 Oh, and welcome to the session. This is Professor Farhad, and this session we would look at an introduction to the third tax asset and the third tax liability. This topic gives students a lot of problems, especially in intermediate accounting or on the CPA exam. I'm here to help you. I'm gonna demystify this topic. This is an introductory topic, so please make sure to take notes and you should be good to go. Before we start, just wanna remind you that if you haven't connected with me, connected with me only then please do so. YouTube is where you would need to subscribe. I have 1,500 plus accounting, auditing, finance, and accounting lectures. Here are a list of all the courses that I cover. I have a Facebook page as well as an Instagram page. You can follow me there. Also on my website, farhadlectures.com, I do have additional resources. In addition to the lectures, you'll have access to the notes, PowerPoint slides, additional practices, multiple choice questions. And if you're studying for your CPA exam, you'll have 2,000 plus CPA questions. So in this session, what we're gonna go over is accounting fundamentals for accounting for income taxes. This topic is quite challenging for a lot of students. So the strategy is to listen to the lecture, listen to the lecture. Then after the lecture, you're gonna have to work multiple choice questions. Make sure to work the multiple choice questions because without working the multiple choice questions, it's not gonna be very helpful for you because you need to practice what you have learned. If you don't practice what you have learned and to a degree, it's useless because you really don't know if you really understood something unless you practice. So please practice, make sure to practice after the lecture. So what is the big idea here? And it's a big idea. The big idea is this. Corporation must file an income tax return. And here we are talking about 1120. So let's talk about form 1120. Let's assume we are looking at a corporation and what they do every year, they form their 1120. And what do they follow when they form the 1120? They follow the IRS rules. Now that's on one hand. On the other hand, they have to prepare their financial statements. So companies, they have to prepare their financial statements. And when they prepare their financial statements, their financial statements are prepared for external users. Therefore they have to use generally accepted accounting principles. So they do use different rules for preparing their financial statements. And because there are differences between GAP and IRS, if they were the same, we wouldn't be doing this chapter now. If both IRS and GAP had the same rules, then there's no reason for the third income taxes and the third tax liability. But since they differ, we have to account for the difference in terms of the third tax asset or the third tax liability. So here we go. In this session, I'm gonna be referring to something called income tax expense. Every time I say income tax expense, it means that's the GAP or the financial statement expense. So if I say financial statement income tax, it means GAP. If I say GAP, it means tax expense. If I say tax expense, it means GAP. And this is how they are used in the real world as well as the on the CPA exam. The same thing apply when I say income taxes payable. Income taxes payable, it means you have to pay it to the IRS. It means that's the IRS. So when I say this is income taxes payable, this is how you compute income taxes payable or this is how you compute your taxes for IRS, it means I'm referring to income taxes payable. So make sure you write this down right now. Okay, if you're not writing it down, write it down because it's gonna become very handy as we go through this. And this is a picture of what I just said. Hopefully it will make more sense to you. We have investors and creditors, they follow GAP, okay? So what they do is they compute something called financial income, pre-tax financial income. Again, pre-tax financial income is a GAP terminology. Then pre-tax financial income will give them their income tax expense. Remember income tax expense is GAP. Now for tax purposes, we're gonna have the term as taxable income. So notice here, financial income or pre-tax financial income or income before taxes versus taxable income. The IRS for tax purposes, we use taxable income. Then we compute our taxes, then we come up with income taxes payable. Notice there are differences between how we do things, differences in terminology and differences in actual computation. So notice this is tax and this is financial statement. The reason we prepare financial statements is for external users and the Securities and Exchange Commission. The reason we compute our taxes is to pay our taxes to Uncle Sam following the IRS. There are differences between the two. Now to illustrate these concepts, the best way is to work an example and go through it step by step. So let's start with this example. We have Chelsea reported revenue of 130,000, expenses of 60,000 in each of the first three years of operation. Notice for tax purposes, Chelsea reported the same expenses. So notice as far as tax is concerned, the expenses of 60,000 are the same. So we don't have to worry about the expenses, just keep in the example simple. Chelsea reported taxable revenue. Notice taxable revenue, it means for IRS purposes of 100,000 in 2020. So if we're looking at 2020, they reported revenue of 100,000. For 2021, they reported revenue of 150. And for 2022, they reported revenue of 140. And this is for tax purposes. This is how they reported the revenue for tax purposes. Okay, what is the effect on the account of reporting different amount of revenue for gap versus taxes? So let's take a look at how they reported it for gap as well so we can compare the information side by side. Now remember, expenses will be the same. So if you're wondering why expenses are the same for both is because we say expenses are both as far as gap and as far as IRS. So we don't have to worry about the expenses. We have to focus on the revenue. And the reason we do it this way is to illustrate the point, to illustrate the point initially that you understand. You need to have a fundamental understanding of the third tax asset and the third tax liability in order to understand it. Da, yes, you need to understand something in order to understand it. And that's the purpose. So notice, let's go through the IRS again. For tax purposes, they reported 100,000 revenue for tax purposes. For gap purposes, they reported 130,000. Simply put, if you're looking at this, what does that mean for you? Let's just simplify it. What does that mean? It means for gap, they reported more revenue. How much more revenue? 