 Hello and welcome to the session. This is Professor Farhad in which you would look at a CPA simulation that deals with deferred income taxes, income tax expense and income taxes payable. This topic is covered on the CPA exam as well as an intermediate accounting and give students a lot of problems on the exam. So I will try to simplify to explain this concept for you in details. But before I start, I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1900 plus accounting, auditing, tax finance, as well as Excel tutorials. If you like my lectures, please click on the like button. If they benefit you, it means my lectures might benefit other people. Please share the wealth. On my website, farhadlectures.com, I help accounting students as well as CPA candidate pass the CPA exam. I do not replace your backer, your Roger, Wiley or Glam. I can do that. I wish I can do that. I can do that. All what I can do is I can help explain the material little bit more in details and slower than the other courses. Not I am better than the other courses. I do things differently. CPA courses, they don't expect to teach you because they assume you learn it in college and they're reviewing it with you. I teach you the material. So please check out my website, farhadlectures.com, if you are studying for your CPA exam, or if you are taking accounting courses and if you'd like to supplement your accounting education. So let's take a look at this problem. I'm going to break it down for you piece by piece and go over this. Now, this problem, although it's going to be work as a simulation, based on this problem, I can ask maybe 15 to 20 different multiple choice questions. So understanding what you are being asked is important. Okay, don't assume this is what they are asking for. Just look at the information very closely, read the problem very closely. So let's take a look at this problem and a simulation you basically have to understand the full picture. And that's why I like the simulation. I think the simulations are easier than the multiple choice, because if you really understand what is the simulation asking you, you can get the whole simulation correct. It means sometimes it's one simulation for the whole Tesla and you can get it right. Okay, so let's take a look at this. Adam consulting sometime perform services for which it for which it receives payment at the conclusion of the engagement up to six month after services commence. That's fine. Adam recognizes service revenue for financial reporting purposes when the services are performed. Pretty straightforward for gap. Once the services are performed, we recognize the revenue. For tax purposes revenue is revenue is reported when the fees are collected for tax purposes. When do we recognize revenue when the fees are collected so we have gap. And we have the IRS and here we are dealing with revenue. When is revenue recognized here revenue when performed when we perform the service. We recognize the revenue. When do we recognize the revenue under the IRS when we receive the cash. Okay, so those are the timing service revenue collection and pre tax accounting income from 2020 to 2023 RS follows they're given us for consecutive years and the reason I made it for years is for you to see the the additional years to see what happened the following year and the following year and the following year, but I'm going to be dealing only with one the third tax. I don't want to make it so complicated here. I just want to make sure you understand the concept. Starting with 2020 we have service revenue collection and pre tax accounting income. We have that for 2020 2021 2022 2023. Here is here's the service revenue. And when we say the service revenue it means how much revenue did we recognize earn as far as gap. So this is basically, if you want to think of it this is the gap revenue collection is how much cash you receive think of it as tax. This is the tax. This is the taxable income in a sense that what we collected this tax. And here they're given us the pre tax accounting income for the whole company. Assume no differences between accounting income and taxable income other than the temporary differences described above and simply put the temporary difference described above deals with account receivable because when we're dealing with revenue on the balance sheet is account receivable. So we're looking at one difference and that's account receivable also assume the tax rate is 25%. I'm just going to assume that that we're going to be changing the tax rate at 25% for the all the years. Prepare the journal entries to record income tax expense income taxes payable and the third component for the years 2021 22 and 23. It's pretty comprehensive exercise and hopefully we can take care of it. Now when you are faced with a problem like this. First, you have to understand how you want