 Hello and welcome to the session in which we explain the concept of temporary differences for the third tax asset and the third tax liability. First of all, what is a temporary difference? It's a difference between the tax basis of an asset or a liability and the carrying or the book value of that asset and liability on the financial statements. What does that mean? It means you have two sets of books, one for tax when you prepare your taxes and one is the four financial statements. The tax books follow the IRS rules. The financial statements follows gap. And what's going to happen is this, you're going to have differences in assets and liabilities reported on your financial statements. For example, you might have sales on account. As a result, you're going to have an account receivable for financial statements. However, for tax purposes, you can only record the sales and the rep the sales when you receive the cash. So when you book the account receivable, you don't have anything for tax purposes. Therefore you have an asset, for example, for $10,000 on the books, financial statements, zero asset account receivable for tax purposes. When these two differences arises, we're going to have what's called a temporary difference between the book, which is the here are the books, and the tax record. And as a result, we're going to have a future taxable amount. So in the future, when you receive the money for that account receivable, you're going to have to pay taxes, or we might have a future or deductible amount depending on the asset and the liability and how it's going to reverse. And this is exactly what we'll explain in this topic is the type of reversal, the type of tax future taxable amount and future deductible amount. So technically, we have two temporary differences. One's going to give you future taxable amount. And it's temporary. And that's going to result in a tax liability, the third tax liability, because in the future, you're going to have a taxable amount. And one difference would result in a future future deductible temporary difference. And because in the future, you're going to have a deductible temporary difference that's going to give you a benefit. A deduction is good for taxes. It's going to give you a deferred tax asset for now. So you're going to have revenues that could result in future future taxable difference, and you're going to have expenses that result in future taxable difference. And you're going to have revenues that will result in future deductible amount. And you're going to have expenses that would result in future deductible amount. So in this session, I'm going to explain all these topics, each one separately, starting with revenues, certain revenues, what's going to happen to them is this, we're going to tax it first, we're going to tax the revenue first, then the revenue will be reported for gap later. So when we tax it, we have to pay taxes now. So we have revenues and as a result, pay now, pay the IRS now, if you pay it now, in the future, we don't have to pay it. So in the future, when it's reported for gap, there's no tax bill. So that's going to result in a deferred taxed asset. Well, because we have a future tax savings, because when we recognize the revenue for gap, there's no expense for gap. What could be some examples of this type of deferred taxed asset? Well, forms of unearned revenues, what are unearned revenues? Remember unearned revenues is you receive the cash first, you debit cash, and you credit unearned revenue for gap. For gap, this is what's going to happen. First, you have the cash and you have the unearned revenue 30,000, 30,000. For tax purposes, you receive the cash, that's revenue 30,000 and 30,000. This is for tax. So what's going to happen is this 30,000 is taxed now. Because it's taxed now, you're going to pay the taxes. And let's assume this is a three-year contract. So we're going to recognize the revenue 10,000 per year. So what's going to happen, as we as we recognize the 10,000 per year for the next three years, we don't have to pay taxes on them for gap when we report them for gap because we already satisfied our tax obligation. So subscription revenue received in advance. This is a form of unearned revenue. Advanced rental receipts. Well, if you pay you, if you pay your rent, if somebody pay you rental in advance, that's taxable for you. Prepaid contract and royalties receive in advance. Notice they're all form of advanced payments. So if you're receiving advanced payment for revenue to be provided later, as far as the IRS is concerned, they're going to say pay now because you have the money to pay for gap, you would recognize it later. Also know that sales and leaseback, we tax the amount now, but the amount is deferred for later. What is a sales and leaseback? Sales and leaseback is when you own a property and you need, you're in need of money. You own, for example, a building, a restaurant. What you do is you sell the restaurant to someone that immediately, so they'll pay you the money, they'll pay you like $100,000, whatever they pay you, then immediately you would lease it back from them. So you sell it to them and you lease it back at the same time. As far as the IRS concerned, you receive this $100,000, which is basically a form of financing. Nevertheless, it's a sales, it's taxed now, for gap, that's the amount is recognized later. The amount of revenue is recognized later. Now these are revenues that results in the third taxed asset. We're going to also have revenues and slash gains because sometimes we could have gains. Now we're going to have gains or end revenues that's going to result in the third tax liability. Before we discuss revenues that result in the third tax liability, most likely, if you're watching this lecture now, you're either an accounting student or a CPA candidate. And if that's the case, I'm happy that you are because I can help you. Please visit farhatlectures.com. I can help you with your accounting courses, CPA preparation by providing you lectures, multiple choice, true, false, exercises