 Hello and welcome to this session in which we'll discuss the third tax liability. What is a deferred tax liability? For one thing, it's a liability. Liability means it's an obligation. We owe something for the future. That's what the definition of a liability. But what type of a liability do we have? It's a result of something called deferring the taxes. It means we have to pay something in the future as a result of a tax transaction. What does that mean? It means we have something that's temporary difference in nature. What is a temporary difference? Although we talked about deferred taxes in the prior session, I'm going to focus here on the deferred tax liability. So a temporary difference, bear in mind, we have temporary difference and we have permanent difference or permanent differences. But the temporary difference is the difference that give a rise to something called deferred tax liability or a deferred taxed asset. It's a difference. It's a difference between two things. Between the tax basis and the book basis of an asset or a liability, the way it's reported on the tax record and the way it's reported on the financial statement record. Let me explain. We have basically two sets of books. One is for GAP and one is for tax. The tax follows the IRS rules. GAP follows FASB. What happened as a result of those differences? The way we account for certain transaction, for example under GAP, we could have an asset for $100 and for tax purposes for that particular year, the asset is zero. There is no asset. As a result, we have a difference of 100 and we're going to assume this difference is temporary because we have permanent differences. So as a result of this difference, as a result of this difference, what's going to happen in the future, we're going to be responsible for future taxable amount or future deductible amount since we are talking about the third tax liability. I'm going to take out future deductible amount because if it's a future deductible amount, we are dealing with the third tax asset, not in this session. So this is the third tax liability. There's a difference between, obviously we're going to work an example, there's a difference between the tax basis of an asset and the book basis. Tax means IRS, book means GAP. There's a difference in the basis of that asset or of that liability. As a result, when that difference reverse, we're going to have to pay more taxes. So the future taxable amount result in a third tax liability and the third tax liability represent an increase in taxes payable in the future as a result of a taxable temporary difference that's going to reverse. So when that temporary difference reverse, you're going to have to pay taxes. The best example, the easiest example to illustrate is if you are accounting for revenue under the accrual basis, accounting for revenue under the accrual basis for book purposes, for GAP purposes, and you are accounting for that same revenue under the cash basis under taxes. If you are accounting for something under accrual basis for GAP, what's going to happen is once you earn, you're going to have an account receivable under GAP. Well, under tax, when you have an account receivable, you don't have an account receivable for tax because your revenue is accounted for under the cash basis. So as a result, you're going to have a difference between the book basis of an asset account receivable and the tax basis, which is zero versus some other number under the GAP basis. And this is what we mean by the third tax liability. Now the best way to illustrate this concept is to work an example. Let's take a look at this example. Adam Company has one temporary difference, which is an account receivable at the end of 20x1 that will reverse and cause a taxable amount of 60,000 in x2, 55,000 in x3, and 75,000 in x4. Well, if we take 60,000 plus 50,000 plus 75,000, simply put, we have a temporary difference of 190,000. So simply put, on GAP under the GAP, we have 190,000 of account receivable. Under the tax basis, we have zero receivable. And what's going to happen to that receivable? That receivable is expected to be received in year one, year two, and year three. In year one, we expect to get 60,000. This is when we pay the taxes. In year two, we expect to receive 55,000. And in year three, we expect to receive 75,000 in total of 190,000. Here's what we are telling the investors. We're telling the investors that as a result of this temporary difference, we're going to be responsible in the next three years paying taxes on that future income. And we show you this future taxable amount in form of the third tax liability. For the purpose of this example, the tax rate is 20%. And for the year x1, we have financial income, GAP income of 300,000. So what we're going to do in this example, we're going to compute taxable income, we're going to compute income taxes payable, we're going to compute income tax expense. Now, they all sounds familiar. Isn't taxable income the same as income tax expense the same as income taxes payable? Not at all. Each one of them has a separate meaning for the context of the third tax asset and the third tax liability. So we're going to have to compute each one of them and explain each one of them separately. And how does it relate to the full picture? Then we're going to prepare the journal entry. So let's first take a look at this data and try to analyze it step by step. Well, here's