and
to a degree it's useless because you
really don't know if you really
understood something unless you practice
so please practice make sure to practice
after the lecture so what is the big
idea here and it's a big idea the big
idea is this corporation must file an
income tax return and here we are we are
talking about 1120 so let's talk about
11 and 411 20s let's assume we are
looking at a corporation and what they
do every year they fall under 1120 and
what do they follow when they form the
1120 they follow the IRS rules now
that's on one hand on the other hand
they have to prepare their financial
statements so companies they have to
prepare their financial state
and when they prepared your financial
statements your financial statements are
prepared for external users therefore
they have to use generally accepted
accounting principles so they do use
different rules for preparing their
financial statements and because there
are differences between GAAP and IRS if
they were the same we wouldn't be doing
this chapter now if both IRS and the
GAAP had the same rules then there is no
reason for the further income taxes and
deferred tax liability but since they
differ we have to account for that
difference in terms of the third taxed
asset or the third taxed liability so
here we go in this session I'm going to
be referring to something called income
tax expense every time I say income tax
expense it means that's the gap or the
financial statement expense so if I say
financial statement income tax
it means gap if I say gap it means tax
expensive I said tax expense that means
gap and this is how they are used in the
real world as well as the on the CPA
exam the same thing apply when I say
income tax is payable income taxes
payable it means you have to pay it to
the IRS it means that's the IRS so when
I say this says income taxes payable
this is how you compute income taxes
payable or this is how you compute your
taxes for IRS it means I'm referring to
income taxes payable so make sure you
write this down right now okay if you're
not writing it down and write it down
because it's going to become very handy
as we go through this and this is a
picture of what I just said hopefully it
will make more sense to you we have
investors and creditors they follow GAAP
okay so what they do is they compute
something called
financial income pre-tax financial
income again pre-tax financial income is
a GAAP terminology then pre-tax
financial income will give them your
income tax expense remember income tax
expenses GAAP now for tax purposes we're
gonna have the term is taxable income so
notice here financial income or pre-tax
financial income or income before taxes
versus taxable income the IRS for tax
purposes we use taxable income then we
compute our taxes then we come up with
income taxes payable notice there are
differences between how we do things
difference differences and terminology
and the
for instance in actual computation so
notice this is tax and this is financial
statement the reason we prepare
financial statements is for external
users and the Securities and Exchange
Commission the reason we compute our
taxes is to pay our taxes to Uncle Sam
following the IRS there are differences
between the two now to illustrate this
these concepts the best way is to to
work an example and go through it step
by step so let's start with this example
we have Chelsea a reported revenue of
130,000 expenses of 60,000 in each of
the first three years of operation
notice for tax purposes
Chelsea reported the same expenses so
notice as far as tax is concerned the
expenses of 60,000 are the same so we
don't have to worry about the expenses
just keeping the example simple Chelsea
report the taxable revenue notice
taxable revenue it means for IRS
purposes of one hundred thousand and
twenty twenty so for looking at 2020
they reported revenue of one hundred
thousand four twenty twenty-one they
reported revenue of 150 and for twenty
twenty-two they reported revenue of one
hundred and forty and this is for tax
purposes this is how they reported the
revenue for tax purposes okay what is
the effect on the account of reporting
different amount of revenue for gap
versus taxes so let's take a look at how
they reported it for gap as well so we
can compare the information side-by-side
now remember expenses will be the same
so if you're wondering why expenses are
the same for both is because we say
expenses are both as far as gap and as
far as IRS so we don't have to worry
about the expenses we have to focus on
the revenue and reason we do it this way
is to illustrate the point to illustrate
the point initially that you understand
you need to have a fundamental
understanding of the third taxed asset
and the third tax liability in order to
understand duh yes you need to
understand something in order to
understand and that's the purpose
so notice let's go through the IRS again
for tax purposes they reported one
hundred thousand revenue
for tax purposes for GAAP purposes they
reported one hundred and thirty thousand
simply put if you're looking at this
what does that mean for you let's just
simplify it what does that mean it means
for GAAP they reported more revenue how
much more revenue thirty thousand more
revenue remember just to kind of tell
you why would why would that happen just
kind of it's also it's very they're very
important to understand why would this
happen remember for GAAP purposes we use
accrual so we book revenue before we
receive it in cash maybe for tax
purposes we are using cash method so
before tax purposes we are using the
cash method therefore we only report one
hundred thousand four for GAAP purposes
we are using accrual now to be more
specific let me show you the journal
entry this way you can have also I want
you to see this clearly before you
proceed for GAAP here's what's gonna
happen for gap for GAAP let me show you
the journal entry side by side for GAAP
they reported revenue so they credit
revenue of 130,000 they debited cash for
100,000 and they debited account
receivable for 30,000 so this could be
this is good of what happened so they
add up add up end up with revenue of
130,000 for tax purposes they only
reported the cash so they debited cash
one hundred thousand they credited
revenue one hundred thousand and this is
what happened for tax purposes and this
is what happened for financial statement
purposes okay so I just want make sure
