 Oh, and welcome to the session in which we will work a CPA exam simulation that deals with earnings and profit. It's very important to understand how do we compute current earnings and profit that eventually lead to our earnings and profit in order to determine whether a distribution is considered dividend, return of capital or capital gains. So as a future CPA or as an accounting student or as an enrolled agent, this is an important topic. What I have here is a series of transaction and the question is, can you determine the impact of each transaction on taxable income and on earnings and profit, whether it's an increase, a decrease or it has no impact. So what I suggest you do pause and see if you can find the impact before I work this exercise. 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. Let's go ahead and get started. Starting with the first transaction, $70,000 of federal income taxes were paid in the current year. How would that affect taxable income? How would that affect earnings and profits? How would that affect taxable income? Well, if you pay taxes, how does it affect taxable income? No impact. Not deduct, the federal income taxes on your taxable income. You wrote a check, but you cannot do that. How does it affect your earnings and profit, which is your dividend paying capacity? It's going to do what? It's going to reduce your dividend paying capacity. And here's what I'm going to do here, just kind of remind you, it's a negative. So make sure on the exam, I'm adding this to remind you, if it says in the instruction of the simulation, put it as negative, make sure you put it as negative. Let's take a look at the next transaction. Makers depreciation of $90,000, alternative depreciation rate is $100,000. So for makers, which one is, how does it affect taxable income? If a taxes is makers, if a taxes is a maker taxes, does it affect your taxable income? Yes, we use makers for taxable income. How much is the deduction? $90,000 for makers. Now, what about the adjustment for earnings and profit? Because we should have used for alternative depreciation rate, we should have used $100,000 of depreciation. What type of adjustment we need to make for earnings and profit? Do you know? And the answer is deduct an additional $10,000. Why? Because you already deducted $90,000 to arrive to taxable income, but to arrive to earnings and profit deduct an additional $10,000. So that's why the adjustment is negative $10,000. So in total, because from taxable income you deducted $90,000, then you deduct an additional earnings and profit of $10,000, you came up with $100,000, end up deducting $100,000. As an extra first year bonus depreciation of $50,000 was claimed in the current year. How would that affect your taxable income? Is first year bonus depreciation allowed? And the answer is yes. How is that going to affect your taxable income? It's going to reduce your taxable income by $50,000. Well how would that affect earnings and profit? What did we learn about extra first year bonus depreciation? Well that deduction is not allowed for earnings and profit. So after you get to your taxable income, to go to your earnings and profit, you are going to add back the $50,000, therefore as far as CEP, the effect of that is zero because you deducted it for taxable income, you added back for earnings and profit the effect is zero. Suction 179 deduction and mounting the $100,000 was claimed in the current year. So for tax purposes you took a $100,000 section 179 deduction. How would that affect your taxable income? It's going to reduce your taxable income by exactly $100,000. So that's the in the current year and that's the first year of this deduction. How much of this deduction should be taking on EMP? So can you take the full $100,000? Is it suspended like the first year depreciation, the first year extra bonus depreciation? And the answer is no. It is allowed, however you have to take the deduction over five years. So in the first year when you took the deduction, you have to say okay I have to spread this over five years. If I have to spread this over five years, I can only take a deduction of $20,000. If I can only take a deduction of $20,000 in the year I took the $100,000, I have to add back $80,000 of EMP. As a result for EMP I technically took only negative $20,000. Now impact of the current year, section 179 and succeeding years on the next five years or the next following year, we're assuming it's five years because I divided it by five. What's going to happen in year two for this section 179? How would that affect your taxable income? No effect on your taxable income. So we're discussing this section 179. Why? Because the full $100,000 was taken in year one. I took the $100,000, I can no longer deduct this. What do I have to do now for EMP? Now I'm going to start to deduct those $20,000 and that's going to happen for the next, you know, this was year one, which is I added 80 but as a result the net effect was negative 20 and year two, I deduct negative 20, year three, negative 20, so on and so forth. Over the next five years I can't take the full deduction. Dividend amounting the $30,000 were received from a corporation with a 5% ownership stake along with the dividend to receive deduction and we're going to assume taxable income limit is not applicable. In other words, we can take the dividend to receive deduction. So if you received $30,000 of dividend and you own 5% in that company, what's going to happen is this, you're going to report the dividend, then you're going to have a dividend receive deduction of 50% of the dividend. What can you do for the taxable income? What can you do? You are going to add back $15,000 to your taxable income. In other words, it's going to the net effect on taxable income. You're going to add 30, then you're going to have a deduction of 15 of the dividend receive deduction at 30 minus 15. The net effect on taxable income is 15,000. How about earnings and profit? Well remember here, let me put this in a different color, you made a deduction of 15,000 here that's called dividend receive deduction. Well this dividend receive deduction is basically a phantom deduction. It reduced your taxable income by 15,000 which you wanted it, but did it really, did you pay for it? And the answer you did not pay for this dividend receive deduction, this was given. Therefore for earnings and profit, you add back this 15,000. So as far as earnings and profit, the total is, the total dividend is 30,000 and it should be accounted for 15,000 came from taxable income, then you add back the 15,000 that you took as a deduction and all in all for EMP, you have, you received 30,000 of dividend and that's part of your dividend paying capacity. Let's take a look at this example. The equipment was sold to unrelated party for 360 with a basis of 240. You didn't opt out of the installment method and no payment were received in the current year. Well, in other words, you sold an asset and you are using the installment method and no payment was received in the current year. Well, if no payments are received and you did not opt out of the installment method, as far as taxable income, there is no taxes, no impact on taxable income because under the installment method, you only get taxed when the money is received. You did not receive any money. How about for earnings and profit? What did we learn about the installment method? Well, regardless, whether you received a payment or not, you have to include the profit and EMP for that year. And what's the profit? 360 minus 240 amount realized minus the basis will add 120 on earnings and profit. So, this is a CPA exam simulation. It's a great exercise that illustrated and I would not be surprised if you see something like this on the exam. You have to be very, very careful and in order to analyze each transaction separately and don't forget whether it's a deduction to put the pluses or the minuses follow the instruction. You have to understand how each item affect taxable income and earnings and profit. I'm going to have a summary, one session summary of all these adjustments, but you cannot memorize those adjustments. It will be too much to memorize. Understand them. Understand them. And once you understand them, that's going to help you in future chapters as well. You know, schedule M1. How does it affect taxes? How does it affect books? You have to understand how a transaction affect your taxable income. How does it affect your earnings and profit, which is your dividend-paying capacity? Same thing, you have to understand how certain items affect your taxes and how the same item affect your books and do the reconciliation between them. My job is to help you understand this concept inside out. What should you do now to understand it further? Go to Fahab Lectures, look at additional MCQs, true-false questions, additional exercises to test your knowledge. Good luck, study hard, and of course, stay safe.