 Hello and welcome to the session in which you would look at basics of accounting for income taxes. What is the big idea? Corporations will have to follow basically two sets of rules when they are preparing their taxes versus when they are preparing their financial statements for gap purposes. For the IRS rules, when they fill out the 1120C, they'll can have to follow the IRS code, the internal revenue code. And when they prepare their financial statements for the investors, they have to follow gap, a generally accepted accounting principle. And as a result, the way we account for income, the way we account for revenues, the way we account for deduction, the way we account for expenses, which is basically the same deductions and expenses are the same, is differently between gap and IRS. Remember, the IRS, the purpose is to tax you. For gap purposes, the purpose is to provide relevant information to the investors and users. Therefore, we're going to be following two sets of rules. For the IRS, you're going to have to compute something called taxable income. And please pay attention to the terminology. Taxable income is an IRS language. So on the exam, when I refer to taxable income, it means we are dealing with an IRS number. Then based on the taxable income, we multiply this by a rate and we come up with income taxes payable. Then income taxes payable is IRS language. Income taxes payable is how much you pay. What's the check that you have to write to the IRS? What's the amount of money you send to the IRS? This is the, you complete this on 1120C. For gap purposes, for generally accepted accounting principle, you are targeting investors and creditors. Therefore, you follow gap. The rules are different. Then you compute something called pre-tax financial income, pre-tax financial income or simply put financial income is a gap terminology. And based on the financial income, you will arrive to your income tax expense. You have to be aware of the rules, the terminology, because it's different. In a sense that you have to know whether you are being asked to compute taxable income or income tax expense or income taxes payable. They're different things. So the first thing, be familiar with the terminology. So why would there be any difference between gap and IRS? The list is endless. Let me show you a few examples, which will discuss them much, much more in details. Depreciation. The way you book depreciation for tax purposes, for example, online 18 here, is different than your way you book depreciation for, for gap purposes. So if you have depreciation here based on selling general and administrative, the way you book depreciation is different. Therefore, it's going to give you a different financial income than taxable income. They will be different. The way you account for warranties, for example, remember for gap, you can accrue warranties. You can account for the expense before it occurs. For IRS, you cannot accrue a warranty. Same with bad debt expense. For gap, you estimate bad debt expense. For IRS, you have to use the direct method. Two different method, long term construction revenue, prepaid expenses, so on and so forth. There's a lot of rules that differ between how you account for the IRS income, taxable income, and how you account for gap, financial income. And as a result, you're going to have differences in taxable income and financial income. As a result, you're going to have to account for those differences under the third tax asset and the third tax liabilities. Now, the best way is to look at an example to illustrate this concept. Although this example is simple, you may think it's challenging, but make sure you follow step-by-step because I'm only changing one thing. I'm dealing with one difference, which is the third tax liability. I just told you this because I want you to focus. So Adam Company reported revenues of 130,000 and expenses of 60,000 in each of the following three years. For tax purposes, Adam reported the same expenses to the IRS in each of the years. So we have a three-year company. As far as expenses, no difference between gap and IRS. However, Adam reported taxable revenue of 100,000 in year X0, 150 in year X1, and 140 in year X2. For gap, they reported all the years as 130,000. So here's the gap numbers. Here's the gap financial statement. Revenues of 130, expenses of 60, financial income of 70,000. 70,000 times 20%. Well, don't worry about this. Income tax expense is 14. Ignore the rate. Same thing for year X1, same thing for year X2. Total 390 in revenues over the three years, expenses 280, 180 in pre-tax financial income to 10. And income tax expense total of 42. For gap purposes, the revenue that they reported for year X0 was not 130, was 100,000. Why? Because the way IRS want you to report revenue is based on cash. So if you receive the cash, you have revenue. Therefore, in year X0, they received $100,000 in cash. Therefore, they credited revenue 100,000 in total, they debit cash 100,000. So what did they do for gap purposes? They reported 130,000. Well, the only explanation I can tell you is there wasn't a crawl of 30,000. So simply put, for gap, they reported revenue of 130, of which 100 was in cash, which we know from the tax record, and the 30,000 must be an account receivable. So that's why I just wanna show you the difference. Now, the expenses are the same for both companies. If you notice over a three year period, the total revenue was 390, because it was just a temporary difference because eventually the customers will pay their bill, will pay the 30,000, and as a result, this 30,000 becomes taxable for IRS. So eventually it would reverse. And that's why it's called, it's gonna reverse. So that's why we're gonna say the third tax asset and the third tax liabilities will reverse. But here's what we need to do. And by the way, this is not income tax expense, this is income taxes payable. Because remember the tax language, I kept this on purpose, I wanted to change it to remind you that income tax expense is not the same thing as income taxes payable. Income taxes payable is an IRS language. Now what we have to do is we have to account for the difference between what we report as income tax expense for GAAP and an income tax expense for IRS or income taxes payable for IRS. And notice the difference in year one is 6,000. So we'll take 14 minus eight. The difference in year two is negative 2,000. The difference in year, I'm sorry, negative four, negative 4,000. And the difference in year three or X2 is negative 2,000. When you net out the differences, plus six, minus four, minus two, the net difference is zero. So just make sure you make a note of this because we're gonna be looking at the differences and account for them on the next slide. 