30,000 more revenue. Remember, just to kind of tell you why would that happen? Just kind of, it's also, it's very, very important to understand why would this happen. Remember, for gap purposes, we use accrual. So we book revenue before we receive it in cash. Maybe for tax purposes, we are using cash method. So for tax purposes, we are using the cash method. Therefore, we only report 100,000. For gap purposes, we are using accrual. Now, to be more specific, let me show you the journal entry. This way you can have also, I want you to see this clearly before you proceed. For gap, here's what's gonna happen for gap. For gap, let me show you the journal entry side by side. For gap, they reported revenue. So they credit revenue of 130,000. They debited cash for 100,000 and they debited account receivable for 30,000. So this could be, this is good of what happened. So they end up with revenue of 130,000. For tax purposes, they only reported the cash. So they debited cash 100,000, they credited revenue 100,000 and this is what happened for tax purposes and this is what happened for financial statement purposes. Okay, so I just want to make sure you understand this. So what happened as a result of this, what happened as a result of this, your pre-tax financial income or gap taxable, gap financial income, pre-tax financial income is 70,000 and there's a 20% tax rate, 70,000 times 20%, your income tax is 40,000. Now, although I did this, I showed you this is how it gets done but this is gonna change. This is a very simple illustration. So this is not how you compute your income tax. Again, not how you compute your income tax. So what I just did is incorrect. The reason I just wanna explain those numbers here while you are seeing these numbers but this is not how we compute income tax. Let me show you how we compute tax for tax purposes. So for tax purposes, we have revenue of 100,000, expenses of 60,000, taxable income is 40. Taxable income times 40% will give us an income tax expense of 8,000. This is how you compute your income tax expense. Your income tax expense, if you want to write it down, please go ahead. It's very important that you write it down. So you take your taxable income. I know you're gonna say this is easy but write it down. Taxable income times the rate. Whatever that rate is happens to be. This is how you compute your income taxes for tax purposes. Not the same for gap purposes, okay? But let's do year 21, 22, just to show you what happened overall, then we'd look at the deferred income tax asset and deferred income tax liability. In 2021, gap had 130,000 of income. Now in 2021 for tax purposes, we received more revenue. Notice in 2021, we have more revenue for tax purposes. It means the client paid us more in cash and less for gap. So as a result, our taxable income is 90,000 and our taxes are 18,000. For 2022, for gap, it's 130,000, our revenue for tax purposes 140,000. Again, as a result, we have minus 60,000 in taxes. Our taxable income is 80,000 and our taxes are 16,000. So the 8,000 here, the 18,000 here and the 16,000 here, this is what we actually send to the IRS. This is the money. This is the check that we send to the IRS. This is what we are responsible for. This is what we are responsible for. So basically, when we say income tax expense, this is also income taxes payable. So the 8,000, the 18,000 and the 16,000 are income taxes payable. Now let me show you the total over a period of three years. So this is the total. And there's an error on this slide. Revenue 130 plus 130 plus 130 equal to 390,000. This is the error. Expenses over three years equal to 180. Notice for tax purposes, revenue over three years is 390. Revenue expenses over three years is 180. What does that mean? It means over a period of three years, revenues and expenses are the same. They differ from year to year, but in total they are the same. In total, your pre-tax financial income is 210. Your taxable income is 210. Your income tax expense is 42,000. And your income tax expense for IRS purposes, 42,000. So for a period of three years, they are the same. What does that mean? It means those changes reverse. So those, what we call those, we're gonna learn the term later. Those are temporary differences. It means differences that they are different from year to year, but overall over the long period, they reverse and they equal to each other, okay? Hopefully you see the big picture. Now let's see the difference between the income tax for GAAP and the income tax for the IRS. Again, the way we computed GAAP is not accurate, but this is, it will help us just to kind of, it will help us just to, for now, it will help us for now. For 2020, GAAP income tax was 14,000. Income tax is payable, which as I said, income tax expense for IRS, we call it income tax is payable, 8,000. So notice, in 2020, we paid less to the IRS. We paid less. Think of it this way. In 2020, we paid $6,000 less than our GAAP income because this is what we actually have to pay, okay? Are there any differences accounted for financial statement? Yes, there are differences between the two, right? Because for, if we paid less taxes in 2020, and overall I told you, overall, over a period of three years, they're gonna be the same. So what happened in 2020, because I paid less taxes, it means in the future, I have to pay more taxes. Does that make sense? If they are this, if over a period of three years, and I already showed you this, that GAAP and IRS are the same. And I paid less this year in taxes. Well, guess what? This less of taxes this year will catch up for me in future years, okay? Now, what does that mean from the third tax asset and the third tax liability? It means for 2020, I have to report at the third tax liability by $6,000. Let me explain this for you. What does that mean is this? It means in 2020, I computed my taxes and I find out I'm paying $6,000 less to the IRS than my GAAP income tax. Well, guess what? That difference