that's going to help you clarify the concept. I don't replace your CPA review course. This is a list of all my accounting courses. My CPA material is aligned with your Becker, Roger, Gleam, and Wiley. So I don't I don't replace your courses. I just basically supplement them. I also give you access to 1500 previously released AI CPA questions with detailed solution. Those questions appeared on the exam before. Please connect with me on LinkedIn. If you haven't done so and take a look at my LinkedIn recommendation, like this recording, it helps me tremendously. If it's helping you, it means it might help other people be generous and share it with other connect with me on Instagram, Facebook, Twitter, Reddit. And I have a group me account that's called CPA exam support group. If you're studying for the CPA exam, you can join this group and discuss exam topics with other candidates. Let's discuss revenues slash gains that could result in the third tax liability. How does the third tax liability work? Well, what's going to happen to the revenue or the gain? It's going to be taxed later. We're going to tax it later. Therefore, we're going to recognize the revenue now, but we don't pay the taxes now. We're going to pay the taxes later. Well, if we have to pay the taxes later, we have a deferred tax liability. And this is called future taxable amount. We have a future taxable amount. What could be examples of deferred tax liability? Well, if you are accounting for sales under the accrual basis for financial reporting, so the sales is reported now because under accrual and using the installment method or cash basis for tax purposes, installment means technically cash, it means when they make the payment. So under the accrual basis, you would report the revenue now. Under the installment basis, you'll pay the taxes on that revenue later when you receive the cash. Another example is contract accounted for under the percentage of completion method for financial reporting purposes. But for tax purposes, a portion of the gross profit is deferred. What does that mean? It means under the percentage of completion method, and I hope you know what the percentage of completion method. Otherwise, go to my lectures about the percentage of completion method is you recognize the revenue in pieces. How do you recognize the revenue? Well, depends on the degree of completion based on that total cost to total current cost percentage to date. But for tax purposes, you're only going to receive not the whole profit, only portion of the profit. And that portion will be for the cash received. How much cash did you receive relative to the profit? Another example is investment accounted for under the equity method for financial reporting purposes and under the cost method for tax purposes. What does that mean? If you have an investment and you're accounting that for that investment under the equity method, well, the equity method, you would recognize revenue when the company reports net income when you're subsidiary when you're investing report net income. So when you're investing reports net income, you will debit investment for I'm just making up some numbers 20,000 credit earnings of 20,000. So what is this? This is for gap. This is acceptable. So you increase your investment and you increase your earning. This is because the subsidiary, you are using the equity method, the subsidiary reported, for example, 100,000 in net income and your portion is 20%. Therefore, you would recognize 20,000. And well, you would report gap, you would report this for gap for tax purposes, you don't do this for tax purposes, you wait until the subsidiary pays dividend. When the subsidiary pays dividend, you debit cash for let's assume they paid 12,000 in cash and cash dividend. This is how much you received and you credit dividend revenue of 12,000. Now this is for tax. Notice for gap, you reported 20,000 in earning because based on the net income for tax purposes, you had to wait until they actually paid the dividend. This is when you recognize the revenue. Again, this is an example of a temporary difference. Gain an involuntary conversion of non-monetary asset. If you have a non-monetary asset such as a warehouse, a building and something happened to it, it caught fire, the government took it by force, whatever the reason is. As far as, if you have a gain, as far as financial reporting, you will have the gain, you would report the gain. But for tax purposes, there's a rule and you will defer the gain for that involuntary conversion. Simply put, the rule is you have to buy another property. That's what the rule is. For financial reporting, it doesn't matter. You report the gain. For tax purposes, you will wait. That gain will not be reported until you sell that new asset, the replacement asset. So it's deferred. Also, if you have unrealized holding gain for financial reporting purposes, when you have investments, when your investment go up in value, you have an unrealized gain. And that unrealized gain is a gap gain, is a gap type of gain. Well, for tax purposes, they don't care about unrealized gain because you did not sell it. So the gain is deferred for later. Once you sell it, then you recognize the gain. Again, that's another difference where it's going to give you everything that we're discussing here are gives you the third tax liability. So we talked about revenues that gives you the third tax asset, revenues that gives you the third tax liability. Let's talk about expenses. Because remember, we said expenses, they could result in the third tax asset or the third tax liability. Certain expenses, we deduct them now. For tax purposes, we'll take advantage of that deduction. And we deduct them now. Then for gap, we'll expense it later. We deduct them now, we expense later. What's that going to result into? Well, if we took the deduction now, it means we have less deduction in the future. So that's going to result in the third tax liability. Simply put, in the future, we are responsible for more taxes. So we have a future taxable amount. What are