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Please join us. I will be there as well as other CPA candidate. So let's examine the difference between the income tax expense, which is GAP and income taxes payable IRS. And as I just mentioned in the prior slide, there's a difference of 6,000 and X0, 4,000 negative and X1 and negative 2,000 as a result over three year, the difference is negative. Now we need to know why, why did that happen? Why do we have a difference? Well, the difference is, if you remember for GAP, we had an additional 30,000 included in income. This 30,000 not taxable was not taxable in year X0. Why not? Because the customer did not pay it. They bought the product, but they did not pay it. Therefore it's not taxable. As a result, we need to tell the users of the financial statement. Okay, we need to tell them, yes, we are paying $8,000 this year, but please pay attention. In future years, customers will pay us an additional 30,000 and we are responsible for paying 20% taxes. Therefore we have an additional tax bill of 6,000. This is what we're saying. We're telling the users that in future years, we're gonna have additional tax bill. Not now, in future years, why? Because we have an account receivable on the books, that's not on the IRS, on the tax record yet. So we must account for those temporary difference in the financial statement. Now this 6,000 is a liability. Specifically, we're gonna call it a deferred tax liability. It means in the future, we are responsible for an additional 6,000 based on the receivable that we have on the books for financial accounting. This is what we're saying. Therefore what we do is we create a T account telling, I'm gonna abbreviate D to L, telling the users of the financial statement, please pay attention. We have additional 6,000 in the future, which is not bad because we're gonna be receiving cash. In year acts two, notice here what happened to this, what happened to this liability, the difference reversed. In year acts one, which is year two, which is this is year two, in year two or acts one, what happened is we paid the IRS 18,000, but our income tax expense was only 14. Why? Well, it appears that we are starting to receive the money from the customers. As we receive the money from the customers, we have more in taxes to pay, but for gap purposes we already accounted for that account receivable in year X zero. So our D to L is reduced by four. Then in year acts two, in year acts two, also we have a negative difference of 2000. Well, why? Because the customer kept paying and as the customer paid, we have to send more money to the IRS. And why don't we account for this under gap when the customer paid? Because we already accounted for it in year X zero when it was an account receivable. Therefore by year three, the deferred tax liability is fully reversed and we'll talk about what fully reversed is in a moment. But let me show you how things are reported on the financial statement. For year X zero, under liabilities, we're gonna have the third tax liability of 6000, which is this number here, the difference. It means in the future we have to pay, we are responsible for an additional $6,000. Income tax is payable, this is the money that we're gonna have to send to the IRS 8,000. Our income tax expense is 14,000. Now, this is no coincidence. The 14,000 is composed of two numbers. We have to pay the IRS, the current portion, because you have to know the current portion, the current portion of the taxes is 8,000. We have to pay to the IRS. And we have 6000 the third. The third means we have to pay in the future. So your income tax expense is always composed of two components, the current portion, which represent your income tax is payable, and the third portion. Now, the third portion here happens to be a liability, or increase in liability. Sometime the third portion could be an increase in the third tax asset, which could decrease your income tax expense. I know I'm jumping the gun now, but I just wanna make you aware that you could have the third tax liability, an increase in that, a decrease in that, an increase in the third tax asset, and a decrease in the third tax asset. Don't worry, we'll discuss this later on. But the point is your income tax expense has two components, a current and a long term, and we'll discuss this later on. So why are we doing all of this? We have to go through all this problem, because we had a temporary difference. What is a temporary difference? It's a difference between the tax basis of an asset, or a liability, as it's reported, and the financial statement that would result in a future taxable amount in future years. What does that mean? What does the statement mean? It means per books, per gap, for the purpose of this example, we had an account receivable of 30,000. Per tax return, we cannot account for the account receivable, because we don't have account receivable. We only have taxes when we receive the cash. So as a result of this difference, we have a third tax liability. We have a taxable amount in the future. Now, the temporary difference could result in a deductible amount. The deductible amount means you're gonna have more tax savings in the future rather than a tax liability. Therefore, the temporary difference could result in the third tax liability, D2L, represent an increases in taxes in future years. This is the example that we saw as a result of a taxable temporary difference existing at the end of the year. Or the temporary difference could result in the third taxed asset, which is the opposite, represent the increases in taxes refundable or saved. So sometimes the difference could result in a future tax savings, which we'll see that later on in a different example, where we have the third taxed asset that exists at the end of the current year. Let's go back and look at this full picture and see what happened in year X1 and