eventually will catch up with me. So for me to show that difference to the investors, so tell the investors and the users, look, I paid less taxes to the IRS this year, but look, I'm gonna have to pay an additional $6,000 in IRS payment more in future years. And to show them this, I have to book a third tax liability. Therefore, a third tax liability is born. Just a third tax liability is born because I'm responsible for more taxes. Again, how did I know I'm responsible for more taxes? Well, I looked at my 2020. I paid the IRS $6,000 less than what my GAAP income tax is. And I know that difference would reverse. It means in the future, I'm responsible for $6,000. It means the third tax liability is born of $6,000. Which reverse in the future? When is it going to reverse? It's gonna reverse in 2021 and 2022. Let's see what happened in 2021. In 2021, my income tax expense for GAAP is $14,000. My income tax expense for the IRS is $18,000. Notice I wrote a check. This is the check. The $18,000 is the check. I wrote to the IRS an $18,000 check, but for GAAP purposes, I only booked. I only reported $14,000 in income tax expense. What does that mean? It means that $6,000, that I said it's gonna be the third tax liability, it's catching up with me. Now, since I paid more to the IRS, I'm going to reduce. I'm going to bring down that liability by $4,000. Okay? I'm gonna have the third tax liability reduction reduced by $4,000. Now, what's happening is my liability is reversing. My liability is reversing. My third tax liability is reversing. In 2022, my GAAP taxes are $14,000. My IRS taxes are $16,000. It means I paid more for the IRS. Exactly how much more? $2,000 more. Well, guess what? You remember that $6,000? 4,000 of it was reversed in 2021. The remainder, the $2,000 remainder will be reversed in 2022. Well, from a T-account perspective, if you really, if you wanna see it from a T-account perspective, this is the third tax liability. And I'm gonna show you the journal entry in a moment. So I have $6,000. This is year 2020. Basically, by putting $6,000 as the third tax liability, I'm telling the investors, look, I'm responsible for more taxes in the future, which indeed in 2021, 4,000 of it reversed and in 2022, 2,000 of it reversed, the whole thing is reversed. So notice over a period of three years, everything equal over a period of three years. So all what I'm doing is I'm accounting for the difference between my income tax expense for financial statement purposes and my income taxes payable for IRS purposes. Now let me show you how things are reported on the financial statements. And this is where, this is, and I'm gonna tell you how to compute income tax expense. So, so maybe I should show you the journal entry first. So let me show you the journal entry for 2021. I'm gonna show you the journal entry for 2021. So I'm gonna erase everything and show you the journal entry. So here's, so this is the first journal entry and this is important that you understand this journal entry. It's gonna help you understand future journal entries. You always start with the easy one. The easiest is income taxes payable. Income taxes payable. Why do I say it's the easiest? Because it's the easiest. Income taxes payable is the easiest. Because it's your taxable income times the rate. So it happens to be 8,000. So I would credit, sorry, I would credit income taxes payable. Income taxes payable, $8,000. I'm done with this. Then notice my deferred tax liability went up by 6,000. Well, I have to book a deferred tax liability. I have to credit a deferred tax liability of how much of 6,000. Hold on a second, where did that 6,000 came from? It's the difference between what I paid to the IRS and what I booked on the income tax return. Now I'm missing a debit. Those are both credit because they are both liabilities and they're both going up. The debit is income tax expense. And what's my income tax expense? Think of income tax expense as a plug. Hold on a second, did you just say a plug? Yes, think of it as a plug. It's the deferred tax plus current tax. So this income tax is payable. This is what I'm gonna be paying currently. So we call this current tax. This is my current bill right now. The $8,000 is my current tax bill. The deferred tax liability is my deferred tax. So income tax expense equal to what I paid now and what I'm gonna have to pay in the future. Therefore, six plus eight equal to 14,000. And this is the journal entry, write it down so I can, I will show it to you on the, how everything is reported on the financial statement. Okay, so this is the journal entry. I'll show it to you later, a little bit further later down the road. So here's how things are reported on the income statement. Once again, I compute my income taxes payable first. Then I compute my deferred taxes. The third taxes, liability plus income taxes payable will give me my income tax expense. My income tax expense is my gap. And this is my IRS. 8,000 is my IRS number. Okay, and the 6,000 is the difference. Where does the deferred tax liability gets reported on financial statements? It's a liability. It's a liability. Okay, now let's talk more about future taxable and deferred amount. So let's talk about something called temporary difference. So what is a temporary difference? A temporary difference, and this is, we looked at it, but now we're gonna define it, is the difference between the tax basis of an asset or a liability and it's reported carrying value amount and the financial statements that would result in a taxable amount and that would result in a taxable amount or a deductible amount. Well, what does it mean? It's gonna result in a future taxable amount. Well, I just showed you, it's gonna result in a deferred tax liability. Let me go back and show you what I mean by the, between the tax basis of an asset and the tax basis of a liability and it's reported carrying value. Remember for gap, when I booked the entry, I said for the first year, my revenue was 130,000. I debited account receivable of 30,000. I debited cash of 100,000. Then for IRS purposes, I said I only have cash and revenue of 100,000. If you remember that entry, this is the tax entry. Now, what is the difference between these two? The difference is the account receivable. The account receivable is an asset. So I don't have the asset for tax purposes. So