you understand this so it so what
happened as a result of this what
happened as a result of this your
pre-tax financial income or gap
financial gap taxable income gap
financial income pre-tax financial
income is seventy thousand and there's a
twenty percent tax rate seventy thousand
times twenty percent your income tax is
forty thousand now although I did this I
I showed you this is how it gets done
but this is gonna change this is a very
simple illustration so this is not how
you compute your income tax again
not how you compute your income tax so
what I just did is incorrect the reason
I just want to explain those numbers see
how while you are seeing these numbers
but this is not how we compute income
tax let me show you how we compute tax
for for tax purposes
so for tax purposes we have revenue of
one hundred thousand expenses of 60,000
taxable income is forty Texa belen come
times forty percent will give us an
income tax expense of eight thousand
this is how you compute your income tax
expense your income tax expense if you
want to write it down please go ahead
it's very important that you write it
down so you take your taxable income I
know you're gonna say this is easy but
write it down taxable income times the
rate whatever that rate is happens to be
this is how you compute your income your
income taxes for tax purposes not the
same for GAAP purposes okay but let's do
year twenty one twenty two just to show
you what happened overall then would
look at the deferred income tax asset
and the third income tax liability in
2021 GAAP had 130,000 of income now in
2021 for tax purposes we received more
revenue notice in 2021 we have more
revenue for tax purposes that means the
client paid us more in cash and less for
gap so as a result our taxable income is
$90,000 our eighteen thousand for 2022
for gap it's one hundred and thirty
thousand our revenue for tax purposes
purposes one hundred and forty thousand
again as a result we have minus sixty
thousand in taxes our taxable income is
eighty thousand and our taxes are
sixteen thousand so the eight thousand
here the eighteen thousand here and the
sixteen thousand here this is what we
actually send to the IRS this is the
money this is the cheque that we send to
the IRS this is what we are responsible
for this is what we are responsible for
so basically when we say income tax
expense this is also income taxes
payable so the eight thousand the
eighteen thousand and the sixteen
thousand our income taxes payable now
let me show you the total over a period
of three years
this is the total and there's an error
on this slide revenue 130 plus 130 plus
130 equal to three hundred and ninety
thousand this is the error expenses over
three years equal to 180
notice for tax purposes revenue over
three years is 390 revel expenses over
three years as 180 what does that mean
that means over a period of three years
revenues and expenses are the same they
differ from year to year but in total
they are the same in total your pre-tax
financial income is 210 your taxable
income is 210 your income tax expenses
42,000 and your income tax expense for
IRS purposes 42,000 so for a period of
three years they are the same what does
that mean it means those changes reverse
so those who are we call those we're
going to learn the term later those are
temporary differences it mean
differences that they are different from
year to year but overall over the long
period they reverse and they equal to
each other okay
hopefully you see the big picture now
let's see the difference between the
income tax for gap and the income tax
for the IRS again the way we compute
that gap is not accurate but this is it
will help us just to kind of that will
help us just to for now it will help us
for now for 2020 gap income tax was
14,000 income taxes payable which is I
said income tax expense for IRS we call
it income taxes payable 8,000 so notice
in 2010 2020 we paid less to the IRS we
paid less think of it this way in 2020
we paid $6,000 less than our GAAP income
because this is what we actually have to
pay okay are there any differences
accounted for financial statements yes
there are differences between the two
right because for if we paid less taxes
in 2020 and overall I told you overall
over a period of three years they're
gonna be the same so what happened in
2020 because I paid less taxes it means
in the future I have to pay more that's
does that make sense if they are this if
have over a period of three years and I
already showed you this that gap and IRS
are the same and I paid less this year
in taxes well guess what this less of
taxes this year will catch up for me in
future years okay now what does that
mean from a deferred tax assets and the
fur tax liability it means for 2020 I
have to report at the third tax
liability by $6,000 let me explain this
for you what does that mean is this it
means in 2020 I computed my taxes and I
find out I'm paying $6,000 less the IRS
then my GAAP income tax well guess what
that difference eventually will catch up
with me so for me to show that
difference to the investor so they'll be
investors and the users look I paid less
taxes to the IRS this year but look I'm
gonna have to pay an additional six
thousand in IRS payment more in future
years and to show them this I have to
book a deferred tax liability therefore
at the third tax liability is born just
a deferred tax liability is born because
I am responsible for more taxes again
how did I know I'm responsible for more
taxes well I looked at my 2020 I paid
the IRS $6,000 less than what my GAAP
income taxes and I know that difference
would reverse it means in the future I'm
responsible for 6000 it means that the
third tax liability is born of $6,000
which reverse in the future when is it
going to reverse it's gonna reverse in
2021 and 2022 let's let's see what
happened in 2021 in 2021 my income tax
expense for gap is 14,000 my income tax
expense for the IRS is 18,000 notice I
wrote a check this is the check the
18,000 is the check I wrote to the IRS
and $18,000 check
but for GAAP purposes I only booked I
only report that 14,000 in 14,000 in
income tax expense what does that mean
it means that $6,000 that I said it's
gonna be the first tax liability it's
catching up with me now since I paid
more to the IRS I'm going to reduce am
going to bring down that liability by
$4,000 okay I'm gonna have a third tax
