 Hello and welcome to this session in which we will discuss the third income taxes. Specifically, we're going to be discussing this topic, the third income taxes when financial statement consolidation exists. Now, why am I making this distinction? Because we did cover the third income taxes in much, much, much more details in intermediate accounting. Simply put, in intermediate accounting, I have 10 different lectures for this topic. So when you are taking advanced accounting, which is financial statement consolidation chapter, the assumption is you already completed your intermediate accounting course and intermediate accounting. We cover this concept, the third income taxes. So all what I'm trying to say is I may not go a little bit in depth as I might go because the topic is not about the third income taxes. It's about the third income taxes when it comes to consolidation. So if you're not comfortable with the third income taxes, just go to my intermediate accounting, finish those lessons, then come back. However, I will do a quick review about the overall concept about the third income taxes, why the third income taxes arises. Well, simply put, we have two sets of books when it comes to companies, US companies. For tax purposes, they have to pay their taxes based on the IRS code. Then we have US GAAP where they have to prepare their financial statement, which is called financial reporting. So as a result of those two sets of standard or two sets of rules, differences will arise. How we account for something for tax may not be the same for US GAAP. How we account for something under US GAAP may not be the same as tax. Well, as a result, we're going to have differences. What are some examples of these differences? For example, the way we depreciate an asset under tax is totally not totally it's different than we do depreciation under US GAAP. So as a result, the book value of our fixed asset property, plant and equipment for tax purposes will differ from the book value of the US GAAP based book value. Why? Because the depreciation amount is different. Revenue recognition, the way you recognize revenue under the internal revenue code, we might have to use the percentage of completion. And under US GAAP, we might have to use the completed contract or vice versa. Warranty liability expense, the way we account for warranty liability under US Treasury Code or the US tax system is when you pay it, you take it. You take the expense under US GAAP, you can accrue this expense. And this is just a sample of examples. And there's many, many of them. I just want to just a quick review to kind of set the ground for what I'm doing here. So difference result in either a taxable liability or deductible amount. So simply put, if you have a taxable if differences is going to result in more taxes and the future, you're going to have a liability. If that difference is going to result in more savings, more deductible, you're going to have a deferred tax asset. Again, this is the simplified version of it. Income tax deferral amount depend whether the consolidation reporting entity files are consolidated or a separate return. So when it comes to consolidation, it also makes a difference whether the parent company is including all the subs. So the parent company and the sub, they're all filing one tax return. And we talked about when would that happen and why or if the parent company and the sub, each one of them, in other words, the subs are also filing their own separate income tax return. Specifically, we have to be aware of few topics here. Intra entity dividend, when we have a dividend transfer, the impact of goodwill and other intangible and intra entity profit. And for intra entity profit, we're going to break them into two parts. The intra entity profit when it comes to inventory, intra entity profit other than inventory. Now, what I'm going to do, I'm going to go over these concepts, explain, explain, explain them briefly, then work an example illustrating the concept. Before we proceed any further, I have a public announcement about my company, Farhat Lectures dot 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. Let's start with intra entity dividend. What do we need to know? Well, when it comes to gap, dividends are eliminated. Why between the subsidiary and the parents? Because they represent intra entity cash transfer. Well, they are simply eliminated. Under the tax law, that's the same concept as long as the parent owned more than 80 percent of the subsidiary. Under those circumstances, dividend are also removed. Why? Here you need to know a little bit of tax rule. And I'm assuming you already took your tax course. If you own more than 80 percent of a particular company, well, you would report the dividend as dividend income. So let's assume the company paid you $80,000 in dividend income. Then this is part of your income. Then when it comes to your deduction or your expenses, you're going to have something called DRD, Dividend Received Deduction, and you will be able to take it out. So you would report it as income, then you will have the Dividend Received Deduction, it will eliminate it. Therefore, if you own more than 80 percent, it's the same effect as when you consolidate. It's considered intercompany cash transfer. In other words, there are no differences at that level. What happened if you own less than 80 percent of the subsidiary? Well, if you own less than 80 percent of the subsidiaries for financial accounting purposes, you could still consider it into entity transfer. Here we are assuming you are consolidating, you own more than 50 percent. That's fine for tax purposes. If you own less than 80 percent, then you cannot deduct the whole thing. Thirty five percent of it is taxable. So if you report $80,000 in dividend income, if this is