I have a basis. I have a carrying value of an asset of 30,000 that's going to do what? That's going to reverse down the road. That's going to reverse down the road. Now, if you think about it, if I take $30,000, okay, and it's gonna reverse down the road. Reverse means what? Reverse means it's gonna go to the tax purposes. It's gonna consider revenue to tax purposes. So as it's considered revenue, I'm gonna have to pay taxes on it. So what does that mean? It means I'm gonna take $30,000 multiplied by some tax rate that's gonna reverse at, and it gave me $6,000. It gave me $6,000. So simply put, that book basis, the $30,000, it's gonna reverse down the road. It's gonna reverse down the road. And remember, the tax rate is 20%. Okay, so that $30,000 eventually will turn into actual taxes. And when it turn into actual taxes, I have more taxes of $6,000. It means this is a temporary difference. So let's look at the temporary difference of a liability. Okay, so the definition to be for a liability will be something like this. A temporary difference is the difference between the tax basis of an asset or a liability and it's reported book value in the amount of the financial statement that would result in a taxable amount. Stop right there. Stop right there. This is the definition of a deferred tax liability. It's a temporary difference that's gonna give me more taxes in the future. Now, let me give you the deferred taxed asset definition, which as we did not see an example, we'll see shortly. A temporary difference is the difference between the tax basis of an asset or a liability and it's reported carrying or book value in the financial statement that would result in a deductible amount in the future. So the deferred taxed asset, this is the deferred taxed asset, it's what I'm gonna happen in the future. I'm gonna have more deduction. And what would deduction give me? Duction will give me lower taxes and lower taxes will give me more assets. So this is the definition for the third tax liability, represent an increase in taxes in future years as a result of a taxable temporary difference existing at the end of the current year. And this is the example that we worked. So what happened is in the future, I'm responsible for more taxes. Why? Because whatever I deferred now, it's gonna catch up with me. Therefore, I'm responsible for more taxes. Future deductible amount, which we did not look at this, it's a deferred taxed asset, represent the increase in tax refundable or saved. So I'm gonna either have, I'm gonna either have a refund, or I'm gonna save more taxes in future years as a result of a deductible temporary difference existing at the end of the current year. When I have a deferred taxed asset, which will work an example to illustrate it, in the future years, when it reverse, it's gonna give me more savings. It's gonna give me either more savings or it's gonna give me more refund as a result. I book a deferred tax asset, a deferred tax asset. Let's take a look at this. So in Chelsea, a situation, the only difference between the book basis and the tax basis of the asset and liability related to the account receivable that arose from the revenue recognized for book purposes. So I showed you poor books. I have a $30,000 of receivable for tax purposes. I don't have any. And I showed you this when I did the journal entry. Now this $30,000 in 2020, it would reverse, some of it reverse in 2021, some of it reverse in 2021, 20,000 reverse in 2021 and 10,000 reverse in 2022. So guess what? Basically it over the period of two years, taxable amount was higher in those years as a result, the liability reversed, okay? Chelsea assume it will collect the account receivable and report the $30,000 collected as taxable revenue in the future tax return, okay? And by doing so, she would start to deferred, that she would start to reduce her tax liability or the third tax liability, okay? So once again, the first tax liability represent the increase in taxes payable in future years as a result of a temporary difference existing at the end of the current year because of a temporary difference that's happening now and that temporary difference would reverse in the future. When it reverse, I'm responsible for more taxes. I have a deferred tax liability, okay? Because it's the first year of operation, there's no deferred tax liability at the beginning of the year. So we're keeping this example simple because there's no prior deferred tax liability but we're gonna have to deal with prior deferred tax liability but it's very important to understand the idea, okay? Again, this is a picture of what we just did and this is the journal entry as I told you, income tax expense is the current, this is income taxes payable, this is current taxes plus deferred, so the both of those, current plus deferred equal to income tax expense. So this is the journal entry for 2020. Now, can you do the journal entry for 2021? Can you do the journal entry for 2021? All right, let me do the journal entry for 2021 for you. Again, how do you start? How do I start? Easy, simple. I start with income taxes payable. My income taxes payable is 18,000, this is the amount I have to pay to the IRS. So I'm gonna credit income taxes payable 18,000. Okay, now, the difference is a reduction in deferred tax liability, so I'm gonna debit, I'm gonna abbreviate DTL, deferred tax liability, I'm gonna debit the third tax liability, $4,000. Hold on a second, didn't you tell me income tax expense is a plug? Yes, I told you it's a plug, what am I missing? I am missing income tax expense. So income tax expense for GAAP purposes, the difference between those two, I'm looking for a $14,000 debit and this is how you compute your income tax expense. So here, income tax expense equal to your current taxes minus the reduction in the deferred tax liability. Okay, let me show you the journal entry for you. So income taxes, 18,000, easy, this is what I pay the IRS. This is my current taxes. The third tax liability is a reduction. Since it's a reduction, it's gonna reduce my current taxes, okay? So 18 minus four, so it's basically 18 minus, I'm sorry, 18 minus four equal to 14,000, which is my income tax expense. This is my GAAP number, this is my GAAP number. That's, can you do 2022? 