 Welcome to the session in which we would look at a deferred income tax problem that could appear on the CPA exam or you could see in your intermediate accounting course. Now why the third income taxes is considered challenging or difficult or complicated for many students? There are several reasons that this topic is challenging. The first reason is this, you have to have a good understanding of the tax code. In other words, when you get to income taxes for accounting purposes, for gap purposes, the assumption is you understand how an entry, how a transaction is being treated under the tax purposes. So you have to understand your tax code, then you have to understand how is it treated for gap and you have to reconcile the two. And as a result, you could have deferred income tax asset, you could have a deferred income tax liability. That's not the only thing. Then you have to deal with this deferred income tax asset and deferred income tax liability in future years. In other words, when those deferred income taxes and liabilities reverse. And every entry for deferred income taxes would require at least three different accounts, which is at least three, which is your income tax payable. How much do you have to pay this year to the IRS? What's your income tax expense? And also what happened to your deferred income tax asset or deferred income tax liability or both? So sometimes the entry could have the entry could have four accounts and they're all moving parts. And you have to understand how all these parts fits together. In this exercise, I will try to simplify the matter, not simplify it. I'm going to work a problem, but I'm going to explain it in details how you have to treat this. Now, if you are a CPA candidate or an intermediate accounting students, I strongly suggest you visit my website, farhatlectures.com. If I'm known for anything, I'm known for my deferred income tax explanation. In other words, my first video that reached over 100,000 views was my deferred income tax. So I strongly suggest you check out my website, farhatlectures.com. If you're taking a CPA course, that's fine. You can keep it. I'm not, I don't want to replace it. I can't replace it. I don't recommend replacing it, but I can be a useful addition. I can add 10 to 15 points by explaining each of these topics little bit more in details or differently than your CPA review course. Without giving you those short mnemonics to help you understand, then the short mnemonics will help you once you understand the concept. You can try me for one month. That's your risk. Your potential gain is passing the exam. And if not for anything, take a look at my website to find out how well your university is doing for the CPA exam. I do have resources for other courses such as intermediate accounting, as well as audit finance and any other course. Connect with me on LinkedIn. If you haven't done so, please like this YouTube, follow me on Instagram and Facebook. Okay, so let's take a look at this problem to illustrate the concept. Adam Manufacturing uses the straight line depreciation for financial statement reporting purposes and is able to deduct 100% of the cost of the equipment in the year the equipment is purchased for tax purposes. So in your mind here, you should be thinking tax, 100% deduction in the year of its purchase gap. We use the straight line. Four years after its purchase, one of Adam's manufacturing machine has a book value of 800,000. Good. Fair enough. There were no other temporary differences and no permanent differences. That's even make it easier for us. Full income was 30 million. Aram tax rate is 25%. What is the deferred tax liability to be reported on the balance sheet? Assuming the deferred tax liability balance was 248,000 the previous year prepared the appropriate journal entry. Okay, so one other piece of information we are giving that deferred tax liability was 248,000. Now this problem gave us some easy information and some information we have to kind of conclude for ourselves. The easy information is they're telling us we are dealing with a deferred tax liability. So that's easy because sometimes they don't have to tell you whether it's a deferred tax asset or deferred tax liability. Now why is this a deferred tax liability? And hopefully you understand why this is a deferred tax liability because four years ago, four years ago, they purchased an asset. They're not giving us the cost, which is that's why it's like it's tricky. They're not giving us the cost and they're not giving us the life of the asset. So we don't know what's the difference. What's going to be the difference year over year? They're not giving us this, but they're giving us a different piece of information. They're telling us four years later, the book value of this asset is 800,000 for four gap purposes. That's given. What's the book value because the third tax asset and the third tax liability deals with the difference in the book value. The difference, the book value for tax purposes. Guess how much? Well, I hope you know it's zero. Why? Well, they're giving you this information indirectly. They told you in the year they purchased it, they can deduct the whole thing. Therefore, for tax purposes, whatever the cost was for this asset, we don't even care what the cost was. All what we know is the cost minus accumulated depreciation for the full amount gave us a book value of zero, right? When we purchased it because you can take the deduction upfront. What does that mean? It means for tax purposes, you took advantage of this purchase four years ago. So you took advantage and you took the taxes. Therefore, for future years and future years, you are going to have to, you're going to have a deferred tax liability. And that's why that's what I said. I hope you understand that we have a deferred tax liability because you took advantage of this purchase four years ago. But since you took advantage four years ago, you're no longer going to be able to deduct this asset. So it doesn't matter what this asset was. Let's assume it was