X2. Because in X0, basically, we know that we're gonna be receiving $30,000 in cash. In year X1, we receive the 20,000. In year X2, we receive the 10,000. Now, as we receive this money, it becomes taxable. It becomes taxable. So let's take a look at how we prepare the journal entry for year X0. Listen to me carefully. This is how you prepare the journal entries. The first thing you figure out in the journal entry is what is my income tax payable? How much do I have to pay the IRS? Well, that's basically a function of your taxable income. Notice the language is very specific times the rate. And we already did this on slide two. And taxable income times the rate gave us $8,000 of IRS bill. So we credit income taxes payable, $8,000. The next thing we figure out is whether we have an income, the third tax asset or the third tax liability, an increase or a decrease. Well, we have a third tax liability. The prior balance was zero and now we book $6,000. Therefore, we credit the third tax liability, $6,000. Now we compute our income tax expense. What is our income tax expense? Our income tax expense is a function of how much you're paying now and what's the changes in the third tax liability. Well, income tax expense now is a plug. Yes, it's a plug, simply it's a plug. Well, you have two credits of 14, the debit must be 14, but you need to understand why, you need to understand why. So I'm writing a check for $8,000. This is part of my income tax expense. And in the future, I'm gonna have to write another check for $6,000. Therefore, my income tax expense for this year is $14,000. Simply put, if you're the third tax liability, increases, you have a credit, how does it affect your income tax expense? Well, if you're the third tax liability went up on the credit, it's gonna increase your income tax expenses. As you're the third tax liability went up, you're saying I'm responsible for more taxes. You have to write this as taxes, like you are accruing an expense. You credit a liability, you debit the related expense. You are accruing an expense because you're saying I'm gonna have to be responsible for that $6,000. And once again, where that $6,000 came from, well, I have a receivable on the books. Eventually I'm gonna be receiving the money as a result I have to pay 20% on it as a result I'm responsible for $6,000. So this is X zero, year X zero. So let's take a look at what happened in year X one, in year X one, when I actually start to receive the $20,000. When I received the $20,000, now I have to write a check to the IRS, my taxable income becomes $18,000. If you don't know where that $18,000 coming from, scroll back or pause and go back and see where the taxable income coming from. So I have to write a check to the IRS for $18,000. My income taxes payable is $18,000. Now what happened, the check I'm writing is reducing my deferred tax liability. Why? Because now I receive this 20,000, 20,000 times 20%, now I reduce my liability by 4,000 because I receive the money and I'm paying the cash for it. Therefore my liability goes down. Now if you have a liability called the third tax liability and it's going down and the corresponding account is when you created this liability is income tax expense, if this is going down with a debit, what's happening to your income tax expense? If this is a debit, this must be a credit. It means your income tax expense is going down. Therefore you're gonna debit the third tax liability because now you receive 20,000, you paid the bill, your liability is going down. As a result for that year, your income tax expense will go down as well. So as your deferred tax liability goes down, your income tax expense goes down. Notice we credited income tax payable 18,000. My liability went down by four and this becomes a plug. But I'm telling you what the plug is, you paid 18,000 of that amount. 4,000 is a liability, therefore I need to reduce my expense by that 4,000. Now if I look at my T account, this was X zero and this is X one, I still have a liability of 2,000. And this is when I would receive the 10,000. Now I receive the $10,000, my income tax is payable. I have to write a check to the IRS for 16,000. That's the first thing you do income tax is payable 16. My liability went down, my deferred tax liability went down by 2,000, why? Because if I receive the money, I have to pay 20% taxes on it. I satisfied that liability that I set up initially. Remember I had 6,000 initially, went down by four X one. Now I paid the remaining 2,000, went down by two. My deferred tax liability went down to zero. Remember when my deferred tax liability goes down, it reduces my income tax expense. Now my income tax expense is 16 minus two. 16 minus 2,000 is 14,000. Remember my income tax expense is a function of my current portion of the taxes. And the deferred, now the deferred is going down, not going up. Therefore I'm paying 16, of which 2,000, I'm reducing my deferred, therefore my current, my income tax expense, my total income tax expense is 14,000. So this is what happened to my deferred tax liability after everything is reversed. It means it went down to zero. Now this is how things will show on the balance sheet on the financial statements. For X zero, I had 8,000 of income taxes payable and the third tax liability of six, eight plus six equal to 14,000. And this is my income tax expense. In year X one, my income tax payable was 18 and my liability went down from six to two. So 18 minus four is 14,000. And this is my income tax expense for year two. For year three, my income tax payable is 16 and my liability went from 2,000 to zero. So it went down by two. Eight, 16 minus two equal to 14,000. So notice as my liability goes down, I'm deducting it from my expense. When my liability went up from zero to six, I took eight plus six, gave me the 14,000 in year X zero, which is year one. So this is X zero, X one and X two. What should you do? This is just an introductory session about this topic. I'm gonna have future sessions, but you should go to farhatlectures.com, work MCQs, look at additional resources. This topic is challenging. I'll try to simplify, demystify it as much as I can. Don't shortchange yourself, whether you are a student or a CPA candidate, invest in yourself. Give me a try, I can help you do better. Good luck, study hard, and of course, stay safe.