2022, what do I start with? Start with the IRS, 16,000 for the income taxes payable. Then that year, my deferred tax liability reduced by 2,000, my income tax expense is 14,000. Again, income tax expense is a plug. Again, these, hopefully you are following, but remember we're gonna be adding balances at the beginning of the year, which we'll deal with that shortly, okay? So this is the T account for the third tax liability. I created $6,000 over the third tax liability. In 2021, 4,000 of it is reversed. In 2022, 2,000 of it is reversed. Therefore, my balance by 2022 equal to zero, equal to zero. Let's take a look at the balance sheet and the income statement, balance sheet and the income statement. So here's what's gonna happen on the balance sheet and the income statement for 2020. I'm gonna have on the balance sheet, income tax expense payable, deferred tax liability. On the income statement, it's gonna be this plus this equal to 14,000. In 2021, I'm gonna have income tax payable of 18,000, deferred tax liability of only 2,000. Deferred tax liability only of 2,000. So notice what happened. There was a reduction of 4,000. So 18,000 minus the reduction equal to 14,000. Notice there was a reduction. 2022, my income tax payable is 16,000. My deferred liability went to zero. It means it went down by 2,000. So 16,000 minus the decrease equal to 14,000. Now you might be saying, why did you do this the decrease and 18,000 and you did 18,000 plus six? Well, 18,000 plus six because there was zero and it went from zero to 6,000. So I took 8,000 plus the increase of 6,000 and just in case to be consistent. This is how I come up with the 14,000 for 2020. For 2022, it's 18,000 minus the decrease. So it's 18,000, but my liability went down. So I reduce it from my liability. So I reduce it from my liability. So let me show you specifically how things will appear on the income statement. For example, for 2020, here's how you would, this is how you would show your income statement. On the income statement, income tax expense is composed of two components, current and deferred. The current portion is 8,000. The deferred portion is six, okay? And I had to pay in total 14,000. I had to pay in total 14,000. I have to pay in total 14,000. Okay, let's look at another example that deals with the third tax liability. So let's look at another example of the third tax liability to make sure we understand this. So South Carolina Corporation has one temporary difference at the end of 2020 that will reverse. It's a temporary difference and cause a taxable amount of 55,000 in 2021, 60,000 in 2022 and 75,000 in 2023. What does that mean? If I'm gonna, if I have a difference and that's gonna reverse and cause a taxable income in the future, it means I'm looking at a deferred tax liability, although it's here, but let's assume it's not here. Hopefully you understand, you're looking at a deferred tax liability. Starfield pre-tax financial income, translation, gap income for 2020 is 300,000 and the rate is 30% for all years. Now this is important because later on we're gonna be changing the rate. So make sure the rate is very important. There are no deferred taxes at the beginning of the year. So this is basically a simple example because there are no deferred taxes at the beginning of the year. Compute taxable income and income taxes payable for 2020. Well, let's start with taxable income. How do we compute our taxable income? How do we compute our taxable income? Okay, so for 2020, for 2020, are they giving us taxable income? They're not, but we have to compute taxable income. How do we compute taxable income? Gap income, they gave us gap income of 300,000 that was given to us. The gap income is 300,000 and they told us there is a difference, there is a difference of 55, 60 and 75. So in future years, 55 plus 60 plus 75 would reverse. What does that mean? It means this year, those are not taxable. It means to compute our taxable income we have to deduct those three amount, 55,000 plus 60,000 plus 75,000 and those three equal to 190,000. So I'm gonna deduct 190,000 and while I deduct this, those are the amount that are going to reverse. So they're not included in taxes this year. It means my taxable income equal to 110,000. Well, if my taxable income equal to 110,000, I'm responsible for paying 30% in taxes, 100,000 times 30% equal to 33,000. I just figured out my taxable income. I just figured out my taxable income. Okay, I just figured out my taxable income. Now, let me show you the, let me show it to you on the second slide because it's easier to show it to you but hopefully you understand this. So first I went, I did the first thing I did is my 2020, I said gap is 300,000, temporary differences of 190, which is the reversal. My IRS taxable income is 110 times 30%, gives me income taxes of 33,000. Therefore, what you do is you credit income taxes payable of 33,000 immediately. Then you would say in future years in 2021, I have more $55,000 more, I have $60,000 more in taxes and $75,000 more in taxes. From the year 2021, 55,000 times 30%, I'm gonna have more taxes of 16,500. From year 2022, I'm gonna have 18,000 more in taxes and from year 2023, I'm gonna have 22,500 more in taxes. So this plus this plus this is what I called the third tax liability in increase from zero to 57,000. So my third tax liability was zero and it increase to 57,500. So I credit the third tax liability, 57,000. Now 33,000 plus 57,000, those two together equal to the income tax which is a plug. This is how you compute your income tax. I know this is funny, but income tax expense for financial accounting purposes is a plug. It's the result of the current plus current and deferred. I'm not gonna say plus, sometimes we have to deduct, therefore current and deferred, sometimes we have to depending what the deferred is. So it's the current and the deferred. I'm not gonna say plus because you don't always add. Sometimes you have to deduct if there was any reduction in your deferred tax liability or when it comes to the deferred tax asset, it's the opposite. So we'll hold on that. So let's take a look at another example. Let's take a look at another example and see how this all fits together. So hopefully you are getting to wrap your head around the deferred tax liability. During 2020, Cunningham estimate its warranty costs related to the sale of microwave oven to be half a million, paid evenly over the next two years. For