the income, the only expense you can take now from this is 35 percent of this can be deducted to 35 percent of this can be deducted. In other words, there's going to be a difference between your dividend income for tax purposes and your dividend income for financial accounting, which is zero because you you eliminated because as a result of having a future liability, because now you have an amount to pay, you're going to create a liability for that dividend. Also dividend declared, but not yet paid. Well, when you declare a dividend, OK, but you did not pay it yet. Well, guess what? You have a tax liability in the future because once you clear a dividend, the subsidiary is going to pay it. They have not paid it yet. Well, regardless, since they now you have a liability on the books and it's going to be paid into the future, you're going to be paid, you're going to be paid in the future. Then it's going to create a difference because you have a liability for tax. You don't have a liability for financial accounting. The amount will differ. Therefore, it's going to create a tax payment in the future. As a result, you have a deferred tax liability. Again, when does this exist when you have less than 80 percent ownership? The liability will the liability amount will differ between the two. Impact of goodwill. Now, if you don't know what goodwill is, it's when you purchase another company and you purchase more than its identifiable, identifiable fair market value. How does the tax law treat intangibles? Intangibles of goodwill and other purchased asset referred to as Section 197 are amortized over 15 years, so you will take the deduction over 15 years. When it comes to gap, what do you have to do with goodwill? You have to evaluate goodwill and if it's impaired, you write it off. So let's assume you purchase a goodwill or curated goodwill or you purchase an intangible asset and for the sake of illustration, it's 15,000. You're going to divide it by 15 years and every year you'll take 1000. That's for tax. When it comes to gap, you're going to have that 15,000 on the books and you don't do anything unless that asset is impaired. So you only take deduction, you only take a deduction, not deduction and expense to differentiate, you only take an expense for gap when that asset is impaired. So if that asset is impaired, is not impaired, what's going to happen after year one, the book value of it after year one will be 15,000 because you did not, you did not take any expenses for tax purposes. It will be 14,000 because 15 minus one is 14,000. Notice there's a difference and this is what's going to create the difference for the goodwill. So the presence of tax deductible goodwill create a temporary difference. We're going to have the third income taxes. It could be an asset, it could be a liability because for tax purposes, you might only take 1000 then for gap. Well, you find out that was a bad deal. When you bought this company, you might have to take 5000 in expenses. So notice now you have more deduction for gap. So it could differ between the two. You could have the third tax asset or the third tax liability. Just be aware of this. Also, a temporary difference exists for other purchase intangible asset that qualify under section 197 property. Again, here you have to know, be familiar with a little bit with the tax rules. Enter entity profit. Specifically, I said we're going to deal with inventory and enter entity profit other than inventory will be dealt with separately because they use separate rules. Just to review, if you remember when we talked about enter entity profit, when it comes to consolidated financial statements, simply put, we're consolidating everything, any gross profit from the sale of inventory on an intra entity profit. So the parent selling the sub, the sub selling to the parent is the third until that inventory is sold to a third party. And if you remember when I explained this, I said, OK, this is the parent. This is the sub this way. This is the parent and this is the sub. They're going to sell each other and they're going to have profit. As long as that profit within the whole entity, it didn't go outside. This entity, it's deferred as long as what? As long as they're consolidating, of course. Well, guess what? The same concept apply if we are consolidating for tax purposes. So also the parent and the sub, it could be many subs. They're also consolidating. Also, we defer this. We defer this profit. We defer this profit if a separate return is filed. Now we have the parent and we have the sub for financial accounting. They are consolidating, but when it comes to tax, they have their own tax return, they have their own tax return. If that's the case, if that's the case, the gross profit is recognized and taxable income here. You can no longer say I'm going to defer it for tax purposes because you're not consolidating. So from a tax perspective, what they're saying is from a tax perspective, each entity is different. So what's happening here is something like this. When you taxes paid on intra intra company profit from inventory, it's considered a prepayment. So when the sub, let's assume the sub have an intra entity profit and they paid their taxes because they already paid their taxes on that profit. When they actually sell it to a third party later on, the taxes are already paid. So what's going to happen because you paid your taxes, it's going to give you a deferred tax asset or if the parent paid the taxes on that intra entity profit, why? Because you paid it and it's not sold to an outside party yet. So if you paid it and not sold to an outside party yet, you prepaid your taxes. So when it's sold to an outside party, you don't have to worry about this because you already paid your taxes on that profit. So that's why when it