 Hello and welcome to the session. This is Professor Farhad and the session we're going to be working practice questions that deal with the third tax asset, as well as the third tax liability. A topic that's challenging for many students. Those practice questions are based on the previous session, which I introduce. I go over the third tax asset and the third tax liability from an introductory perspective. LinkedIn is where you would need to connect with me. If you haven't done so, YouTube is where I house my 1,500 plus accounting, auditing finance lectures. This is all the courses that I cover. So in this session, we're looking at something in intermediate accounting, as well as technically CPA questions. On my website, you can find additional resources, questions, quasi practice simulation notes, PowerPoint slides, as well as many, many more resources for you to succeed as an accounting or as a CPA student. Let's go ahead and start with the first sets of questions. So the first thing I'm going to ask you is a list of true, false to make sure you understand the most basic concept. So the first question is this true or false? What I want you to do, I want you to pause before each question, try to answer it. Then listen to my recording and see if you got it right. Let's look at the first true, false, a temporary difference is the difference between the tax basis of an asset or a liability, and it's reported amount in the financial statement that would result in a taxable amount or a deductible amount in the future and future years. Is this a correct statement? Yes or no? And the answer is, yes, this is a true statement. This is exactly what a temporary difference is. It's a temporary difference because of the tax basis of an asset and a liability, and it would result in a future taxable amount. Taxable amount means it might result in a deferred tax liability or a deductible amount it might result in a deferred taxed asset. So a temporary difference will get you either a deferred taxed asset or a deferred tax liability, depending on what the difference is. Second question. When the book amount of an asset or a liability differs from the tax basis as a result of a temporary difference, basically what we're saying, same thing here, the future tax effect on taxable income must be reported solely in future financial statement that the difference effect. Hold on a second. So first we gave the, basically the definition of a temporary difference. Then we said the future tax effect must be reported solely in future financial statement. No, not at all. It has to be reported now. The temporary difference has to be reported now as either a deferred taxed asset or a deferred taxed liability. So this statement is false. This statement is false. Okay. So it's reported in future financial statement, not in current, sorry, in current, not in future. The third tax liability is the amount of the third tax consequences attributable to an existing temporary difference that would result in net taxable amount in future years. Is this what a, the first tax liability is? Yes. A deferred tax liability would result in more taxes in future years. So that's a true statement. That's, that's the definition of the third tax liability. A deferred tax expense is the decrease in a deferred tax liability balance from the beginning to the end of the accounting period. Now, you're at this statement. You are really stuck. I really don't know the answer. Okay. Let's look at it from a, from a journal entry perspective to see if this makes sense. And there is an important concept here. A deferred taxed expense. So the third tax expense. Remember, what do we do with expenses? We debit expenses. So notice this is a deferred tax expense. We debit expenses is the decrease in the third tax liability. Hold on a second. If you have a liability and that liability decrease, I also have to debit the liability. So what you're saying, I debit the third tax expense, then I debit the third tax liability. That doesn't make any sense. Well, if I'm debiting the third tax expense, if the third tax expense debiting, if I'm, if I am connecting this to the third tax liability, the third tax liability must be increasing, right? Because to increase a liability, you credit a liability to increase an expense, you credit an expense. You credit an expense. Okay. Therefore, the third tax expense. So what does that mean? This is, there's an important concept here. It means every time the third tax liability goes up from year to year, your deferred tax expense goes up. And as a result, your income tax expense goes up because the third tax expense is part of your income tax expense because your income tax expense, part of it is current, part of it is deferred. If deferred goes up, your income tax expense goes up. Now, also we can say if a deferred tax liability decrease, write these down, the third tax expense goes down. It means, it means if I'm debiting the third tax liability, the corresponding credit is the third tax expense, which is part of income tax expense. I am crediting the third tax expense. I am crediting the third tax expense. And using the same logic, let me, since we are going there, using the same logic, every time the third tax asset goes up, okay, the expense, the corresponding expense must go down. And every time a deferred tax asset goes down, it means the change is a decrease, your deferred, your income tax