book purposes in 2020, Cunningham reported warranty expense and related estimated warranty liability of 500,000 in its financial statement. Let's translate this into simple English. What happened is the company sold an item and as a result, they sold a warranty with it and from financial accounting statements hopefully you know that you have to book a warranty expense of half a million and you have to credit estimated warranty liability of half a million. So for GAP, this is what you have to do and you learn this. Now for tax purposes, what do you have to do for tax purposes? Nada, nothing. You don't have to do anything for tax purposes. For tax purposes, you cannot take, you cannot estimate your warranty liabilities. You have a liability when you actually pay for it. What does that mean? It means for book purposes, for GAP purposes, you have a liability of half a million and for tax return, you did not report any expense. So this expense did not exist on the tax return and this liability don't exist on your balance sheet for tax purposes. So now what's gonna happen in the future, you are going to have a deduction. So in the future, when these customers come back and ask you to repair their product, you are going to have an expense. But for GAP purposes, you will not have an expense. It means in the future in the next two years, this half a million would reverse. So let me show you when it reverse what's gonna happen. In future years, you're gonna have a future deductible amount. It means in future years, you're gonna have a lower taxable income because you have lower taxable income than GAP income because you're gonna have more deduction. So in 2021, you're gonna have more tax deduction. 2022, more tax deduction. Total, you're gonna have half a million of tax deduction. What does that mean? It means in the future, you have more savings. What does that mean? It's in the future, you're gonna have to book now a deferred tax asset. Why? Because if in the future, you have more savings, you have a deferred tax asset. So when Cunningham pay for the liability, it report an expense that's deductible for tax purposes. Cunningham report this future benefit. So they report this future benefit now. They report it now. How do they report it? They report it as a deferred tax asset. They report it as a deferred tax asset. And this is how a deferred tax asset will be born. So we'll have a deferred tax asset and we'll book in the deferred tax asset half a million times whatever the future rate is. Let's assume it's 20%, that's 100,000. Therefore, we have a deferred tax asset year 2020 of 100,000. This is how a deferred tax asset is born, okay? Let's take a look at, let's take a look at the definition of a deferred tax asset. The deferred tax asset represent the increase in taxes saved in future years as a result of a deductible temporary difference. So that warranty is a deductible temporary difference that exists at the end of the current year. Let's take a look at this example to see how it all works. Hunt Company has revenues of 900,000 for both 2020 and 2021. It also has operating expenses of 400,000 for each of these years. In addition, Hunt accrues a loss and related liability of 50,000 for financial reporting purposes because of appending litigation. So what happened, Hunt has to book a contingent liability. What does that mean? It means they debit lawsuit loss of 50,000 and they credited estimated liability, estimated contingent liability of 50,000. So they debited a loss, which is they take for GAAP, this is for GAAP. For GAAP, they have a loss and a liability. For tax, what did they have for tax purposes? Nada, nothing, because for tax purposes you cannot deduct a future liability. You cannot deduct the contingent liability. Hunt cannot deduct this amount for tax purposes until it pays the liability, expected in 2021. So this was 2020. Guess what, in 2021 they're gonna pay the lawsuit, therefore then that's when they take the deduction, okay? As a result, a deductible amount will occur in 2021 when Hunt settles the liability, causing a taxable income to be lower, okay? So let's take a look at the picture first. So this is GAAP. GAAP, we have revenues, expenses minus the lawsuit. Our pre-tax financial income is 450. For tax purposes, we have revenues, expenses, notice no lawsuit for 2020, taxable income of half a million times 20% income taxes payable of 100,000. Can you do the entry? Can we do the entry? Can you do the entry now? Can you do the entry now? Let's do the entry. So for 2020, you will say income taxes payable, income taxes payable, 100,000, okay? Income taxes payable is 100,000 coming from here. Now, what's the difference between income taxes, what's the difference between income taxes payable and what I have to pay in taxes? Well, the difference technically is $10,000. The difference is $10,000. The difference is $10,000. Well, this is the third tax liability of $10,000 because in the future, I'm gonna, I'm sorry, I apologize, it's not the third tax asset. The difference is at the third tax asset of $10,000. In the future, I have a deduction. And what is the deduction? The deduction equal to 50,000 times 20%. So in the future, I'm gonna be saving, when I pay that lawsuit, I'm gonna be saving $10,000. Therefore, I have a third tax asset. Therefore, I book my deferred tax asset of $10,000. Now, all what I have to do now is book income tax expense. What is my income tax expense? It's my current portion and my deferred portion. My current portion is 100,000. And in the future, I'm gonna be saving $10,000. So I'm gonna be reducing my taxes. Therefore, my income tax expense is only $90,000. And this is how I compute income tax expense. It's 100,000 minus 10. It's the current portion minus the increase in the third tax asset. So if I have a deferred tax asset, I'll take the, if I simply put, if the deferred tax asset went up, I'm gonna take my current minus the increase in the third tax asset. Minus the increase in the third tax asset. If I have a deferred tax liability, if I have a deferred tax liability increase, the third tax, I'm sorry, the DTL increase, I'm gonna take my current, sorry, my current taxes plus the increase in the third tax liability to get to my income tax expense. Expense to get to my here income tax expense, okay? So make sure you know these two formulas. You