liability reduction reduced by $4,000
now what's happening is my liability is
reversing my liability is reversing my
deferred tax liability is reversing in
2022 my gap taxes are 14,000 my RS taxes
are 16,000 it means I paid more for the
IRS exactly how much more $2,000 more
well guess what you remember that $6,000
4,000 of it was reversed and 2021 the
remainder the $2,000 remainder will be
reversed in 2022 well from a t-account
perspective if you really if you want to
see the from a t-account perspective
this is the third tax liability and I'm
gonna show you the journal entry in a
moment so I have $6,000 this is year
2020
basically by putting $6,000 as a
deferred tax liability I'm telling the
investors look I'm responsible for more
taxes in the future which indeed in 2021
they treat 4,000 of it reversed and in
2022 2,000 of it reverse the whole thing
is reversed so notice over a period of
three years everything equal over a
period of three years so what I'm doing
is I'm accounting for the difference
between my income tax expense for
financial statement purposes and my
income taxes payable for IRS purposes
now let me show you how things are
reported on the financial statements and
this is where this is I'm not and I'm
gonna tell you how to compute income tax
expense so so maybe I should show you
the journal entry first so let me show
you the journal entry for 2021 I'm gonna
show you the journal entry for 2021 so
I'm gonna erase everything and show you
the journal entry so here's this so this
is the first journal entry and this is
important that you understand this
journal entry it's gonna help you
understand future journal entries you
always start with the easy one usually
the easiest is income taxes payable
income taxes payable why do I say it's
the easiest because it's the easiest
income taxes payable this
easiest because it's your taxable income
times the rate so it happens to be 8000
so I would credit sorry I would credit
income taxes payable income taxes
payable $8,000 I'm done with this
then notice my deferred tax liability
went up by 6,000 well I have to book a
deferred tax liability I have to credit
and the third taxed liability of how
much of 6,000 hold on a second what is
that 6,000 came from it's the difference
between what I paid to the IRS and what
I booked on the income tax return now
I'm missing a debit those are both
credit because they are both liabilities
and they're both going up the debit is
income tax expense and what's my income
tax expense think of income tax expense
as a plug hold on a second did you just
say a plug
yes think of it as a plug it's the third
taxed plus current tax so this income
taxes payable this is what I'm going to
be paying currently so we call this
current tax this is my current bill
right now the SiC the $8,000 is my
current tax bill the third tax liability
is my deferred tax so income tax expense
equal to what I paid now and what I'm
gonna have to pay in the future
therefore six plus eight equal to 14,000
and this is the journal entry write it
down so I can I will show it to you on
the on the how everything is reported on
the financial statement okay so this is
journal entry I'll show it to you later
a little bit a little bit further later
down the road so here's how things are
reported on the income statement once
again I compute my income taxes payable
first then I compute my deferred taxes
the third taxes liability plus income
taxes payable will give me my income tax
expense my income tax expense is my gap
and this is my IRS 8,000 is my IRS
number okay and the 6,000 is the
difference what does the deferred tax
liability gets reported on financial
statements it's a liability it's a
liability okay now let's talk more about
future taxable and the third amount so
let's talk about about something called
temporary difference so what is a
temporary difference a temporary
difference and this is we looked at it
but we now we're going to define it is
the difference between the tax basis of
an asset or a liability and it's
reported carrying value amount and the
financial statements that would result
in a taxable amount and that would
result in a taxable amount or a
deductible amount well what does it mean
it's gonna result in a future taxable
amount well I just showed you it's gonna
result in a deferred tax liability let
me go back and show you what I mean by
the the between the tax basis of an
asset and a tax basis of a liability in
its reported carrying value remember for
gap when I book the entry I said for the
first year my revenue was 130,000 i
debited account receivable of 30,000 i
debited cash of a hundred thousand then
for IRS purposes I said I only have cash
and revenue of a hundred thousand if you
remember that entry this is the tax
entry now what is the difference between
between these two the difference is the
account receivable the account
receivable as an asset so I don't have
the asset on tax for tax purposes so I
have a basis I have a carrying value of
an asset of 30,000 that's going that's
going to do what that's going to reverse
down the road that's going to reverse
down the road now if you think about it
if I take $30,000 okay and it's kind of
reverse down the road reverse means what
reverse means it's gonna go to the tax
purposes that's gonna considered revenue
tax
so as it's considered revenue I'm gonna
have to pay taxes on it so what does
that mean it means I'm gonna take
$30,000 multiplied by some tax rate
that's gonna reverse that and it gave me
$6,000
it gave me $6,000 so simply put that
book basis the $30,000 it's gonna
reverse down the road it's gonna reverse
down the road and remember the tax rate
is 20% okay so that $30,000 eventually
will turn into actual taxes and when I
turn into actual taxes I have more taxes
of 6,000 it means this is a temporary
difference so let's look at the
temporary difference of a liability okay
so the definition to be for a liability
will be something like this a temporary
difference is the difference between the
tax basis of an asset or a liability and
it's reported Book value in the amount
of the financial statement that would
result in a taxable in a taxable amount
stop right there
stop right there this is the definition
of a this is the definition of a
deferred tax liability it's a temporary
difference that's gonna give me more
taxes into the future now let me give
you the the third taxed asset definition
