 Hello and welcome to this session in which we would look at an exercise or quasi-CPA simulation that deals with consolidation including intra entity transaction plus deferred taxes. I am sure these topics are my students' favorite topics, right? All these topics combine in one example. That's not an easy task but we're going to go ahead and deal with this appropriately. So here we are dealing with a parent and a sub where the parent owns 70% of the sub. We're going to be computing the income tax expense as well the income tax payable including any deferred taxes. Now the parent and the sub they cannot file a consolidated return because the parent only owns 70% of the sub. In order to file a consolidated tax return you need to own more than 80% and the corporation has to be a domestic corporation. It doesn't matter, less than 80%, they have to file separately. Here's the data for the parent company. They have a separate operating income of 600,000. Intra entity gross profit including and operating income so this 50 is included here and this is from inventory of 50,000. Dividend received from the sub 35,000. They did not pay any dividend and the tax rate is 21%. For the subsidiary they made a profit operating income of 200,000 that's obviously before paying taxes included in this amount 40,000 of intra entity gross profit from inventory. They did not receive any dividend and they paid 50,000 of dividend of which 70% went to the parent and the tax rate is 21%. So first we are going to compute the income tax expense income taxes payable for the sub. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions as well as exercises. Go ahead start your free trial today no obligation no credit card required. So let's go ahead and get started for the sub their operating income is 200,000. We're gonna multiply this by 21% and they have to pay taxes of 42,000 now. So this 42,000 is income taxes payable because they have to write a check to the IRS. So simply put they have 200,000 we don't deduct the intra entity profit because it's included they're filing separately it's not the third therefore we pay we are responsible for 42,000. Now we have to figure out how much of that 42,000 is basically payable for the current taxes and how much of it is payable for future period why because remember we pay taxes on that intra entity profit well the intra entity gross profit is 40,000 so 40,000 times 21% 8,400 so what happened is this of this amount of this 200,000 we have 40,000 that is that's gonna be taxable later in a sense that it's an intra entity profit however we pay taxes on it now if we pay taxes on it now we satisfied our income tax basically we prepaid the tax we prepaid the tax well that's gonna give us a deferred tax asset of 8,400 as a debit so we have to pay for 42,000 of which 8,400 for future period and what's left is 33,600 for the current income tax now you might see it in another income tax course or in your CPA exam course will they show you income tax expense dash current and they will say this amount is 33,600 income taxes payable 33,600 then they will debit the third tax asset which is this account here 8,400 net they will credit income taxes payable 8,400 so that's another way of showing you this to show you there is a current portion this is the current portion which is 33,600 33,600 and we have a third portion of 8,400 in total we are responsible for paying in total notice 8,400 plus 33,600 so this is the journal entry that the sub will make now what else do we have to know about this exercise because remember we have to we have to compute also this journal entry for the parent company now here's what we know about the sub just kind of since we are we're gonna keep going with the sub we know from the sub that the income tax expense is 33,600 this is basically the income tax expense therefore if we take operating income minus the inter entity profit minus the income tax expense it's gonna give us after income tax for the sub of 126,400 now from this amount we are going to pay dividend of 50,000 remember they pay dividend of 50,000 the dividend comes from net income well what's left is undistributed earnings in the sub 76,400 now we have to also go a step further of this amount of 76,400 which is basically retained earnings of the sub goes into retained earnings 70% of that is that of the parent company 53,480 in theory since they own 70% they are responsible for not responsible they own 70% of this undistributed earnings which is retained earnings of the sub so this is the parent share just make a note of it i'm gonna show you where this number where we're gonna where we're gonna be using this number later so this is what we have to compute as well now let's take a look at the parent company the parent company they have operating income of 600,000 which is coming from here they received dividend from the sub of 35,000 now since they own since they own 70% of the sub they'll get something called dividend received deduction which is called d or d dividend received deduction and what is this deduction it's think of it as a phantom as a as as an phantom means a fake deduction basically the government gives you a deduction so simply put since you