make sure you know these two formulas. If I have a deferred tax asset and it went up, I'll take the current minus the increase. If I have a deferred tax liability and went up, I'll take the current plus the increase. Now, the opposite is true. If my deferred tax liability goes down, I'm gonna take the current plus, if it went down, it's the current plus. And I showed you already what's gonna happen to the third tax liability. If it went down, it's the current minus, okay? Copy this dose formula down, okay? So the deferred tax asset is 10,000 and the beginning was zero, okay? So the deferred tax asset at the end of the year is 10,000, the beginning was zero. Therefore, there was an increase of 10,000. There was an increase of 10,000. So the current tax expense is income tax expense is 90,000, which is the current minus the increase, minus the increase in DTA, minus the increase in DTA, because the beginning was zero. So from a T account perspective, this is DTA. The beginning was zero and the account went up to 10,000. It means there was an increase of 10,000. If it's an increase, I take the current minus the increase in DTA and the third taxed asset. And this is the journal entry. So income tax is fable is 100,000. Remember, what we did is we took half a million times 20% for tax purposes. Then for the 10,000 here, we took 50,000, which is the lawsuit that we're gonna be deducting later times 20%, the tax rate will be 20%. It gives us the third taxed asset. So our income tax expense is the current. This is the current and this is the deferred. So we'll take the current minus the increase in the third taxed asset. Now in 2021, when it actually reverse, when it actually reverse, what's gonna happen is this. When it actually reversed, remember I had 10,000 at the beginning of the year. When it reverse, I'm gonna reduce that 10,000 down to zero. Therefore DTA will go down, DTA will go down. Well, DTA will go down. Let's see how it works from a, let's see how it works. So 2021, gap for gap, I have 900,000 in revenues, 400,000 in expenses, the lawsuit already deduction taken. I have pre-tax financial income of half a million. I'm gonna stop right here. Let's go to tax purposes, 900,000. 400,000 and now I paid for the lawsuit, 50,000. Therefore my taxable income is 450. 450 times 20%, I have to pay the IRS $90,000. I have to pay the IRS $90,000. I have to pay the IRS only $90,000 because I paid them the prior year 100,000. I paid them more. So that $10,000 difference, it reversed. Because it reversed, I have to reduce my DTA. Remember when DTA goes down, I'll take my current, which is 90,000 plus the, if DTA goes down, if DTA, which is it's gonna go down, I'll take the current plus the reduction. So 90,000 plus the reduction of 10,000. So notice what's gonna happen. Income tax expense equal to 100,000, which is the beginning was 10,000 and the ending was zero. So it went down. It went down by 10,000. It went down, DTA went down by 10,000. Therefore I'll take my current plus the reduction in DTA will give me my income tax expense. And this will be my journal entry. Income tax is payable 90,000. This is 450 times 20%, 90,000. This is a reduction. Remember that 50,000 lawsuit, it's gonna have to reverse. And as it reverse, my DTA, my DTA, my deferred tax asset will go down. As it goes down, it's gonna increase my income tax expense because for gap purposes, I cannot take that $50,000, okay? So it's gonna increase it. So let's take a look from a presentation perspective. For 2020, your income tax is payable is 100,000. Your deferred tax asset is 90,000. In 2021, you pay the IRS 90,000 and you no longer have income tax asset. For 2020, this is your income tax expense on the income statement. The current portion was 100,000 minus the increase in the deferred tax asset, minus the increase in the deferred tax asset, okay? In the subsequent year, it reverse. In the subsequent year, what happened, current was 90,000, then the third tax asset was a plus, I added 10,000. Therefore, income tax expense was 100,000 in 2020, 21. I'm not sure if you're gonna see it. You don't see 2021, but I just showed it to you what happened in 2021, okay? Okay, notice the 90,000 is right here. Your income tax asset goes down. As it goes down, I add the increase in deferred tax asset. Therefore, income tax expense equal to 100,000. So this is what happened in 2020. They created the deferred tax asset in 2021, it reversed. Therefore, the balance is zero. Therefore, the balance is zero. Let's take a look at another example for deferred tax asset, deferred tax asset, okay? So we have Columbia Corporation has one temporary difference at the end of 2020 that would reverse and cause a deductible amount of 50,000 in 2021, 65,000 in 2022 and 40,000 in 2023. It's a reversal. It's gonna cause a deductible amount. It's gonna give me a deferred tax asset into the future. Columbia pre-tax financial income for 2020 is 200,000, aka gap income to 200,000. And the tax rate is 34% for all three years. There are no deferred taxes at the beginning of the year of 2020. We are still keeping things simple. Columbia expected to be profitable in future years. You're gonna see why this is important later on. Compute taxable income and income taxes payable. Again, you start with taxable income and income taxes payable. Can you compute taxable income? Hopefully you can. You have 200,000 for gap. Now, as far as the IRS are concerned, you did not take, you cannot take, you are losing a deduction this year of 50,000 of 65 and 440. So in total, those three, 50,000 plus 40 equal to 90 plus 65 equal to 155. You are losing a $155,000 deduction this year that's gonna reverse in future years. It means if this is gap, your IRS must be way higher than gap because you're not taking those deduction. Therefore, I have to add those future deduction for this year. Therefore, your taxable income for IRS purposes for this year is 355. Once I find my taxable income, I just did 355. I'll take 355 times 34% to find my income taxes payable. So let's show you this. Gap was 200,000. My future deduction amount, 50,65 and 40 equal to 155. 200 plus 155 equal to 355. I'll take 355, taxable income times the tax rate. Give me my income taxes payable right here. Income taxes payable, 120,700. Now, in future years, 2021, 2022, 2020, 2023, I'm gonna have more deduction, more deduction, more deduction. So the 158 would reverse. As first let's compute the future benefit. 