 Hello and welcome to this session in which you would look at the CPA simulations that deals with the third taxed asset and the third tax liability. In my opinion, or I strongly believe if you can solve this simulation, solve this exercise, you should be in good shape when it comes to the third taxed asset and the third tax liability. If you want to pause and try it, that's fine, otherwise you can follow and see how we would solve an exercise like this. Atom company purchased a machine costing 90,000 on January 1st, 2021. For financial statement reporting purposes, which is GAAP, the straight line method was used. The machine has a three-year use for life and no salvage value. So if we purchase it for 30,000, there's no salvage value divided by three, each year will take $30,000 of depreciation for GAAP. Atom company used the accelerated depreciation method that results in depreciation expense of 45, 30, and 15 for the three years respectively, which is X1, X2, and X3. So this is GAAP, this is GAAP depreciation, 30,000, and this is tax depreciation, 45, 30, and 15. Net income before depreciation and tax, which is earnings before depreciation and tax, EBIT, 100,000 for X1, 120 for X2, and 80,000 for the X3. What we need to do now is compute net income, compute the income or net income for book as well as for tax purposes for year X1, X2, and X3, and prepare the journal entries for the income tax expense. What I'm going to do, I'm going to switch to Excel sheet and try to solve these questions assuming the tax rate is 21%. 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 this is the information that we are giving on the prior sheet. This is earnings before depreciation and taxes for each year, the tax rate 21%. This is the tax depreciation for each year, X1, X2, and X3. And this is the tax depreciation, a gap depreciation for year one, year two, and year three. Notice the same amount of depreciation over three years. What we're going to do, we're going to take a look at each year separately, compute the income tax, income tax expense, then we're going to look at net income. Starting with year X1, starting with tax. Earnings is 100,000, so earnings is 100,000, income before taxes and depreciation. Depreciation expense is 45,000 minus depreciation expense. That's going to give us a subtotal of 55. Now, this is income before taxes. We are told taxes are 21%. So if I'm going to take 55,000, I'm going to multiply it by 21%. And that's going to give me 11,000, 11,550. So all what I did is I took income before taxes, multiply it by the tax rate, which is 11,550. What does this number represent? It represents how much I need to pay to the IRS. This number is income taxes payable. This number represents a credit to income taxes payable. This is how much taxes I have to pay now. So this is the check that I have to write to the IRS, 11,550. Now if I take my 55,000 minus my taxes, which is 11,550, my net income for tax purposes is 43,450. Now for gap purposes, the only difference between tax and gap is for tax, I took more of depreciation, more of depreciation. What does that mean? It means I'm going to have to book a deferred tax liability. Why? For this year, for this 2001, I took too much depreciation compared to my gap depreciation. Therefore I used up 15,000. The difference notice is 15,000. Well what's that going to do? We're going to assume the tax rate is for future years is 21%. That's going to create a 21% tax liability for me because I'm going to lose this 15,000 down the road. If I take 15,000 times 0.21, I'm going to have to book a deferred tax liability of 3,150. So this is my deferred tax liability, which is a liability of 3,150. Now how do I compute my income tax expense? As I always showed you in the recording in the lectures that income tax expense is the current portion, there's a current portion, there's a long term portion. The current portion is 11,550. This is the current and the 3,150 is the not long term, it's the deferred or the deferred portion, deferred taxes. Since I have to pay now 11,550, in the future I have a responsibility of 3,150, together they're going to give me my income tax expense. Now in your CPA review course, what they might have do, they might give you two income tax expense, one is current, which is the current portion is 11,550, then they might have an income tax expense deferred and they might give you the 3,150. You have two income tax expense, I combine them and they combine to 14,700, which is my income tax expense, which is the income tax expense that I compute for gap purposes. Now my subtotal under gap 100,000 minus the depreciation of 30 equal to 70 minus my income tax expense that I computed here, which is going to give me net income for gap purposes of 55,300. So this is year one, this is year one net income