expense goes up. So make sure you jot these down. So those are very important, very, very helpful shortcuts. Let's take a look at this question. The concept of a deferred tax liability meets the definition of a liability established according to GAB because it's a result of a past transaction, present obligation, future sacrifice, represent the future sacrifice. That's exactly what the liability is, and the third tax liability is no different. It means this is a correct statement. An objective of accounting for income taxes is to recognize the third tax liabilities and assets for future tax consequences of event that already been recognized in the financial statement. Hold on a second. Is this the reason of, is this the objective of accounting for income taxes? And the answer is yes. So the third tax asset and the third tax liability tells you what's going to happen in the future that already happened in the financial statement. That's basically what it is. So the, the, it is just correct. The third tax asset represent the increase in taxes payable in future years as a result of a taxable temporary difference existing at the end of the current year. So, so let's, let's see if this is a correct or incorrect statement. So they're asking us about the third tax asset, the third tax asset. Does it represent an increase in taxes payable? No, at the third tax asset, what does it represent? It represent a future savings or, or, or an increase in refund, not an increase in taxes payable in future years. That would have been at the third tax liability would represent an increase in taxes payable, not the third tax asset. The third tax asset would represent future savings. Let's work a few more of these through false. The third tax asset should not be recognized in the accounts because they, they failed to meet the definition of an asset. No, the third tax asset is an asset. It's a future benefit. It's a future benefit. The third tax asset should be reduced by evaluation allowance. If based on the available evidence, it's more likely than not that some portion or all of the third tax asset will not be realized. So this is evaluation question. Is this a true statement? And the answer is yes. This is a true statement. What, what happened is this, if we have a third tax asset, we have to look at available evidence, whether it's negative or positive to determine if we should have an allowance account. And I talked about the allowance account. Basically, if you are not going to be using the third tax asset, you need to write it down. All positive and negative information should be considered in determining whether evaluation allowance is needed. Yes, I just said this. You have to consider positive and negative. Positive means stuff that's gonna affect it positively and negative stuff that's gonna affect it negatively. Basically, we have to look if we are going to lose or have more, if we're gonna, if we're gonna more likely or less likely to use those tax savings in the future. If we are not gonna use them, we need to write down that the third tax asset. We should not have an asset that we are not going to use, which is considered a useless asset. Let's take a look at this multiple choice. With regard to the third taxes, the use of the installment method for tax purpose will typically result in what, okay? So what they're saying here is this. If we use the installment sales method, now if you don't know what the installment sales method is right there, you are in trouble. What is the installment sales method? The installment sales method is when you sell something, let me go back here, when you sell something and they're gonna be making payments in future years. So each acts represent a payment. And if we are using this method for tax purposes, it means every time we receive the cash from those payments, we have to pay taxes. Now, versus maybe for financial accounting purposes, what we did is for financial accounting purposes, we recognize the whole revenue upfront. So for financial accounting purposes, we recognize the whole revenue upfront for tax purposes. This is what we're using here. We are waiting for the payment. What is that going to give us? That would result, would it result under the third tax asset and would that result under the third tax liability? Think about it for a moment and let me know. Okay, hopefully you got it. What's gonna happen in the future is I receive my payment. Whatever that payment is, I have to pay taxes. Every time I receive the payment in the future, I have to pay taxes. I have a future taxes. What do I have? I have a deferred tax liability. I don't have a deferred tax asset. So one is out, A is out, C is out, B is the answer. I have a deferred tax liability. Let's take a look at this question. The reporting of which of the following would typically result under the third tax liability? So we have two, warranty expense and bed debt expense. And which one of them would result under the third tax liability? Let's look at each one of them separately. Now here you have to kind of use your knowledge to know how this whole work, okay? So what happened when we report warranty expense? Okay, so from a financial accounting perspective, here's what happened. From a financial, this is the financial statement and this is tax. What happened when we report a warranty expense? We debit warranty expense, let's say $10,000. We credit estimated warranty