which is we did not see an example which
we'll see shortly
a temporary difference is the difference
between the tax basis or of an asset or
a liability and it's reported carrying
or Book value in the financial statement
that would result in a deductible amount
in the future so the third taxed asset
this is the third taxed asset it's what
I'm gonna happen in the future I'm gonna
have more deduction and what would the
duction give me duction will give me
lower taxes and lower taxes will give me
more assets so this is the definition
for the third tax liability represent an
increase in taxes and future years as a
result of a taxable temporary difference
existing at the end of the current year
and this is the example that we worked
so what happened is in the future I'm
responsible for more taxes why because
whatever I the third now is gonna catch
up with me therefore I'm responsible for
more taxes future deductible amount
we did not look at this it's a deferred
tax assets represent the increase in tax
refundable or saved so I'm gonna either
have I'm gonna have a refund but I'm
gonna save more taxes in future years as
a result of a deductible temporary
difference existing at the end of the
current year when I have a deferred tax
assets which will work an example to
illustrate that in the future years when
it reverse it's gonna give me more
savings it's gonna give me either more
savings what it's gonna give me more
refund as a result I booked at the third
tax asset at the third tax asset let's
take a look at this
so in Chelsea a situation the only
difference between the book basis and
the tax basis of the asset and liability
related the account receivable
that arose from the revenue recognized
for book purposes so I showed you poor
books I have a $30,000 of receivable for
tax purposes I don't have any and I
showed you this when I did the journal
entry now this $30,000 in 2028 would
reverse some of it reverse and 2021 some
of it reverse and 2021 20,000 reverse in
2021 and 10,000 reverse in 2022 so guess
what
basically it over the period of two
years taxable amount was higher in those
years as a result the liability reversed
okay Chelsea assumed it will collect the
account receivable and report the thirty
thousand collect collected as taxable
revenue in the future tax return okay
and by doing so she would she would
start to the third that she would start
to reduce her her tax liability or the
third tax liability okay so once again
the first act liability represent the
increase in taxes payable in future
years as a result of a temporary
difference existing at the end of the
current year because of the of a
temporary difference that's happening
now and the temporary difference would
reverse in the future when it reverse
I'm responsible for more taxes I have a
deferred tax liability okay because it's
in it because it's the first year of
operation there's no the third tax
liability at the beginning of the year
so we're keeping this example simple
because there's no prior the third tax
liability but we're gonna have to deal
with prior the third tax liability but
it's very important to understand the
idea okay
again this is a picture of what we just
did and this is the journal entry as I
told you income tax expense is the
current this is income taxes payable
this is current taxes plus the third so
though both of those current plus the
third equal to income tax expenses this
is the journal entry for four for 2020
now can you do the journal entry for
2021 can you do the journal entry for
2021 all right let me do the journal
entry for 2020 21 for you again how do
you start how do I start easy simple I
start with income taxes payable my
income taxes payable is 18,000 this is
the this is the amount I have to pay to
the IRS so I'm going to credit income
taxes payable 18,000 okay now the
difference is a reduction in the third
tax liability I'm gonna debit I'm gonna
abbreviate DTL the third tax labelling
to Deb I'm gonna debit the third tax
liability $4,000 hold on a second didn't
you tell me income tax expenses a plug
yes I told you it's a plug what am I
missing
I am missing income tax expense so
income tax expense for GAAP purposes the
difference between those two I'm looking
for a $14,000 debit and this is how you
compute your income tax expense so here
income tax expense equal to your current
taxes - the reduction in the - the
reduction in the deferred tax liability
okay let me show you the journal entry
for you so income taxes 18,000 easy this
is what I pay the IRS this is my current
taxes the third tax liability is a
reduction since it's a reduction I'm get
it's gonna reduce my current taxes okay
so 18 minus 4 so it's basically 18 minus
18 minus 4 equal to 14,000 which is my
income tax expense this is my gap number
this is
my gap number let's can you do 20 22 20
22 what do I start with start with the
IRS 16000 for the income taxes payable
then that year my deferred tax liability
reduced by 2000 my income tax expense is
fourteen thousand again income tax
expense is a plug income tax expenses a
plug again this hopefully you are
following but remember we're going to be
adding the balances at the beginning of
the year which we'll deal with that
shortly okay so this is the t account
for the third tax liability
I created $6,000 of a deferred tax
liability in 2021 four thousand of it is
is reversed in 2022 two thousand of it
as reversed
therefore my balance by 2022 equal to
zero equal to zero
okay let's take a look at the balance
sheet in the income statement balance
sheet and the income statement so here's
what's gonna happen on the balance sheet
in the income statement for 2020 I'm
gonna have on the balance sheet income
tax expense payable deferred tax
liability on the income statement it's
gonna be this Plus this equal to 14,000
in 2021 I'm gonna have income tax
payable of eighteen thousand the third
tax liability of only two thousand the
third tax liability only of 2000 so
notice what happened there was a
reduction of four thousand so eighteen
thousand minus the reduction equal to
fourteen thousand noticed there was a
reduction twenty twenty-two my income
tax payable is sixteen thousand right
the third liability went to zero it
means it went down by two thousand so
sixteen thousand minus the decrease
equal to fourteen thousand now you might
be saying why did you do to do this the
decrease and eighteen thousand and you