own 70% of the corporation you add the income then you will deduct 65% of that now if you own more than 80% you can deduct the whole thing the whole 35,000 but the tax law now says it's 65% now the tax law could change but that's what the tax law now it's called d or d d or d stands for dividend received deduction it's a deduction given by the government so we'll take 600,000 plus the dividend minus the dividend received deduction it's gonna give us taxable income of 612,250 we're gonna multiply this by 21% and we're gonna come up with a tax bill of 128,573 and this is payable now payable now means we're gonna have to credit income taxes payable whoops let me go back for this amount 128,573 we're gonna credit income taxes payable that's the income taxes payable that's fine now also what we did in this in this problem of that amount of the amount that we included an income of the 600,000 remember we had 50,000 of intra entity profit just like with the sub the intra entity profit you have to pay taxes on it now it's basically a prepayment so therefore of this amount there's 50,000 of intra entity profit so times 21% will give us the third tax asset of 10,500 because we prepaid our taxes on that intra company profit if we consolidate we don't have intra entity profit because it get canceled because we did not consolidate now we pay taxes we have a third tax asset of 10,500 therefore we debit the third tax asset 10,500 we're not done yet remember what i told you about the undistributed profit we have an undistributed profit of 53,000 remember i said i highlighted in yellow so you would remember this you would remember this number let's see if i can basically bring an audit so here what we have to do is to take this 53,480 and do what and basically take it to the parent company again if the parent company gets that dividend they will get 65 percent of it as a deduction dividend receive deduction as a result they're going to be left responsible for paying 18,718 for dividend times 21 percent equal to 3931 this amount here is there the third tax liability because in the future in the future here's what we're saying in the future you will get this amount in dividend of this amount you can deduct 75 percent you're left with 18,718 you're responsible for paying 21 percent that's in the future so you are responsible for 3931 that's your the third tax liability therefore you credit your the third tax liability of 3931 so here's what we did so far we took care of let me just highlight those let me just put them in a different color so you see so i already showed you how we computed income tax is payable i showed you how we computed the third tax asset i showed you how we computed the third tax liability at this point the third tax expense is a plug okay but here's what's happening here's what's happening i want to show you i want to make sure you understand it now if you are not comfortable with the third tax asset the third tax liability go back to my intermediate accounting and look at those lessons i have like 10 lessons it's not an easy topic but this is advanced accounting it's not only advanced it's advanced with consolidation in the third taxes but the point here is you are familiar with this but anyway you paid you are responsible for paying 128 573 so this is your current portion this is how much you are responsible of paying because notice it's a payable of this amount of this amount you are deferring 3931 which is basically you are responsible for paying that later why why are you responsible for paying that remember because you have undistributed earnings from the sub and that undistributed earning you are responsible for paying taxes on it therefore you book your liability also what happened is this so it's 128 573 plus 3931 plus this amount then you prepaid your taxes on the on the intra entity profit remember you had 50 000 of intra entity profit and you paid your taxes for it now it's included in this therefore you deduct 10 500 and that's going to give you your income tax expense of 120 000 3 which is as i told you it's a plug so income tax expense is always a plug when you have the third tax asset the third tax liability so this is the entry that you make for the parent company again i'm not going to say this is easy topic but i'm not going to say it's difficult why it's not easy because here what you have to know is consolidation how to deal with intra entity transaction and how to compute the third income tax asset the third income tax liability income tax payable and income tax expense there's a lot going on but this is an advanced accounting course and as an accounting student you should be competent capable of looking at exercises like this and be able to solve them i don't think you would receive something like this on the CPA exam i highly doubted i highly doubted maybe the new CPA exam i'm not sure but the current one you don't see something like this but if you do now you know how you know how to deal with it be confident invest in yourself invest in your career go to farhat lectures and look at additional mcqs that cover this topic so you are more confident when you see questions like this good luck study hard and of course stay safe