liability $10,000. What did we do for financial accounting purposes? We don't do anything. We don't do anything. Sorry, for tax purposes for that year, this is 2020. We don't do anything, okay? Now what happened in 2021? In 2021, we are expecting for that warranty expense to materialize. We are expecting for a warranty expense to have occurred. And once it occurred, we'll take a deduction. Hold on a second. So a warranty expense gives us a future deduction because in 2021, so 2021, when actually for tax purposes, when I actually pay for the warranty, I debit an expense and I credit cash. When I pay for the warranty for tax purposes, for financial accounting purposes, I already accounted for that. So it's gonna give me a future deductible amount. Hold on a second. Future deductible amount is not a liability. Future deductible amount gives me a deferred tax asset. Therefore, one is out, A is out, C is out. Now the question becomes to bet that expense. Follow the same logic. Bet that expense, we book bet that expense for financial accounting purposes, but we don't do anything for taxes. Why? Because we only take the write off when it's the direct method under taxes when we actually write off the account. Therefore, the same concept. We book bet that expense for financial accounting purposes. We debit bet that expense and we credit allowance. And for tax purposes, we don't do anything. Then in future years, when we actually write off the amount for tax purposes, this is when we take the expense. Therefore, bet that expense on the financial statement now will give us a future deductible amount in the future. Where therefore it doesn't result in a tax liability. Therefore B is out and the answer is neither one nor two. Okay, both of them are deferred tax asset. Let's take a look at this question. Station Toy Train Company, a cash basis taxpayer prepares it's a cruel financial statement. In year 2013 balance sheet, station deferred income tax liability increased. So the third tax liability went up. Okay, hold on a second before we even proceed. If a liability went up, liability takes a credit. The corresponding to the liability should be an expense. So the expense will go up just before we even proceed any further, okay? Which of the following changes during 2013 would have caused this increase in the third income tax liability? Hold on a second now. So they're asking us why we would have an increase in the third tax liability actually, okay? Well, let's think about it for a moment. The third tax liability went up. It means the third tax expense went up. The third tax expense went up. It means the third tax expense is part of income tax expense, but we have to be specific. The third tax expense went up. So the third tax liability went up. The third tax expense went up. Which of these one, two or three would result in this? Okay, let's take a look at one at a time. An increase in prepaid. Hold on a second, let's see. Go back to your basic journal entries. You're looking at your financial statements and you acquire a prepaid. What would you do for your financial statements? For my financial statements, I debit my prepaid, let's make it 3000 and I credit cash 3000. Prepaid, PP is an asset, prepaid is an asset. Oops, sorry, prepaid is an asset. Now, what do I do for tax purposes? Well, you need to know this. For tax purposes, I am going to expense $3,000 and credit cash $3,000. Okay, this is for tax purposes, you expense your prepaid. You cannot hold them as an asset, generally speaking. That's the general rule, an increase in prepaid. Well, hold on a second. If I took the expense now, I took the expense now, 2020, in year 2020, what's gonna happen is this. In future years, in future years, what's gonna happen in future years for financial statements, so now let's take a look at the future what happened. In future years, I'm gonna have an expense on the financial statement and on the taxes, I'm gonna have no expenses because I took all my expenses. Therefore, yes, an increase in prepaid. If I acquire a prepaid in the future, I'm gonna have a more deferred tax liability because I already took my expense. Therefore, one is in, if one is in, I can take out A, I can take out D immediately. This is how you should be thinking on the exam because if one is in and you're positive about this, all what we'll have to do is determine if two, you know three is out because there's no one, two, and three. Hopefully you see this. Now you just have to know if this is correct. If this is, if this result in a deferred tax liability or not, an increase in rent receivable. An increase in rent receivable. Let's take a look at it from a financial accounting perspective. From a financial accounting perspective, an increase in rent receivable, it means we debit rent receivable and what do we credit? We credit revenue. We credit revenue. So we counted the revenue for financial accounting purposes. For tax purposes, nothing. We don't do anything, no entry. Why? Because we're waiting to receive the money. Once we receive the money, we count the revenue for the rent. Therefore, for this year, I'm gonna say for 2020, for year 2020, I have no revenue for tax purposes. That's good for now, for tax purposes. But guess what? In 2021 and 2022, I'm gonna be receiving this money. Hold on a second. What happened when I received this money? I have more taxes. What happened if I have more taxes? I have more