to approach it. I want to approach this problem from the account receivable perspective because that's the most reasonable, not the most reasonable, the most logical way. This is your temporary difference, which is a count receivable. I should have hid this. I'm going to hide this. Okay. I should have but I did not. So the temporary difference is a count receivable. So here's what happened in 2020 we sold 732,000 worth of merchandise. We debit account receivable 732 we credit sales. I don't care about sales. I'm not showing you sales. So this is the 732. I'm showing you the journal entries. Then we collected 692,000. We debit cash credit account receivable. This is for 2020 2020 ended the balance of 2020 the account receivable balance is 40 40,000 not $40 40,000. Are we all okay with this? I'm going to keep going. I'm going to show you the full picture. You don't have to go through it. I'm just going to go through it to show you how you would approach this problem. If it's on the CPA exam, they might give you some maybe they'll give you one big simulation like this. They may not give you four years. They may give you two or three years, but I'm going to go through four years. 2021 revenue is 822. We debit account receivable credit sales. We received $850,000 in cash. We debit cash credit account receivable. Now the account receivable balance is 12,000. Notice the balance which is in blue went from 40,000 to 12,000. 2022. We sold 782,000 debit account receivable credit sales. We collected 774,000 debit cash credit account receivable. The new balance is 20,000. Our balance went up from 12 to 20,000. In 2023, we sold 788,000 debit account receivable credit sales. We received 792,000 debit cash credit account receivable and our balance and account receivable went from 20 to 16 went down. That's fine. So this is the overall picture. So notice the temporary differences account receivable started at 40 went down went up then went down. Well, why? All depends on how much we are selling and how much we are collecting money. Now. When you are faced with an account receivable, when you have a balance of account receivable, you need to understand, you need to understand, comprehend, comprehend, you need to understand what does that mean from a deferred income tax perspective. Okay, let's look here now ignore everything here. And let's look at the 40,000 because we're starting with 2020. So this is 2020. When you have an account receivable of $40,000, what does that mean? Well, it's the result of those two numbers. You sold 732,000. And you received 692,000 in cash. In other words, you are still waiting to be paid $40,000 and that's reflective in your account receivable. What does that mean? It means in the future in future years, year 21, year 22, year 23, you are expected to receive cash of $40,000. Well, think about it. If in the future, you're going to be receiving cash that you're going to consider revenue for tax purposes. What does that mean? It means in the future, you're going to have a deferred tax liability. I should have hit this. Now we are dealing with the deferred tax liability problem. Okay, so our account receivable is the account that's the difference and it's a temporary difference. And as a result of the $40,000, we are starting with the deferred tax liability. Okay, hopefully this makes sense. Okay, so immediately what I can do is I know I'm going to have a balance here year one, but we're going to find out how much is the balance. Now we're going to start to prepare the journal entry for the year 2020. How do we start the journal entry? Listen to me and listen to me carefully. The first thing you compute is your tax bill. The first thing you compute is your tax bill. How much are you going to send money to the IRS? How much are you going to send money? How do you know how much you're sending money? Here's how you would know. Your pre-tax accounting income, $258,000. This is your gap. This is your gap income because it says accounting income. $258,000. However, including in this $258,000, $40,000 that you did not collect in cash. Why? Because I sold more than what I received. That means I have $40,000 in cash I did not receive. So simply put, you are going to start with $258,000. That's your gap income. Then for tax purposes, you're going to take out of it $40,000 cash that you did not receive. Why? Because you still have it in receivable. Therefore, as far as the IRS, you have 218,218,000 in taxable IRS income. Well, you're going to pay, we're going to say we're going to pay 25%. Well, if we take 218 times 25%, the answer is $54,500. And that's your tax bill. Once you know that's your tax bill, you credit income taxes payable, $54,500. I'm starting with the journal entry, $54,500. You're done with this. So this is no joke. This is step one. This is the first thing you determine is your tax