did eighteen thousand plus six well
eighteen thousand plus 6 because there
was zero and it went from zero to six
thousand so I took eight thousand plus
the increase of six thousand and just in
case to be to be consistent this is how
I came up with the fourteen thousand
four twenty twenty four twenty
twenty-two its eighteen thousand minus
the decrease so it's eighteen thousand
but my liability went down so I
reduce it from my liya penalty so I
reduce it from my liability so let me
show you specifically how things will
appear on the income statement for
example for for 2020 here's how huge
this is how you would show your income
statement on the income statement income
tax expenses compare is composed of two
components current in the third the
current portion is 8,000 that the third
portion is six okay and I had to pay in
total fourteen thousand I had to pay in
total fourteen thousand I have to pay in
total fourteen thousand okay let's look
at another example that deals with the
third tax liabilities let's look at
another example of the third tax
liability to make sure we understand
this so South Carolina corporation has
one temporary difference at the end of
2020 that would that will reverse it's a
temporary difference and cause a taxable
amount of fifty five thousand and twenty
twenty-one sixty thousand and twenty
twenty-two and seventy five thousand in
2023 what does that mean if it's if I'm
gonna if I have a difference and that's
gonna reverse and cause a taxable income
in the future that means I'm looking
added the third tax liability although
it's here but let's assume it's not here
hopefully you understand you're looking
at a deferred tax liability start field
pre-tax financial income translation gap
income for 2020 is three hundred
thousand and rate is thirty percent for
all years now this is important because
later on we're going to be changing the
rate so make sure the rate is very
important there are no deferred tax no
the third taxes at the beginning of the
year so this is basically a simple
example because there are no deferred
taxes at the beginning of the year
compute taxable income and income taxes
payable for 2020 well let's start with
taxable income how do we compute our
taxable income how do we compute our
taxable income okay so for 2024 2020 are
they given us taxable income they're not
but we have to compute taxable income
how
we compute taxable income gap income
they gave us gap income of 300,000 that
was given to us the gap income is three
hundred thousand and they told us and
they told us there is a difference there
is a difference of fifty five sixty and
seventy five so in future years 55 plus
60 plus 75 would reverse what does that
mean it means this year those are not
taxable it means to compute our taxable
income we have to deduct those three
amount fifty five thousand plus sixty
thousand plus seventy five thousand in
those three equal to one hundred and
ninety thousand so I'm gonna deduct one
hundred and ninety thousand and why I
did like this those are the amount that
are going to reverse so they are not
included in taxes this year it means my
taxable income equal to one hundred and
ten thousand well my taxable income
equal to one hundred and ten thousand
I'm responsible for paying thirty
percent in taxes one hundred thousand
times 30% equal to thirty three thousand
I just I just figured out my taxable
income I just figured out my taxable
income okay I just figured out my
taxable income now let me show you the
let me show it to you on the second
slide because it's easier to show it to
you but hopefully you understand this so
first I went um I did the first thing I
did is my 2020 I said gap is three
hundred thousand temporary differences
of one ninety which is the D reversal my
IRS taxable income is 110 times 30
percent gives me income taxes of 33,000
therefore what you do is you credit
income taxes payable of 33,000
immediately then you would say in future
years in 2020 150 if I have more $55,000
more I have $60,000 more in taxes and
$75,000 more in taxes fourth for from
the year 2021 55,000 times 30% I'm gonna
have more taxes of sixteen thousand five
hundred from year 2022 I'm gonna have
eighteen thousand more in taxes and from
year 2023 I'm gonna have
2,500 more in taxes so this Plus this
Plus this is what I called the third tax
liability an increase from 0 to 57,000
so my deferred tax liability was zero
yet it increase to fifty seven thousand
five hundred so I credit the third tax
liability fifty seven thousand now
thirty three thousand plus fifty seven
thousand those two together equal to the
income tax which is a plug this is how
you compute your income tax I know this
is funny but income tax expense for
financial accounting purposes as a plug
it's the result of the current plus
current and the further am I gonna say
plus sometime we have to we have to
deduct therefore current end the first
sometime we have to depending whether
the third is okay so it's the current
that's that current ended the third I'm
not gonna say plus because you don't
always add some time you have to deduct
if there's any reduction in your
deferred tax liability or when it comes
to this the first tax acid it's the
opposite so we'll hold on that okay so
let's take a look at another example
let's take a look at another example and
see how this all fits together so
hopefully you are getting to wrap your
head around the third tax liability
during 2020 cunningham estimate its
warranty costs related to the sale of
microwave oven to be half a million paid
evenly over the next two years for book
purposes in 2020 cunningham reported
warranty expense and related estimated
warranty liability of 500,000 in its
financial statement let's translate this
into simple english what happened is the
company sold an item and as a result
they sold a warranty with it and from
financial accounting statements
hopefully you know that you have to book
a warranty expense of half a million and
you have to credit estimated warranty
liability of half a million so for gap
this is what you have to do and you
learned this now for tax purposes what
do you have to do for tax purposes nada
nothing you don't have to do anything
for tax purposes for tax purposes
you cannot take you cannot estimate your
warranty liabilities
you have a liability when you actually
pay for it what does that mean it means
for book purposes for GAAP purposes you