deferred tax liability to book. Therefore, two would also result in a deferred tax liability. Two would result in a deferred tax liability. Therefore, the answer is C. The answer is C. C as in Charlie. Which is correct regarding current and deferred income taxes? So basically, they're asking us, do you know what current and deferred income taxes are? Because current and deferred compose your income tax expense. The third income tax expense is equal to the change in the third tax liability or asset on the balance sheet from the beginning of the year till the end of the year. Is this a correct statement? Yes, this is what the third income tax is. It's the change in your deferred tax asset and your deferred tax liability. So one is in. If one is in, I can take out B and I take out D. Now you're down to 50-50. Let's take a look, see if the second statement is correct. Current income tax expense, do you know what current income tax expense? Equal to the income taxes payable on the corporate tax return, assuming no estimated payment were made. Is this your current income tax expense? Yes, this is what I explained to you earlier. Your current income tax expense is what you have to pay to the IRS is your income tax payable. Both of these statements are correct. Therefore, the answer is C. Remember, those two, the deferred income tax expense and the current income tax expense together will give you income tax expense. And we talked about this, okay? But those are the definition of them. Make sure you know what they are. Make sure you know the definition, know what they look like, how do they fit together? Okay, let's take a look at this question. Delaney company had revenues of 180,000 for book purposes and 150,000 for tax purposes. Let's take a look at the question. If Delaney has a 35% tax rate, what's Delaney income taxes payable for 2017? What are they asking you? They're asking you how much, what's the check that they should write to the IRS Inc, which is, I can't call it, what's the check that they have to write? I can call it current income tax expense, whatever you wanna call it, but make sure you know it. So basically they're asking you for the current income tax expense, okay? Or income tax is payable. So they have revenue of 180, so for book, I don't care about the book purposes. They have revenues of 150 for tax purposes. So revenues 150. Delaney also has expenses of 100,000 for both. So the expenses for tax purposes also 100,000. This is for tax purposes. Therefore, my taxable income is 50,000. Therefore, if I take 50,000 multiplied by 35%, I should have 17,500. Okay, if I want to journalize this, let's journalize it. You will debit current income tax expense 17,500, income taxes payable 17,500. So this is the current component, the current component of your taxes. Well, since we do the current component, let's do the deferred component. What the heck, you know, let's do it. So what is the deferred component? Well, guess what? You have more taxes now. You paid more taxes now. For financial accounting purposes, you're gonna have 50,000 less of taxes. You're gonna have 50,000. 50,000 means what? Why 50,000? Because remember, from a financial accounting perspective, your revenue is only, oh, actually your revenue for book purposes is higher. Sorry, from a financial accounting perspective, your revenue is 180, actually more. Your revenue is more. And your expenses are 100,000. So it's 80,000. So notice, so from a financial accounting perspective, you have more revenue. It means in the future, you're gonna have, in the future, you're gonna have 30,000 more in revenue in the future. So in the future, you have more revenue. In the future, you have more revenues. 30,000 more revenues. Well, if you have more revenues in the future, you have more taxes to pay. We're gonna assume the future rate is 35%. Let's do this. I believe it's 10,500, but let's... So I'm just gonna show you how can they trick you. I mean, 30,000, you have to know what they're asking. You're times 0.35, that's 10,500. The 10,500, the 10,500 is the third component of your taxes. Therefore, the entry will be the third income tax, 10,500, the third tax liability, 10,500. Now, can I combine... So basically, let me just tell you, simply put, if you wanna combine those two, basically this and this, those two, this is the current and this is the third taxes. Now, I can combine those two. I can put income, my income tax expense is... Sorry, my income tax expense is 27,000, 28,000. Then I, my deferred tax liability, 10,500. In my income taxes payable, taxes payable is the 17,500 credit. Okay, sorry. So this is the combined entry. Hopefully, I mean, you have to re... In other words, for this question, they can ask you for what's the deferred component. The deferred component is 10,500. They could have also asked you, what is the total income tax expense that would have been 28,000. So you have to understand, they could ask you all three questions here. So they ask you about the taxes now. The taxes now is 17,500. The deferred is 10,500. Together is 28,000. If you understand this question, you have a good understanding of things. Let's take a look at this question. Morene Corporation reports income taxes before, before income taxes, before taxes of 500,000, AKA GAP, and its income statement. But because of timing difference, taxable income is only 200,000. So for financial statement, they have a half