what we are told. We are told that our GAP income, our GAP financial income right here, pre tax GAP income, because when we say financial income, it means GAP income is 300,000. Let's start with that. So GAP income is 300,000. Now we're going to find compute taxable income. You have to go from GAP income to find taxable income. We are told we have a temporary difference of 190,000. I just showed you earlier. In other words, we have to back out. So what's included in this $300,000 in financial income? What's included in it $190,000 in revenues that was recorded as an AR? Well, for tax purposes, I have to back out that revenue. There's a temporary difference of 190,000. So I'm going to back in out. I'm deducting this revenue. Therefore, my taxable income is only 110,000. So although if you look at my financial statement, it shows I have 300,000 in pre tax income. When it comes to my taxes, I'm only responsible for 110,000 times my tax rate, which is 20%. Therefore, my tax bill is only 22,000 because my taxable income is lower than my financial income. Why? Because there's that 190,000 of account receivable that would reverse in the next three years. Now, this is how it's going to reverse. Again, 60,000 in X1, 50,000 in X2. I'm sorry, this should be X2, X3 and X4. 60,000 in X2, 50,000 in X3 and 75 in X4 because this is X1, year X1. Now, let's prepare the journal entry and we're going to assume the tax rate is the same, which is this is important because in some exercises, we're going to learn later that your future tax rate could differ, obviously, because the government changes that, changes the tax rate. So let's look at the journal entry. As I showed you in the prior recording, the first thing you do is you figure out your income taxes payable when you prepare the journal entry. So the first thing is we compute a taxable income right here. This is 110,000 because you could be asked what's taxable income. You could be asked what is income taxes payable. What is income taxes payable? It's the amount that you have to write to the IRS to check 22,000. Well, so you credit income taxes payable 22,000. It means you have to write a check to the IRS for the amount of 22,000. That's income taxes payable. Now, we know that we're going to be responsible for future taxes as a result of this account receivable and the future taxes amount to how much? Let's say 60,000 times 20% 12,000. 50,000 times 20% is 10,000 and 75,000 times 20% is 15,000. When we add all of those, this is our responsibility for future years. So for future years, assuming the tax rate stayed at 20%, we are responsible for $37,000. So this is equal to $37,000. So we have a tax bill now that we have to pay 22,000 and for the next three years, we're going to be paying 37,000 in total. Therefore, we have to book this future liability. Why is this a liability? Because the customer is going to pay the cash on that receivable. As we receive the cash, we include that cash in our taxes and our tax bill taxes to the IRS. Now, what's left is so we figure out income taxes payable, which is 22,000. We figure out our income tax liability, 37,000. So notice, if this is a multiple choice questions, you could be asked about taxable income, income taxes payable, deferred tax liability. There's so many things they can ask you and that's why you need to be 100% comfortable, comfortable with the terms that we are using. Now, what's left is income tax expense. How do we compute income tax expense? Remember, income tax expense is a plug. Plug means what? Plug means is the last entry that you will put. Well, if I need a debit, if those are both credit, my debit should be 59,000 and income tax expense is 59,000. Income tax expense is a plug, but you need to understand what that plug is. Although it's a plug, you need to understand how it's, how does it come to life basically. Well, here's my income tax expense. I have a current portion of my taxes. The current means this year I have to pay 22,000 and in future years I have to pay, this is the future. So my income tax expense consists of a current portion and the future portion. So my total taxes is 59,000 and now in some textbook and in some CPA review courses, what they do, they have income tax expense current 22,000 and they have an income tax expense future for future years 37. So rather than 59, they will show you those separately. And it's, it's, I believe it's more beneficial to see that those are separately because you could be asked also, what's the current portion of income tax expense? Well, the answer is 22,000. What's the third portion? Not current, not future, the third, the third portion, sorry, I'm using the wrong terminology, the third 37,000. Now, this is an example for the third tax liability. Very, very simple, straightforward example. We have no prior, the third tax liability balance. We have the same tax rate in future years. So we kept everything simple. Now in the next session, what I'm going to do, I'm going to look at the third tax asset to kind of make sure you understand how the third tax asset work. Now, what should you do now? Go to farhatlectures.com, work multiple choice through false, invest in yourself, invest in your career. I can help you do better in your courses. I can help you do better for your CPA exam. And that's going to pay you dividends in the future. Don't hesitate, invest in yourself. Good luck, study hard. And of course, stay safe.