have a liability of half a million okay
and for tax return you did not report
any expense so this expense that nothing
does not exist on the tax return and
thus liability don't exist on your
balance sheet for tax purposes okay so
now what's gonna happen in the future in
the future you are going to have a
deduction so in the future when these
customers come back and ask you to
repair the product you are going to have
an expense
but for GAAP purposes you will not have
an expense it means in the future and in
the future in the next two years this
half-a-million would reverse so let me
show you when it reverse what's gonna
happen in future years you're gonna have
a future deductible amount it means in
future years you're gonna have a lower
taxable a lower taxable income because
you have you have lower taxable income
than GAAP income because you're gonna
have more deductions on 2021 you're
gonna have more tax deduction 2022 more
tax deduction total you're gonna have
half a million of tax deduction what
does that mean
it means in the future you have more
savings what does that mean it's in the
future you're gonna have to book now at
the third tax asset why because if in
the future you have more savings you
have at the third tax asset
so when Cunningham pay for the liability
it reports an expense that's deductible
for tax purposes
Cunningham report this future benefit so
they report this future benefit now they
report that now how do they report it
the report is at the third tax asset
they report it as a deferred tax assets
and this is how at the third taxed asset
will be born so we'll have a deferred
tax asset and we'll book and the third
taxed asset half a million times
whatever the future rate is let's assume
it's 20% that's 100,000 therefore we
have a deferred tax assets year 2020 of
100,000 this is how the third taxed
asset is born okay
let's take a look at let's take a look
at the definition of a deferred tax
asset and the third taxed asset
represent the increase in taxes saved in
future years as a result of a deductible
temporary difference so that warranty is
a deductible temporary difference that
exists at the end of the current year
let's take a look at this example to see
how it all works
hunt company has revenues of nine
hundred thousand for both 2020 and 2021
it also has operating expenses of four
hundred thousand for each of these years
in addition hunt accrues a loss and
related liability of fifty thousand for
financial reporting purposes because of
a pending litigation so what happened
hump has to book a contingent liability
what does that mean it means they debit
lawsuit loss of fifty thousand and they
credited the estimated liability
estimated or Canton's contingent
contingent liability of fifty thousand
so they debited a loss which is they
take owe that for for for GAAP this is
for gap for gab they have a loss and a
liability for tax what did they have for
tax purposes nada nothing because they
for tax purposes you cannot deduct a
future liability you can neither dock
the contingent liability hunt cannot
deduct this amount for tax purposes
until it pays the liability expected in
2021 so this is this was twenty twenty
guess what in 2021 they're gonna pay the
lawsuit therefore then that's when they
take the deduction okay as a result a
deductible amount will occur in 2021
when hunt settles the liability causing
a taxable income to be lower okay so
let's take a look at the picture first
so this is gap gap we have revenues
expenses minus the lawsuit our pre-tax
financial income is 450 for tax purposes
we have revenues expenses notice no
lawsuit for 2020 taxable income of half
a million times 20% income taxes payable
100,000 can you do the entry can we do
the entry can you do the entry now can
you do the entry now let's do the entry
so for 2020 you will say income taxes
payable income taxes payable 100,000
okay income taxes payable as 100,000
coming from here now what's the
difference between income taxes what's
the difference between income taxes
payable and what I have to pay in taxes
well the difference technically is
$10,000 the difference is $10,000
the difference is $10,000 well this is a
deferred tax liability of $10,000
because in the future I'm gonna I'm
sorry apologies it's not at the first
taxed asset the difference is at the
third taxed asset of $10,000 in the
future I have a deduction and what is
the deduction the deduction equal to
50,000 times 20% so in the future I'm
gonna be saving when I paid that lawsuit
I'm gonna be saving $10,000 therefore I
have a deferred tax as a dear for I
booked my deferred tax assets of of
10,000 now all what I have to do now is
book income tax expense what is my
income tax expense it's my current
portion in my and my the third portion
my current portion is 100,000 and in the
future I'm gonna be saving 10,000 so I'm
gonna be reducing my taxes
therefore my income tax expenses only
90,000 and this is how I compute income
tax expense its 100,000 - then it's the
current portion - the increase and the
third taxed assets so so if I have a
deferred taxed asset I'll take that if
at the simply put over the third taxed
asset went up
I'm gonna take my current - the increase
and the third taxed asset - the increase
and the third taxed
if I have a deferred tax liability if I
have a deferred tax liability increase
the fur tax I'm sorry the DT d2l
increase
I'm gonna take my current sorry my
current taxes plus the increase in the
third tax liability to get to my income
tax expense to get to my here income tax
expense okay so make sure you know these
two formulas you make sure you know
these two formulas if I have a deferred
tax assets and it went up I'll take the
current minus the increase if I have it
a third tax liability and went up I'll
take the current plus the increase now
the opposite is true if my deferred tax
liability goes down I'm gonna take the
current plus if it went down it's the
current plus and I showed you already
what's gonna happen to the third tax
liability if it's if it went down it's
the current - okay copy this dose
formula down okay so that the third
taxed asset is 10,000 and the beginning
was zero okay so did the third tax asset
at the end of the year is 10,000 the
beginning was zero therefore there was
an increase of 10,000 there was an
increase of 10,000 so the current tax
expense is is income income tax expense
is 19,000 which is the current - the