comes to intra entity profit, other than inventory. Well, what's other than inventory if you sold equipment and other assets? Well, recognize the related income tax effect and the period in which the transfer occurs. So when that happened, you do it. You recognize the taxes. There is no deferred component. So for intra entity profit other than inventory, you just have to pay your taxes. Now, as a result, let's assume you sold a piece of equipment or or land or a machinery. Now, usually, usually if you do that, you might, you know, let's assume you have a gain to order loss. It doesn't matter what's going to happen after the fact. There's going to be a difference between the book value and the tax basis. So you're going to have the difference between the book value of that asset and it's the book value for financial and the tax basis, which is the IRS. We're going to have a difference and we're going to they're going to have a different depreciation amount. And this is a separate story will account for that differently. But the gain or the loss on the transaction itself is not the third. It will create a deferred tax asset or the third tax liability, because the book value between the two will differ, but not. But we're not talking about this. We're talking about the depreciation. The depreciation amount might be different. Then we'll account for that separately. This is what we talk about when we discuss the third income taxes and intermediate accounting. Now, the best way to illustrate this concept is take a look at an example. Just going to get a feeling of how this works. I'm going to switch to an Excel sheet and take a look at an example. OK, let's take a look at this example. On January 1st, 20X0, Adam purchased 85% of Ryan outstanding shares. What does that tell us? If we have more than 50, we can consolidate for financial accounting purposes. If we have more than 85, now we can also consolidate for tax purposes. If we choose, if we choose, remember, if we don't, we don't have to. We're assuming Ryan is a domestic company. Domestic means it's a U.S. company because we're assuming here home is the U.S. The tax rate is 21 percent. Now, we're going to be giving the data for X0, the data for X1, and we're going to determine the tax expense and the tax payable for assuming they file a consolidated return or assuming they file a separate return. Let's take a look at the data that we are giving. Since we are giving two years, let's look at both years. Sales 600,000, operating expense 400,000. Inter company gross profit included with sales 120. So this is inter company gross profit. It's included in sales. Dividend income from Ryan, which Ryan, this is how much we received. We own 85% of Ryan. Ryan paid 30, we received 25,500. And in 20X0, Ryan generated 210, operating expenses of 130. The question is about 20X1. Why am I going over 20X0? Well, the reason is because the inter company gross profit that was included in sales, that was included in sales will be the third, will be the third. What does that mean? It's mean it's remember if they consolidate, it's going to be the third. It means this 120,000, we assume it's going to be realized in 20X1. So we have to add it to the 20X1. Now, in 20X1, we had sales of 800,000 for Adam, operating expenses of 500,000, and we have an inter entity profit included in sales of 150. Now we have 150 included in this amount. Well, this is inter company. What do we do if we consolidate? We are going to defer this till X2. So it's important to understand why I am emphasizing those inter company gross profit that's included in sales in X1, included in sales in X2. But for consolidating, it's going to be the third. So then Ryan, then Adam received 42500 from Ryan. Ryan sales was 370, operating expenses 270. So let's take a look at their tax bill. Sorry. Assuming they file a consolidated return. Adam will have, Adam income will be 250, which is 800,000 minus 550. Ryan income is 100,000, which is 370 minus 270. Now, you might be saying, why didn't we include the dividend from Ryan as part of income? Yes, we do include this. So the dividend from Ryan, we do include 42500. This is dividend income. Then on the same tax return, we're going to have a something called dividend received deduction. I emphasize earlier, then we'll take the deduction. So the effect is zero. So that's why kind of, you know, Adam's income is 250 because if we include the dividend, we're going to have to deduct it as a deduction. Then the net effect is zero. And bear in mind, whether we file a consolidated return or each company file a separate return, Adam would still qualify for the dividend received deduction because Adam owns 85, which is more than 80%. So the dividend received deduction does is not only applicable when we file a consolidated return, it's always applicable or available to the taxpayer as long as they own more than 80% of the other corporation. Now, remember this 120,000? That was the third. Well, it was the third from 20X0. Now it's going to be in 20X1. So we're going to add this 120,000 to our taxable income because it was the third. Then this 150,000 that was generated in 20X1 will have to deduct because this is going to X2. So all in all, if we take Adam's income, Ryan's income, add the third profit from the prior year, subtract the third profit that's going to next year, we're going to have a taxable income of 320. We said the tax rate is 21%, assuming my Excel is working properly. You have a tax bill to the IRS of 67,200. Now, from an income tax perspective as well, the income tax expense is also 67,200 because there is no difference. We consolidated and since we consolidated, we don't create a difference. Simply put, the profit is the third. The profit is the third, therefore, no difference. So enter entity profit on inventory