for each scenario, which is the gap as well as tax purposes, let's look at year two. Year two, my revenue is 100,000 for gap, 100,000 for tax. For year two, this is 100,000, my tax depreciation is 30,000, so 120 minus 30,000 will give me my subtotal, which is my income before taxes, I'm going to multiply this by how much by 21%, so I'm going to take 90,000 and the tax rate is 21%, if I take 90,000 times 0.21, that's going to give me 18,000, 18,900. Now my profit for tax purposes is 90,000 minus 18,500, which is, let's see, let me just say I have the number here, 71,100. For gap purposes, again, the revenue is the same, and guess what, for that year depreciation is the same, depreciation for tax and gap are the same, there's no difference, therefore 90,000. Now, since tax and gap are the same, I have no deferred tax asset, I have no deferred tax liability for this year, therefore, so let's first, why don't we do the journal entry for the 18,900? For the 18,900, I have to credit income taxes payable, again, income taxes payable is my current taxes that I have to pay the check I sent to the IRS, income taxes payable. Now I don't have any deferred taxes, it means the debit is income tax expense, therefore my debit is income tax expense and as a result, my net income for gap is the same, so notice, because there is no difference between the two, they are the same. Let's take a look at year X3, starting with tax purposes, my income is 80,000, my depreciation for tax purposes is 15, 80,000 minus 15 will give me taxable income of 65,000, what am I going to have to do? I'm going to have to take 65,000 multiplied by 21%, and as a result, I have to write a check to the IRS of 13,650, so I'm going to credit, let's start with the journal entry, I always like to do the journal entry step by step, income taxes payable of 13,650, that's fine. Now if I look at the difference between my gap depreciation and my gap and my tax, my gap and my tax for year 3, I am taking less depreciation for tax purposes and exactly 15, all what's happening, this 15,000 now that I took upfront, that I took at year 3, now I'm losing it in year 3 and it's reversing. If it's reversing, it means this tax liability that I created, this tax liability that I created, this DTL that I created, it's going to reverse. Well it's going to reverse, I'm going to have to remove it because now I am getting less deduction, therefore I am going to debit the third tax liability to reverse this one, 3,150. Okay, so let me first compute net income for tax purposes, which is 51,350, now what is my income tax expense, well I have to write a check for 13,650, then I'm going to have to reduce my liability, which means I am now reducing my liability, I'm not recorded as an expense because I already recorded it as an expense, I recorded this 3,150 as an expense when I accrued it in 20x1. Now 13, the check minus the reduction in the liabilities will give me income tax expense of 10,500, therefore my income tax expense is 10,500 and my net income is 39,500. Few things I want you to observe from this exercise, I want to make sure you understand this, the first thing is notice total depreciation for all 3 years is 90,000, the 15,000 less that I took more in tax depreciation was reversed in year 3, therefore the difference overall is 0 and if I compute my net income for gap purposes, if I add this number, this number plus this number plus this number, let me highlight them, if I add this plus this plus this, it's going to give me 165,900, the sum of those 3 numbers for gap over 3 years, my net income is 165,900, now if I'm going to add my tax, tax, tax net income over 3 years and it also gives me 165,900, why? Because the differences are temporary differences, the only difference here is temporary difference which is exactly the only difference is depreciation which is it started in year 1, which it gave me the third tax liability, then it reversed in year 3, income is the same for tax and gap, therefore guess what, over 3 years everything reversed and everything equal to each other, so this exercise I strongly believe if you can follow the journal entries, how we did the computation, how we did the journal entries, we only dealt with the third tax liability, obviously you want to work another example with the third tax asset, look at the journal entries and once you are comfortable with this, once you are comfortable with this, you know bring it on, the third tax asset, the third tax liability, but what should you do now? Go to Farhat Lectures and look at additional true, false, MCQs, exercises that's going to illustrate this concept, that's going to help you better, the third tax asset is a difficult topic, if you don't learn it, if you learn it, it's easy topic, bring it on, good luck, study hard and of course stay safe.