increase - the increase and the TA - the
increase in DT a because the beginning
was zero so from a t-account perspective
this is DT a the beginning was zero in
the account went up to 10,000 it means
there was an increase of 10,000 if it's
an increase I take the current - the
increase in DT a in the third text asset
and this is the journal entry so income
taxes payable is a hundred thousand
remember with what we did is we took
half a million times 20% for tax
purposes then for the ten thousand here
we took 50,000 which is the lawsuit that
we're going to be deducting later times
20%
tax rate will be 20% it gives us a
deferred tax tacit
so our income tax expense is the current
this is the current and this is the the
first so we'll take the current - the -
the increase and the third taxed asset
okay now in 2021 2021 when it actually
reverse when it actually reversed what's
gonna happen is this when it when it
actually reversed when it actually
reversed remember I had 10,000 at the
beginning of the year when it reverse
I'm gonna reduce that 10,000 down to
zero therefore DTA will go down the PA
will go down well DTA will go down let's
see how it how it how it works from a
YUM let's see how it works so 2021 gap
for gap I have 99 hundred thousand and
revenues for hundred thousand and
expenses the lawsuit already deduction
taken I have pre-tax financial income of
half a million I'm gonna stop right here
let's go to tax purposes nine hundred
thousand four hundred thousand and now I
paid for the lawsuit fifty thousand
therefore my taxable income is four
fifty four fifty times twenty percent I
have to pay the IRS $90,000 I have to
pay the IRS $90,000 I have to pay the
IRS not only $90,000 because I paid them
the prior year one hundred thousand I
paid them more so the ten thousand
dollar difference it reversed because at
reverse I have to reduce my BTA remember
when DTA goes down I'll take my current
which is ninety thousand plus the DTA
goes down if DTA which is it's gonna go
down I'll take the current plus the
reduction so ninety thousand plus the
reduction of ten thousand so notice
what's gonna happen income tax expense
equal to one hundred thousand which is
the beginning was ten thousand and the
ending was zero so it went down it went
down by ten thousand that went down DTA
went down by ten thousand therefore I
will take my current plus the reduction
in DTA will give me my income tax
expense and this will be my journal
entry income taxes payable ninety
thousand this is 450
times twenty percent ninety thousand
this is a reduction remember that 50,000
50,000 lawsuit it's gonna have to
reverse Anna tree as it reverse my D ta
my D ta my the third tax asset will go
down as it goes down it's gonna increase
my income tax expense because for gap
purposes I cannot take that $50,000 okay
so it's gonna increase it so let's take
a look from a thermal presentation
perspective for 2020 your income taxes
payable is one hundred thousand your
deferred tax assets is ninety thousand
in 2021 you pay the IRS ninety thousand
and you no longer have income tax asset
for 2020 this is your income tax expense
on the income statement the current
portion was a hundred thousand minus the
increase in the deferred tax tacit - the
increase under the third taxed asset
okay in the end the subsequent here at
reverse and the subsequent year what
happened current was ninety thousand
then the third tax asset was a plus I
added ten thousand therefore income tax
expense was a hundred thousand in 2021
I'm not sure if you're gonna see it you
don't see twenty twenty-one but I just
showed that you would happen in 2021
okay okay notice the ninety thousand is
right here your income tax asset goes
down as it goes down I add I add the
increase in the third taxed acid
therefore income tax expense equal to
one hundred thousand so this is what
happened in 2020 I created the third
taxed asset and twenty twenty-one at
reverse therefore the balance is zero
therefore the balance is zero let's take
a look at another example for the third
taxed asset the third taxed asset okay
so we have Columbia corporation has one
temporary difference at the end of 2020
that would reverse and cause a
deductible amount of 50,000 and 2021
65,000 and 2022 and 40,000 and 2023 it's
a reversal it's going to cause a
deductible amount it's gonna give me a
deferred taxed asset under the future
Columbia pre-tax
financial income for 2020 is 200,000 AKA
gap income to 200,000 and the tax rate
is 34% for all three years there are no
deferred tax taxes at the beginning of
the year of 2020 we are still keeping
things simple Colombia expected to be
profitable in future years you didn't
see why this is important later on
compute taxable income in income taxes
payable again you start with taxable
income and income taxes payable can you
compute taxable income hopefully you can
you have two hundred thousand four gap
now as far as the IRS are concerned you
did not take you cannot take you are
losing a deduction this year of fifty
thousand of sixty five and four forty so
in total those three fifty thousand plus
forty equal to 90 plus sixty five equal
to 155 you are losing a one hundred and
fifty five thousand dollar deduction
this year that's gonna reverse in future
years
it means if this is gap your IRS must be
way higher than gap because you're not
taking those deduction therefore I have
to add those future deduction for this
year therefore your taxable income for
IRS purposes for this year is 355 once I
find my taxable income I just did three
hundred and fifty five I'll take three
hundred and fifty five times thirty four
percent to find my income taxes payable
so let's show you this the app was two
hundred thousand my future deduction
amount fifty sixty five and forty equal
to 155 two hundred plus one fifty five
equal to three hundred and fifty five
I'll take three hundred and fifty five
taxable income times the tax rate gives
me my income taxes payable right here
income taxes payable 127 hundred now in
future years twenty twenty one twenty
twenty to twenty twenty eight twenty
twenty-three I'm gonna have more
deduction more deduction more deduction
so the one hundred and fiftieth would
reverse as it as first let's compute the
future benefit fifty thousand times
thirty four sixty five thousand times
thirty four and forty thousand times
thirty four so four twenty twenty one
it's gonna give me a tax saving of