for two million. I'm just making this number up. The asset was for two million, okay? So you took the two million or let's say 1.5 million or it doesn't matter what number. It doesn't matter. So you took the whole 1.5 million in year one. For gap purposes, you were taking that deduction over a straight line. We don't know the life, but it doesn't matter. All what we know is we still have 800,000 to be taken in future years. All what we know. Why? Because the book value is still 800,000 and we are going to depreciate this 800,000 to bring the book value down to zero. What does that mean? It means we are still reversing this deferred tax liability. Now, how do we reverse it? Well, we don't know over for how long we're going to reverse it for how long. But we know it's going to reverse at a tax rate of 25% because we're not giving future tax rates. So we have to use the tax rate that we have. So if that's the case. If that's the case, what we have to do is if we have an 800,000, simply put, this 800,000 was taken long time ago, four years ago, was taken as a tax deduction. Now, it cannot keep on going. We cannot take it more than once. We only take it once. Okay? So what does that mean? It means we have to take the 800,000, which is the book value that's remaining, the book value that's remaining. And multiply this 800,000, multiply this by 0.25. What is that going to give us? That's going to give us how much deferred tax liability are we going to have in the future remaining? Are we going to have in the future? So let's do that 800,000 times 0.25. That's going to give us 200,000. Simply put, our deferred tax liability should be 200,000. Why? Because we still have 800,000 of book value that we took in tax deduction four years ago, we are still reversing. And the tax rate is 25%, and we're going to do it equally. We're going to do this equally because we're using the straight line. Therefore, we have to debit our deferred tax liability, 48,000. So we find out what should be our debit to deferred tax liability. That's really good, because that's going to be the journal entry. The first question, what should be the deferred tax liability balance? The balance should be 200,000. Why 200,000? Let me explain it one more time. I still have 800,000 to take for financial accounting purposes. I still have 800,000 to take. Therefore, my deferred tax liability is based on my tax rate. I still have, I should have in my deferred tax liability 200,000. 200,000. Now, prepare the journal entry. Well, we kind of figured it out already, most of it. How do we prepare the journal entry? Well, usually the journal entry, you don't start with the deferred tax liability. I did this just because to explain the concept. Always when you have a journal entry, start with taxable income. If you are giving taxable income and the tax rate, well, you would say, that's fine. My taxable income is 30 million, 30 million times 0.25. My tax bill should be 2.75 million. Therefore, I will credit, I'm sorry, not 2.7.5, 7.7.5 million. Therefore, my tax bill, I have to write a check to the IRS and the amount of 7.5 million. That's my credit. Well, I know I have to reduce my deferred tax liability by 48,000 because I still have a book value that I am taking for book purposes that I already deducted for tax purposes long time ago. I still have 800,000. It means my deferred tax liability should be 200,000. I have to reduce my deferred tax liability by 48,000. So we know how we come up with this. We know how we come up with this. So what's left is income tax expense. How do you figure out income tax expense? Income tax expense is a plug figure. Income tax expense is a plug figure. What does that mean? That means you are paying 7.5 million, 7.5 million. Your deferred tax liability is reversing at 48 million. So this number minus this number will give you your income tax expense. Your income tax expense on the financial statement, on the financial statement. So this is your financial statement income tax expense will be 7,452,000. So notice you paid the IRS 7.5 million. But you only recorded on your income tax expense, 7,452,000. Huh? Why? Well, I mean, again, I'm going to explain it in a different way. What happened is this. You are paying them 7.5 million. You are paying more than your expense is because for tax purposes, you took the cost of this equipment long time ago. Since you took the cost, that year when you took the cost, the year that you took the cost, year one. When you purchased this asset and you took the cost, what you did is you paid less. You paid less to the IRS. So you paid less to the IRS that year. But your income tax expense was higher. Your income tax expense was higher. What's happening now? The reverse is happening. The reverse is happening. Now, what's happening is you pay more. OK, you pay more in future years. You're going to start to pay more in taxes because you took the whole thing in year one. You're going to be paying more in taxes. But you are going to record less of expense on your income statement because now you are taking the depreciation on that asset. Therefore, your income tax expense will be lower than the amount of cash that you paid. So I hope this exercise makes sense or it helps you clarify the third tax asset, the third tax liability. Once again, this is not an easy. This is not an easy topic, but it's not a difficult topic. So how can you get better at this? How can you get better at this? Well, I'm going to again invite you to visit fourhatlectures.com. If I'm good at anything, well, let me rephrase it. My best lectures, my best lessons are about the third tax asset, the third tax liability. Again, how do I know this? Why do I know this? Why am I so confident that I can teach you this? It is because my first 100,000 views and my first 100 likes and my first, I'm known for this. The third tax asset, the first tax liability, I can teach you this, I can make you ace it. And so this way you can focus on other topics. Move on, pass your exam, move on with your life. Study hard, stay safe.