 Hello and welcome to the session in which we will discuss Schedule M3 of Form 1120. In the prior sessions, we looked at Schedule M1 and we looked at Schedule M2. So it's very important to real quick review what's in Schedule M1. In Schedule M1, we looked at our book income or simply put gap income. Then we compare gap income. We reconciled, we did not compare. We reconcile gap income to taxable income. What is taxable income? Income under the IRS rule. So we looked at the differences because the IRS is interested in learning why you have, for example, high net income for gap purposes. But when it comes to taxes, you have low net income or even a loss. So their concern is why the discrepancies, if there's any, we need to see them. That's basically what Schedule M1 is. Then in Schedule M2, we looked at the statement of retained earnings, which is just a review, beginning retained earnings, plus net income, minus net loss, minus dividend will give us ending retained earnings. And we discussed Schedule M2 in details in the prior session. In this session, we would look at Schedule M3. So what is the big idea of Schedule M3? 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. Well, Schedule M3 is simply Schedule M1, remember the reconciling of gap to the IRS with much, much more detail. So it's Schedule M1 on steroid. And it applies to large corporation with total asset of 10 million or above. So if you're considered large corporation, this number could change, but generally speaking, if you're a large corporation, well, you're subject to Schedule M3. Now, why? What's the purpose of Schedule M3? Why do they want to see more details about those reconciling items? Well, two reasons. From a shareholders' perspective, it enhances transparency. It shows you higher level of transparency by aligning corporate financial statement. We're looking at your gap financial statements for the shareholders, and they can compare this to tax to see the difference. This increases disclosure for stockholders to let them get more information about the corporation financial position, as well as tax obligation. The true reason is really identifying aggressive tax practices. This is what the IRS wants to know. By mandating the Schedule M3, the IRS can effectively identify, just look, we're going to look at the form, identify companies that employ aggressive tax practices. What is aggressive tax practices? Simply put, you are using strategy to report income on the books, not for tax, or deduction on the tax, but not on the books. Because the IRS, what's the purpose of the IRS? The purpose of the IRS is to increase your income and reduce your expenses. You might say, isn't that good for me? Well, it's not good for tax purposes. For tax purposes, you want to reduce your income and increase your expenses. For financial accounting, you want to increase your income and reduce your expenses, right? It's two different objectives. So that's the difference between the two. So the detailed information provided will help the IRS detecting any potentially questionable or non-compliant tax strategies by this corporation. And for example, for the Phenogonet, Enron, and WordComp, they might have seen large, large discrepancies between the two. So let's take a look at Schedule M3, Part 1. Well, Part 1, basically this part here, Part 1, it reports the sources of financial net income or net loss. It tells you what are the sources from. The corporation must disclose the origin of the financial net income amount used in the reconciliation, because we need to know where is your income coming from? Is it from 10Ks? Is it from audited financial statements? And notice here, they will ask you all these questions. This could be derived from various sources, SEC, Form 10K, audited financial statement, prepared financial statement, or the corporation own books and records. Where is the income coming from? Also, it will ask you, do you have any restatements? Did you have any restatements? For example, here has the corporation income statement has been restated in the prior statement period on line 2A. Did you have any restatement? So they want to know this. So this is one. Simply put, asking you a few questions. What's the source of your income? Staying on Part 1, here, they're asking you to list your income. Worldwide income, notice here, your income, net income from non-includable foreign entities. If there's anything not includable, you deducted it. We want to know what it is. And we're going to work an example showing you how we would use these figures. But basically, there's a lot of lines here. Any net loss or other includable U.S. disregarded entities. Where is your income coming from as well? If you have any losses, where is it coming from? At the end, we're going to get to net income. This is, we're still on Part 1. Part 2 of Schedule M3. What we're looking at are reconciling items for income and losses of includable corporation. What does that mean? Well, what's happening is this. We are looking for items, income slash loss. And those items, they could differ for gap. This is gap line. This is IRS column. You have gap column, IRS column. In between, we have temporary differences. We have permanent differences. So what's going to happen here? You are showing in details any differences between any gap items or IRS. Now, if they're the same, you don't list them here. If they're not the same, you'll list them here. So let me just choose one item that I think it will be easy for you to follow in order to understand this concept. Let's look at interest income. On interest income for IRS, for gap purposes, let's start with gap. You reported, for example, $130,000 of interest income. You reported all of your interest income. That is fine. That is fine. However, some of that income, let's assume 30,000 of it, was municipal interest income. So you reported $130,000 of gap income. You deduct, you take out permanent difference of $30,000. So for on your tax return, you only report $100,000 of interest income. And if there's any other type of adjustments for cost of goods sold for market to market income, for gross foreign distribution previously taxed, any discrepancies, you would list them here. On part three, again, now we're looking at expenses and any expenses that have temporary or permanent differences. And I'm going to choose something that's pretty straightforward. I'm going to choose fines and penalties. If you incur any fines and penalties for gap, this column is gap. This column is the IRS and we have temporary and permanent differences. Let's assume for the sake of simplicity, you incurred $30,000. Let's use another other than $30,000 and fees and penalties for some violation. Well, that's fine. For gap, you could report this expense on your gap, on your financial statements, it will show. However, when it comes to taxes, you can never deduct this because the IRS don't want you to deduct fines and penalties. Government don't want to finance, don't give you a discount, they give you not a discount, give you a deduction for fines and penalties. Therefore, you will not see this $50,000 on your tax return. And the same concept would apply to all of this. Is this a complete list? No, part three is longer and part two is longer. I'm just showing you a sample. Let's take a look at an example to see how this all fits together in an actual example. Let's assume NOAA Outdoor Corporation, specialized in the sale of hunting and fishing equipment. NOAA operates multiple store in Colorado, Utah and Nevada. Additionally, it has a subsidiary in Canada, structured as a Canadian corporation. Now, NOAA being exempt from filing a 10K with the SEC include the income generated by its Canadian subsidiaries in its audited financial statement. So being exempted doesn't have to report this income. The financial statement indicate, when we look at the total financial statement, 35 million for the current year. This is what it shows. However, the Canadian corporation not consolidated by NOAA for tax purposes. Therefore, it's not includeable in the tax return. Therefore, if they generated 5 million from that corporation, so the tax, the financial statement will show, when NOAA shows their financial statement, it shows let's do 35 million. Then what's going to happen for tax purposes, let's assume that's the only reconciliation, we're going to only see 30 million. Now, we want to see why for GAP you are reporting 35 and for IRS, you are reporting 30. So we will do this on part one, line 5A, schedule M3. So here's what we'll do. For worldwide consolidated net income, we're going to put 35 million. This is part of it. Then notice here, on line 5A, income not included from foreign entities, we're going to do 5 million. And here, net income is now 30 million. Now, for tax purposes, we were able to explain the difference between 35 and 30 million. Why? Because we had a subsidiaries in Canada that's not taxable in the U.S. Now, it says here, attach statement. Well, guess what? We'll attach statement explaining what we just did that, you know, we had this Canadian entity and this Canadian entity is not reported, consolidated for tax purposes. Therefore, it's not included. That's all what we have to say. What should you do now? As a CPA candidate, as an enrolled agent, accounting student, go to FAHAT lectures, look at additional resources, MCQs, two false multiple choice, that's going to help you do what? Learn schedule M1, 1120, schedule M2, 1120, schedule M3, much, much more in details. Good luck, study hard, as always, stay safe.