seventeen twenty two thousand one
hundred and thirteen thousand six
hundred I take those three together
I booked my the fur tax tacit that I'm
gonna have for the future three years
that's gonna reverse the next three
years that the third tax tacit would
reverse but I booked it now I booked it
the SIS 2020 I booked it in 2020 but it
would reverse in 2021 2022 and 2023 no
I'm left with my income tax expense my
income tax expenses a plug so I'm
looking for a debit
but specifically it's my current taxes
current taxes - my increase and ETA
because DTA went up - the increase in my
DTA and if you learn this - the increase
in DTA it's gonna make your life easier
when you have a prior balance when you
have a prior balance okay again don't
worry we're gonna work with prior
balances but this is basically an
introduction to this topic the last
thing I'm going to discuss here before
I'm gonna send you to work some
multiple-choice questions is devaluation
allowance okay a company should reduce
the third tax asset by evaluation
allowance if so learn the rules you may
see this on the exam if it's more than
like more likely than not it will not
realize some portion of all the deferred
tax tacit more likely than not means a
likelihood of at least more than 50% now
let's translate this in simple simple
English
remember when you book your deferred tax
tacit what are you saying you are saying
in the future I'm gonna have a future
tax savings or future tax deduction this
is what I'm saying but guess what if you
are not going to have any profit in the
future if you're not gonna have any
taxes how good is your deferred tax
assets useless so if you think you are
not going to be using that the third
taxed asset it means when it reverse
it's useless for you because it's only
good if you have a taxable income guess
what you have to create evaluation
allowance it means you have to reduce
your deferred tax asset to reduce your
deferred tax asset
when do you reduce it when there is 50%
a chance or more you are not going to
realize it okay and the best way to
illustrate this is to actually work an
example jennifer has a deferred taxed
asset account with a balance of 75 at
the end of 2019 do do a single kill
temporary difference of 375,000 ache
simple English we have a dta account and
it has $75,000 as a result of some
temporary difference of three hundred
three hundred and seventy five thousand
okay at the end of at the end of the
twenty twenty the same the same
temporary difference has increased a
cumulative amount of half a million so
this three hundred thousand it increased
to half a million it increased by 120 it
increased by one hundred and twenty-five
thousand taxable income for 2020 is
eight hundred and twenty the tax rate is
twenty percent for all years no
valuation account related to the
deferred tax asset is in the existence
at the end of 2019 okay so what happened
is this temporary difference it's gonna
increase by one hundred and twenty five
thousand as it increase your DTA should
also increase why because you have more
temporary difference that's a future
future deductible amount then it means
you're gonna have more the third tax
asset now assuming that is more likely
than not that fifteen thousand of the
deferred tax tacit will not be realized
what are we saying here we are saying
let's assume after we book the entry
after we book that increase of one
hundred and twenty five thousand
increase from three seventy-five to half
a million let's assume let's assume that
fifteen thousand will not be realized
will not be realized what does that mean
it means right the dtpa down but before
we're it down let's do the let's book it
let's book it so here's what's gonna
happen in 2020 we have financial income
of six ninety five minus the temporary
difference it's going to give us taxable
income of a twenty which was given to us
times twenty percent 164 so we credit
income taxes payable 164 then the
deferred tax tacit is 125 they told us
it's an it's gonna increase from three
seventy five to five hundred thousand it
means an increase of one to one twenty
five times twenty percent that's gonna
give me twenty five thousand my DTA will
increase by twenty five thousand my
income tax expense equal to my current
minus my increase in my deferred tax
asset
my income
expense equal to 139 so I just booked my
DTA then they told me guess what 15,000
of your 15,000 of your dpa now let's
take a look at DTA here the TA when we
started the year it was 75,000 then this
year we booked an additional 25 so DTA
as it stands is 100,000 the third tax
tacit what they told us is guess what
you have 100,000 guess what 15,000 you
will never realize so what do you have
to do you have to create an allowance
account an allowance account and what's
an allowance account basically a
reduction in your deferred tax asset but
don't reduce DTA you would credit an
allowance for the third taxes which
would reduce it's a contra asset so you
would reduce this asset and allowance
for the third taxes of 15,000 and you
debit income tax expense remember so
here's here's a good tip here when
you're the third tax asset goes down
your income tax expense goes up when
you're the third tax asset goes down
your income tax expense goes up notice
what happened here in the prior entry in
the prior entry it's the opposite in the
prior entry notice when you're the third
taxed asset goes up your income tax
expense goes down okay you can say that
when every time you're you are
increasing your deferred tax asset your
income tax expense goes down for tax
purposes goes down for tax purposes okay
let me make sure I said this right yes
as your DTA goes down your income tax
expense goes up as it goes up your
income tax expense goes down that's
right I wanna make sure I hit you're
saying this right and this is how you
show the allowance on the balance sheet
on the balance sheet you would still
show that the third tax asset of 100000
which was 75 plus 25 and you would
reduce it by the allowance amount of
15,000 which will give you the third tax
asset of 85,000 now this is a solid
introduction to the third tax asset and
the third tax liability in the next
session what I would do is I will work
multiple choice questions
covering this topic so make sure you
practice the multiple choice make sure
you master the topic before we move on
as always don't forget to visit my
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