a million for tax purposes. Their taxable income is only 200,000. Now why, there's a difference of 300,000. Why is there that difference? It could be that we took more deduction for taxes or we took more revenues for financial statement. Either we took more deduction for tax purposes, therefore our taxable income 200,000, or we recognize more revenues for financial statement. Okay, it's either or, okay. If the tax rate is 45%, what's the net income should the corporation report? So here what they're asking us really is the net income. What's net income that should the corporation? So we're looking at financial statement perspective. How can you solve a problem like this? Well, you have your income before taxes. So you're looking for your taxes. Okay, what are your taxes? Your taxes are composed of two things, the current and the deferred component. So your income taxes are current taxes and the deferred component. Well, can I compute my current? Yes, I can easily compute my current. I have my income taxes. I multiply this by 45% and that's gonna give me 90,000. So my current taxes is $90,000. This is the current component. What is the deferred component? Well, let's see. The difference between my financial statement, taxable income or financial statement income before taxes and taxable income is 300,000. What does that mean? It means in the future, I am going to lose a deduction or have more revenues of 300,000. Regardless, in the future, I have more liability in the future. I have more liabilities in the future in terms of deferred tax liability. Okay, so I'm gonna have to have more liability because 300,000, it's gonna either, it's gonna increase my taxes or it's a reduction that I'm not going to have, a deduction I'm not going to have. Well, it means the deferred component is an increase in deferred tax liability. It's 300,000 multiplied by 0.45. So 45 plus 45 equal to 90 plus 45 equal to 135. So the deferred tax liability is an increase of 135. Well, guess what? So my taxes are 0,005 to 225. To 225. So my income tax expense is 225. Let me also give you the journal entry for this. So this way you know what the journal entry is well. So the journal entry will be, I'm just gonna call it income tax expense, income tax expense 225. Okay, the third tax liability, which will be a credit of 135, this is the credit and income taxes payable, which also a credit of 90,000, 90,000. So the debit is 225 and those are the two credits. So my income tax is, and my income tax expense is 225, so 225,000 minus my taxes will give me a net income of 275, in the interest to 275. Notice 225 is here, but that's not what they're asking you. They're not asking you about your income tax expense. Also notice the 90,000 is here. The 90,000 is your current income tax expense, which is your, this is the check that you write to the IRS. They could ask you, again, in this question, they could have asked you about many, many component, many component. Just be careful what they ask you. Just be careful what they're asking you, okay? According to GAB, at the third tax liability is what? Result of a pass transaction. Yes, it's a result of a pass transaction. Therefore, D is out. Is it a present obligation? Is it a present obligation? Yes, it is. So A is out. It is present obligation. So it's present obligation. It represents the future sacrifice. Of course, it's a liability. So the answer is C. C. So this is basically the definition of a liability. At the third tax liability is a liability. So that's basically, you have to understand this. It should fit the definition of a liability any way you frame it. Any way you frame it. Glime Inc. has a deductible temporary difference of 100,000 at the end of the first year of operation. Its tax year is 40%. Income taxes payable are 90,000, which is those are the current taxes. Glime properly recorded the third tax asset. Later, after careful review of all available evidence, it's determined that it's more likely than not that 15,000 of the third tax asset will not be realized. What entry should they make to reduce the asset value? Simply put, how do you report an allowance for the third taxes? You debit income tax expense? Yes. Do you credit the third tax asset? No, you don't credit the third tax asset itself. You reduce the third tax asset, but not by crediting the third tax asset. So that's incorrect. Income taxes payable debit? No, no, no. You don't reduce your taxes for the IRS, that's out. And you don't reduce your taxes, neither income tax expense. You debit allowance to reduce the third asset to expected realizable value? Well, allowance is a contra asset. Contra asset, it's not increased by a debit. Therefore, it sees out. Well, by process of elimination, D is the answer. You credit allowance to reduce the third income taxes, which is an allowance account, which makes sense. And you increase your income tax expense because you lost that savings. So D is D. So if you have any questions about these questions by all means email me. In the next session, we would look at additional topics that deals with the third tax asset and the third tax liability to start to expand our horizon because this was an introductory questions. I strongly suggest you subscribe to my website as it's an investment in your career, especially if you are an intermediate accounting student or a CPA candidate as it will help you in both situations. Good luck and study hard.