is not taxed till it's sold to an outside party. So we did not pay any taxes on it. Therefore, there is no deduction or or benefit from that. Therefore, the expense and the liabilities are the same. And remember, the dividend is subject to dividend received deduction. Therefore, we're going to debit tax expense, tax expense, 67,200 credit tax payable or taxes payable, 67,200. And that's it for that's it for the filing a consolidated return. OK, now let's assume, let's assume, now let's assume they file a separate return. If they file a separate return, what's going to happen? Adam will have 250,000, just delete this, 250,000, which is 850 minus 500,000. The tax rate is 21% and they're going to have a tax bill of 52,500. So what are we going to do with the with this amount, 150,000? Hold on on this amount because this is that's what's going to create the difference between between Adam and Ryan. But let's let's compute it one piece at a time. Ryan will have 100,000 of taxable income times 21% is 21,000. So for now, here's what happened. Adam company will have a tax bill of 52,500. Ryan company will have a tax bill of 21,000. Together, they will have an income taxes payable. Let me credit this because this is the credit. So they have to send to the IRS each one of them. 52,500, 21,000, total 73,500. Now we need to discuss the differences because when it comes to when they file separately, when they file separately, guess what? They have to pay taxes on that difference. OK, let's go back to 20 x 0 in 20 x 0. Remember, this is not the third. In 20 x 0, the company paid on the 120,000, 25,200. What is that number coming from? Remember for 20 x 0, because if we're filing separately, nothing is the third. Therefore, Adam company paid 25,200. So that was paid that 120,000. Well, that we paid that amount. OK, remember, we paid we paid that amount. That amount means that 25,200. We paid it in 20 x 0. Then the profit then this profit was accounted for in 20 x 1 because it was the third. Now, we actually sold it to a third party in 20 x 1. Well, that's great. We should have have because we sold it. We should have a tax prepayment. In other words, we are ready to care of this 120,000. Now, the the 150,000 here. Remember this 150,000, as we are told, it's included. The 150,000 is included in sales. So this 150,000, we also paid taxes on it. How much was the taxes specifically? In other words, it's included with this amount here. How much was the taxes? Well, if we take 150,000 times 21 percent, we'll give us the amount 31,500. Now, here's what happened. We included the two figures. We included the we included 120,000 in income from year X zero, which taxes were paid on it, basically. Then we included 150,000 and we also paid taxes on it. So here's what's going to happen of this 150,120 representing this 120 because we deferred it. Now we're paying taxes. We already paid taxes on that. So what's left is we actually paid extra taxes on the 30,000 extra taxes. So we paid an additional whatever that is, 30,000. If we take 30,000 times point to one, what we paid, we paid an additional 6,300, 6,300 in taxes. Why did we pay additional 6,300? Well, because the 120 that we included this year, taxes were already paid for it, the 150, what's going to happen? We're also going to have to pay taxes on it. Of the 150, we're going to assume 120 of it goes to the prior year. So what's left is the extra 30,000. Now this extra 30,000, it's going to a prepayment for 20 X2. And this is going to be the third taxed asset. It's going to be debited to the third taxed asset. Therefore, we're going to send the IRS. A check of 73,500. OK, is this our tax expense? No, this is not our total tax expense. Why? Because of the 73,500, 6,300 of it is for the portion of the intra entity profit on inventory that's going to be paid in 20 X2. Therefore, we create a deferred tax asset of 6,300. Well, the income tax expense is what we paid to the IRS minus the amount that we paid for future taxes, which is 73,500 minus 6,300 income tax expense. This will be always a plug. If you remember, if you follow my intermediate accounting income tax expense is always a plug, if need be, but if you want to understand it, we paid 73,500 of which 6,300 is for future years. Therefore, income tax expense for the current here is 6,200. So this is how we compute our income tax expense for this particular year. So this illustration shows you what happened if the company filed a consolidated return, if the company filed a separate return. Now, specifically, what are the benefit of filing a separate return? That's going to have to be discussed separately. Maybe in the next session, I will explain to you, you know, filing a separate return, why, why not? And maybe we'll look at another example. Again, advanced accounting is by its nature advanced accounting. It's difficult. So think about what we're doing here. It's advanced accounting. It is inter entity profit. OK, and a lot of people find difficulty in advanced accounting. A lot of people find difficulties in inter entity profit and a lot of people find difficulties in, in, in what, in the third taxes. So we're taking all these three concepts and combining them in this example. So if you are a little bit overwhelmed, I hate to use the word confused, but it's OK. Even if you feel confused, that's normal. So the point is to do what? Go back and learn about the third income taxes. Make sure you know, understand this, make sure you know how inter entity profit works, make sure you know this, then come back here and put all three together. Yes, it's challenging. You can do it. I'm always here to help you, whether you are studying for your CPA exam, advanced accounting or whatever certification you are doing. Accounting is worth it. Study hard, good luck and stay safe.