bill. What's the check that you will need to send to the IRS? The next component is your deferred tax. Do you have a deferred tax? I sure do. We already determined it's a deferred tax liability. What does that mean? It means in the future, I have $40,000, $40,000, then I'm going to be responsible for paying taxes on and we said the rate is 25%. And that's easy. That's equal to $10,000. Simply put, I'm going to have a deferred tax liability of $10,000. Therefore, I credit deferred tax liability, $10,000. And I'm pretty much done. I don't have anything else to worry about. Sometimes you might have a deferred tax asset to worry about. But in this problem, I'm giving you one temporary difference. And I will expect on the exam to give you one temporary difference. If you have more than one, I do have examples on my website for that, but I expect that you will receive one temporary difference, at least in the simulation. Now, we have two credits. What's the debit? The debit is a plug. So the income tax expense is a plug. And what's that plug? Well, we have to pay $54,500 this year and we have to pay $10,000 in the future. Our total income tax expense is $64,500. Okay, so the income tax expense is basically a plug. Part of it is your current tax and part of it is your deferred tax. So of this $64,500, this is your current and this is your deferred. So your income tax expense is composed of two components. A current component, the one that you pay now and the one that you're going to pay in the future. Okay, sometimes it's going to be what you're going to pay now plus the savings. You might have a deferred tax asset or your liability could go down. But here you have both something to pay now and something to expect to pay into the future. Okay, so this is what we did for year one. We're basically done with year one. So I'm going to erase year one to start with year two. So we're done with year one. Now let's start with year two. So basically my deferred tax liability balance is $10,000 because I don't have any prior balance. Year two, well, I already did the account receivable. I deputed account receivable, then credit account receivable, my account receivable went down. It means that year I collected more cash than what I sold on account. And clearly it shows here that notice you recorded 822 in service revenue, but you collected 850,000 in cash. You collected more cash than your revenue. What do we do first? We compute our tax bill. How do we compute our tax bill? We are giving pre-tax accounting income. Of 332,000. This is gap income. But guess what? This year we received more cash. This year we received more cash than what we sold. We received more cash than we sold. Look, you can clearly see it here. The difference between what I received in cash and what I sold. So what I'm going to do now, I'm going to be adding the cash. And the difference is 28,000. I'm going to be adding the cash to my taxable income because I received cash. Now I'm going to start to pay taxes on that. Now 332 plus 28 will give us taxable income of 360 for the IRS. Again, I'm going to multiply this by 25%. And as a result, I'm responsible for $90,000. This is the check that I'm going to have to write. I'm going to credit income taxes payable $90,000. Now what happened to my deferred tax liability? Well, my account receivable went down. It means the deferred taxes that I set up earlier, now it's coming to do. I am getting the cash and I'm paying the taxes. Therefore, I'm going to start to reduce my deferred tax liability because my account receivable went down from the prior year. Now what is my balance? What is my balance in my account receivable? My balance is only 12,000. How do I know it's 12,000? Look, it went from 40 to 12. It went down 28,000. It means of the 40,000 of the third tax liability component, I already realized 28,000. What does that mean? It means I'm going to take 28,000 times 0.25 and that's going to give me $7,000. The $7,000 is a reduction in my deferred tax liability. So now I debit the third tax liability and now my balance is $3,000 in my deferred tax liability. Now I debited the third tax liability, $7,000. Now what is the plug? Now what is the income tax expense? I'm going to have to pay, in check, $90,000. Of this $90,000, I have a reduction of $7,000 in my deferred tax liability. Therefore my income tax expense is only $83,000. It's only $83,000. So my income tax expense, notice the expense is $83,000. But I am writing a check for $90,000. Why am I doing so? Because simply put, for this year I'm responsible for $83,000. And I paid, so this is, of this $90,000, you can think of $83,000 is current, paying my current taxes. And I had a reduction, I have to pay $7,000 for past taxes. For past, yes, for past liability, for past liability, which is the third tax liability. Okay. So this is what I did this