50,000 times 34, 65,000 times 34 and 40,000 times 34. So for 2021, it's gonna give me a tax saving of 17, 22,113,600. I take those three together and I book my deferred tax asset that I'm gonna have for the future three years that's gonna reverse. The next three years, that deferred tax asset would reverse, but I book it now. I book it, this is 2020. I book it in 2020, but it would reverse in 2021, 2022 and 2023. Now I'm left with my income tax expense. My income tax expense is a pluck. So I'm looking for a debit, but specifically it's my current taxes, current taxes minus my increase in DTA because DTA went up minus the increase in my DTA. And if you learn this minus the increase in DTA, it's gonna make your life easier when you have a prior balance, when you have a prior balance. Again, don't worry, we're gonna work with prior balances, but this is basically an introduction to this topic. The last thing I'm gonna discuss here before I'm gonna send you to work some multiple choice questions is the valuation allowance. A company should reduce the third tax asset by evaluation allowance if, so learn the rules, you might see this on the exam. If it's more than like, more likely than not, it will not realize some portion of all the deferred taxed asset. More likely than not means a likelihood of at least more than 50%. Now let's translate this in simple English. Remember, when you book your deferred taxed asset, what are you saying? You are saying in the future I'm gonna have a future tax savings or a future tax deduction. This is what I'm saying. But guess what? If you are not going to have any profit in the future, if you're not gonna have any taxes, how good is your deferred taxed asset? It's useless. So if you think you are not going to be using that deferred taxed asset, it means when it reverse, it's useless for you because it's only good if you have a taxable income. Guess what? You have to create evaluation allowance. It means you have to reduce your deferred taxed asset, reduce your deferred taxed asset. When do you reduce it? When there is 50% a chance or more, you are not going to realize it, okay? And the best way to illustrate this is to actually work an example. Jennifer has a deferred taxed asset account with a balance of 75 at the end of 2019 due to a single cumulative temporary difference of 375,000. Simple English, we have a DTA account and it has $75,000 as a result of some temporary difference of 375,000, okay? At the end of the 2020, the same temporary difference has increased to a cumulative amount of half a million. So this 300,000, it increased to half a million, it increased by 120, it increased by 125,000. Taxable income for 2020 is 820, the tax rate is 20% for all years. No valuation account related to the deferred taxed asset is in the existence at the end of 2019, okay? So what happened is this temporary difference, it's gonna increase by 125,000. As it increase, your DTA should also increase. Why? Because you have more temporary difference that's a future deductible amount, then it means you're gonna have more deferred taxed asset. Now, assuming that is more likely than not that 15,000 of the deferred taxed asset will not be realized. What are we saying here? We are saying let's assume after we book the entry, after we book that increase of 125,000, increase from 375 to half a million, let's assume that 15,000 will not be realized, will not be realized. What does that mean? It means write the DTA down, but before we write it down, let's do the, let's book it, let's book it. So here's what's gonna happen. In 2020, we have financial income of 695 minus the temporary difference. It's gonna give us taxable income of 820, which was given to us times 20%, 164. So we credit income taxes payable 164. Then the deferred taxed asset is 125, the tallest, it's gonna increase from 375 to 500,000. That means an increase of 125, times 20%, that's gonna give me 25,000. My DTA will increase by 25,000. My income tax expense equal to my current minus my increase in my deferred taxed asset. My income tax expense equal to 139. So I just booked my DTA. Then they told me, guess what? 15,000 of your, 15,000 of your DTA. Now let's take a look at DTA here, DTA. When we started the year, it was 75,000. Then this year we booked an additional 25. So DTA as it stands is 100,000, deferred taxed asset. What they told us is, guess what? You have 100,000, guess what? 15,000 you will never realize. So what do you have to do? You have to create an allowance account, an allowance account. And what's an allowance account? Basically a reduction in your deferred taxed asset. But don't reduce DTA, you would credit an allowance for the third taxes which would reduce. It's a contra asset. So you would reduce this asset and allowance for the third taxes of 15,000 and you debit income tax expense. Remember, so here's a good tip here. When you're deferred taxed asset goes down, your income tax expense goes up. When you're deferred taxed asset goes down, your income tax expense goes up. Notice what happened here in the prior entry. In the prior entry, it's the opposite. In the prior entry, notice when your deferred taxed asset goes up, your income tax expense goes down. You can say that when every time you are increasing your deferred taxed asset, your income tax expense goes down for tax purposes. Goes down for tax purposes. Let me make sure I said this right. Yes, as your DTA goes down, your income tax expense goes up. As it goes up, your income tax expense goes down. That's right. I want to make sure I'm saying this right. And this is how you show the allowance on the balance sheet. On the balance sheet, you would still show the deferred taxed asset of 100,000, which was 75 plus 25, and you would reduce it by the allowance amount of 15,000, which will give you a deferred taxed asset of 85,000. Now this is a solid introduction to the deferred taxed asset and the third tax liability. In the next session, what I would do is I will work multiple choice questions covering this topic. So make sure you practice the multiple choice. Make sure you master the topic before we move on. As always, don't forget to visit my website for additional resources. Consider subscribing. It's an investment in your career. Good luck.