some examples of this? Well, some examples of this is prepaid expenses. Well, what's prepaid expenses? Prepaid expenses, when you prepay, when you pay for something in advance, well, if you prepay for something in advance, well, you can take it as a deduction. Generally speaking, there are specific rules, but some forms of prepaid, you can take the deduction when you pay it. Well, you're going to take the deduction now. Simply put, let me give you a journal entry. So let's assume you paid a year and a half of rent. Well, for gap, you will debit prepaid rent, and let's assume you paid 15,000. And you credit cash 15,000. This is gap. This is prepaid, prepaid rent. You prepaid your rent. Okay. And this is what happened to gap. For tax purposes, you will debit rent expense 15,000, credit cash 15,000. So this is for IRS. So what you did is you already used up all the expense, all the deduction now. So what's going to happen in the future, when you start to expense those prepaid, when you start to expense those prepaid, well, you don't have a tax deduction. Why? Because you already took the tax deduction upfront. Another example of the third tax liability, which is from expenses is depreciable property, depletable resources and intangible, they're basically all the same thing, allocating the cost of an asset or an intangible or a natural resource. What's going to happen is this usually, usually, usually, when you depreciate something for tax purposes, you depreciate more of it upfront. Therefore, when you take the depreciation upfront, you're going to have less depreciation for later. Same thing with the depletable resources and intangibles. So you have more depreciation now than later. So if we're looking simply for looking at gap versus tax, and you're depreciating an asset for year one, year two, for tax, you might take without going into this particular number, you might take $50,000 of depreciation for gap, you might take 20. So you have more for taxes now. Therefore, you're going to have less of depreciation later for tax purposes. So there's a difference in that. Deductible pension funding exceed expenses. Sometime you're going to have a pension account and you're going to fund that account. If it exceeds the expenses that's needed for that pension, you're going to deduct it now. For gap, you cannot deduct it now, you have to prorate it. Just know that deductible pension funding exceeding expense is deductible now, not deductible for gap. Now it's deductible later. Now we're going to have expenses, on the other hand, which are deductible for tax purposes later, but they are expense for gap now. What do they result into? They result in a deferred taxed asset. Why? Because we're going to take the tax expense later. So we're going to have, we're going to have a future taxable amount. Therefore, we're going to building that asset that we're going to have to take advantage of later. What are some examples? Well, warranties. Warranty liability. What happened under warranty liability? Well, when we estimate a warranty liability, we debit warranty expense, you know, 10,000. We credit estimated warranty or warranty liability, 10,000. This is what we do for gap. And as a result, we expense it now. What do we do for IRS purposes? Nothing. Why nothing? Because we wait until the customer comes back and we actually incur the warranty, then we expense it. Therefore, under gap, you will take the expense now for tax purposes. If you have a warranty, you're going to take the warranty expense later. Also, another example is estimated liabilities related to any discontinued operation or reconstruction cost. Same concept. Under gap, you will estimate those. You will expense them now for IRS. You wait until you pay those employees. If you're doing a restructuring chart where you're laying off employee, changing divisions until that happened, you don't pay the expense for tax purposes. Litigation accrual. Same concept as warranty liability. You will debit an expense. You credit a liability for gap. If you have a litigation accrual where it meets the reasonable assurance and you can estimate the amount for IRS, you don't do anything until you pay that liability. Bed debt expense, the same concept. If you're using the allowance method, you will debit bed debt expense, credit allowance. You debit bed debt expense, credit allowance. You don't do anything for the IRS. For IRS purposes, you will use the direct method. Once you write off the account, you debit the expense and you credit the receivable for that client. You don't estimate the bed debt. Stock compensation expense. Any form of stock compensation expense, such as stock options, stock rights. For gap, you are going to expense them. For gap, there's a journal entry. You debit an expense and you credit some sort of an equity account. For gap, I'm not going to go into the details of it. But for IRS purposes, you don't have an expense until you pay the cash, until you issue the cash, or you issue the stock for that matter, but you actually issued something. Give the employee something. Unrealized holding losses, same thing as unrealized holding gain. You have losses and those losses are unrealized. So you have an investment. It went down in value. You have an unrealized loss. You book the unrealized loss for gap. That's fine. But you cannot take the deduction for tax. When do you take the deduction for tax? If you actually sell it and incur a loss, then by all means take the deduction. What should you do now? Well, you should go to farhatlectures.com, work multiple choice through false. What I discussed here is temporary differences. I need to discuss also what's called permanent differences in the next session. This topic is quite challenging for many students. Take it step by step. Learn the third tax asset, the third tax liability in baby steps, but make sure you see the big picture. Good luck. Study hard. Invest in yourself. Don't shortchange yourself. CPA exam is important. Your accounting career is important. It will pay you dividend down the road. Stay motivated.