year. And this is the entry. And now my balance in the third tax liability is $3,000. Well, that's good. Let's move to year three. Again, let's erase everything and start with year three. We have the balances. Again, starting with account receivable. We already analyzed account receivable $782, received cash of $774,000. The balance is $20,000. What happened between year 21 and year 22? I sold more than I received cash. How did I know this? Look, my account receivable went up by $8,000, went up by $8,000. So overall, I sold more than what I received in cash. And notice you can see it here. I sold $782,000. I received $774,000. Well, you can clearly see it. Let's compute my tax bill. What's my tax bill? It seems my gap income is $300,000. And since I received less cash, how did I know I received less cash? Well, my account receivable went up. How much did it go up by? $8,000. Therefore, it means I did not receive those $8,000 in cash. Therefore, my... I'm going to have to pay a tax bill on $308,000. I'm sorry, not $8,000. $292,000. $292,000. Let me get my calculator here just to make sure I'm doing this right. $292,000 times .25. Okay, I'm responsible for sending the IRS $73,000. That's the first entry you do. You credit. The income tax is payable $73,000. Now what happened to my deferred tax liability? I hope you know my deferred tax liability. It's going to go up. My deferred tax liability will go up. By how much will it go up? It will go up by the amount of the difference in the receivable times 25%. Times 25%. Well, what does that mean? It means, let's see, I went from 12 to... So it's $8,000. So I'm going to take $8,000. Times 25. Let me say $8,000. $8,000 times .25. And that's $2,000. It means my deferred tax liability, it's again, it's $8,000. Let me write it down here. So my deferred tax liability, it's going to be $8,000 times .25. It's going to go up by $2,000. Up means I'm going to credit. I'm going to credit this $2,000. Now my balance is $5,000. So I'm going to credit the third tax liability, $2,000. What is my income tax expense? $75,000. The addition of those two. It means I'm recording $75,000 of expenses of which I'm going to pay now $73,000. This is the current and this is the deferred. In 2000, I'm going to have to pay in the future when I receive my cash. Okay. Now, if I was in your shoes, you should stop now, pause the recording and see if you can get year four, which is year 22, 23. And if you can get it, it means you are on the right track. Okay. Let's look at year four. Year four, the difference, well, let's see, $788 in sales on account and $792 is what I received in cash. So notice my receivable went down by $4,000. But before we do that, let's compute how much do I send the bill to the IRS. My gap taxable income is $272,000, but I received $4,000 more in cash because my account receivable went down. It becomes taxable times plus $4,000. So my IRS taxable income is $276,000 times .25. And $276 times .25, it's going to give me $69,000. I'm going to have to write a check for $69,000. Therefore, I credit income taxes payable $69,000. What's going to happen to my deferred tax liability? It's going to go down. Why? Because my account receivable went down. I'm receiving the money. I'm paying the cash. $4,000 went down by $4,000 times .25 equal to $1,000. So my deferred tax liability will go down by $1,000. And what's my income tax expense? It's the difference here. It's 69 minus 1 is $68,000. It means I am on my income statement gap. I am showing $68,000 of expense of which I'm paying $69,000. Why? Well, because I have to pay $68,000 this year, so of this $69,000. $68,000 for this year and $1,000 I'm paying for revenue I earned in the past, but I'm receiving the cash for now. This is why my deferred tax liability went down. Therefore, let me do this. So I'm going to debit the deferred tax liability. And my final balance is $4,000. In other words, I'm still responsible for $4,000 in the future for the pay taxes for past revenue that I expect to receive in the future. So this is basically how you would approach an income tax expense problem. Now, if this is challenging or if you need more explanation, this is what I'm going to invite you to go to farhatlectures.com. On farhatlectures.com you will find additional lectures, resources, multiple choice, true, false, exercises that's going to help you understand and learn this concept. So when you go to your CPA exam and when they start to throw those acronyms on you, you're like, okay, now those acronyms make sense. Great. So don't forget to visit my website. Subscribe. Your investment in your CPA is a lifetime investment. It's 20 to 30, if not 40 years. We are living longer and longer. It's going to pay you different. Don't shortchange yourself. My subscription is practically minimal. 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