 Hello and welcome to this topic in which you would look at a CPA exam question that deals with deferred taxes. The third taxes, whether it's the third tax asset, the third tax liability, income tax expense is a challenging topic for many CPA candidates because it requires knowledge and gap accounting as well as income tax accounting and you need to combine those two disciplines together. Now whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. My resources are a useful addition. I don't replace your CPA review course. You can keep it. I'm going to give you alternative explanation, alternative in-depth resources in addition to your CPA review course. Your risk with me is one month of subscription. You can try it, see if it's going to help you. If not, you can let it go. And if not for anything, take a look at my website to find out how well or not well your university is doing on the CPA exam. I do have resources for other college and universities as well. If you have not connected with me on LinkedIn, please do so and take a look at my LinkedIn recommendation. Take a look at my YouTube, subscribe, connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this question that I believe it covers many areas of the third taxes. I believe this question is pretty comprehensive. If you can, in my opinion, if you can solve this question easily. And what I mean by easily, it means you have a good understanding of every single thing that's mentioned here. I believe you have a strong basic knowledge for the third taxes. I'm going to go over this problem. And hopefully, if you want to pass, take a look at it, complete the poll on LinkedIn. That's fine. Otherwise, let's go ahead and take a look at this problem. On January 1st, Adam Industries started their operation and recognized for financial accounting purposes 400,000 in warranty expense during the year. Immediately on your piece of paper, if you are working on your exam, just say, OK, I have 400,000 of expenses that I recognize for financial accounting purposes. Immediately, you would say gap. And you're going to know gap. It's going to be the gap. It's going to be lower. Gap income will be lower. Why? Because you recognize expenses. Now they're giving you taxable income. Adam taxable income for the year was 100,000. Now we can start to draw a picture of this. So we have IRS taxable income is 900,000, which is giving. Now gap, we already told the difference between IRS and gap is 400,000. So for gap, you took an additional 400,000. Therefore, your gap net income, which is your financial statement net income, is 500,000. Because why? IRS is 900,000. You have a difference of 400,000. Adam industries expect to make a profit and pay 100,000 in warranty expense starting in year 2 and year 3 and incur losses starting year 4. The enacted tax rate is 21% in current and future period. And the question for this example is compute income tax expense for year 1. So what is income tax expense for year 1? How do you solve this problem? How do you solve this problem? Well, start with the easy, peasy stuff, what you are giving, what answers you can quickly obtain. Because finding the income tax expense, you have to understand the income tax expense, it's not a plug-in, but it's a function of your current and the third taxes. Now, if you're having difficulty understanding these topics, this is what I'm going to invite you again to go to farhatlectures.com, where I have complete resources to help you understand the third taxes from zero. Because your CPA review course don't assumes that you have prior knowledge. I don't assume anything. So how do you solve this problem? I'm going to change the color here. And I'm going to say, well, that's how I would do it. Well, if I'm given the IRS number, if I'm given my taxable income is 900,000, my tax rate is 21%. I immediately can find what is my current portion of income tax, so 900,000 times 0.21, and that's 189,000. Let's keep the calculator here where we will need it. So immediately, although I'm not being asked about this number, and this number, one of the answers, 189,000. What is this number? Well, this is your income taxes payable. Immediately, I'm going to start to build my entry. So you would say my income taxes payable 189,000. And now the debit to this will be current income tax expense. But I am not going to debit income tax expense. But know that the debit, the corresponding debit, is current income tax expense. Because I have to pay the IRS this much money. So this is I'm done with one credit. What else can you compute immediately? Well, you can compute whether you have the third tax asset or the third tax liability. I know I have. I know in the future, in the future, I am going to recognize, I'm going to expense. In other words, I am going to expense an additional 400,000. This is the difference, right? 400,000 at a tax rate of 21%. So in the future, I am going to have savings. Why? Because once I start to pay, once I start to pay year two, remember, I'm going to start to pay those expenses in year two. So I'm going to have 400,000 in future tax savings. When I start to pay those warranty expense times 0.21. And that's going to give me 84,000. And this 84, what does it represent? Well, it's one of the answers. This 84,000 represent my third tax asset. In other words, in the future, I have future warranty expense. I'm going to be paying as I pay. I can take the deduction. That's in the future. So in the future, I'm going to have future tax savings. Therefore, I'm going to debit. The third, I'm going to abbreviate tax asset. And that's 84,000. That's a debit. I'm going to have that. I'm going to have that into the future. Now, this is the future component. This is the future component. I'm going to stop here and tell you what's going to happen. If I am not told, if I stopped here, if I'm not told that I'm going to be incurring losses starting in year four, if I'm not told that piece of information, I can base I'm done. If I'm not told this piece of information, I'm done. Why am I done? Because simply put, if I'm not told this information, what's left is my income tax expense. Okay? And my income tax expense will be, again, but that's not the case. I have additional information, but this is a learning opportunity. 189 minus 84. And this will be my income tax expense. I'm going to put it down and I'm going to erase it just to kind of show you what's going to happen. Income tax expense 105. And that will be it. So if they ask me, what's my income tax expense? I would say my income tax expense is 105. Notice I did not give you this option 105 because I just don't want you to make that mistake. So income tax expense is, that's not income tax expense. Why? Because I'm told in future, after year three, I'm going to be incurring losses. What does that mean? If I'm incurring losses, it means I cannot take advantage of my, deferred taxes. Remember, I have 400,000 of them. I'm going to be using year one and year two. I'm going to be using them. What's left is half of the, the third taxes, half of my warranty expense I'm going to be paying. I'm not going to be able to utilize. What does that mean? It means you're going to have an allowance, a deferred allowance for this 42,000. The third taxable allowance. Well, how much is that? Well, I'm going to take 200,000. I'm going to multiply it by 0.21, and that's going to give me 42,000. What does that 42,000 represent? It represents my allowance. Notice one of the answers is 42, but that's not what they're asking me. Therefore, I'm going to have to credit the third taxable allowance, and this is an allowance account, a 42,000. That's the third piece. That's the third piece of the puzzle. Now, I can compute my income tax expense. Now I can compute my income tax expense. How do I compute my income tax expense? Well, let's look at it this way. Remember what I said? I said if you take 184, 189 minus 84 will give you 105, you remember? And I told you that's not the answer. Why not? That's not the answer because, that's not the answer because I'm going to be losing 42,000 of my allowance. Therefore, I'm going to have to add the allowance, so I'm going to take 105 plus the allowance of 42 and that's going to give me 147. Therefore, my income tax expense is 147. Now, at this point, if you find this entry, this entry and this entry, if you find income tax is stable, the third tax asset and the allowance, income tax expense becomes a plug, but I want you to see that it would have been 105, but since we have an allowance, because we're not going to be using the future tax savings, therefore the allowance, the 42,000 is added to the 105, it comes up with 147 and that's the question. I'm asking you, what is income tax expense? So the income tax expense is 147 and basically it's a plug and that's why I had to go through the entry. So let me real quick go over what I did. First, you compute what you can compute. Income tax is stable, easy. Taxable income times 21%. You can easily compute the third tax asset and you have to know it's a third tax asset. You have to be comfortable by just immediately knowing that I have future deductions, therefore I have a future tax asset, that's 84,000, done. Then I would have been done if I was not told I'm going to be incurring losses starting in year four, which is I'm going to be able to use only 200,000 of my 400,000. It means I have to create the third allowance, 42,000. Once I create my third allowance, that's gonna add to my income tax expense, 50,000. Therefore my income tax expense is 147,000. As I told you from the beginning, if you understand, if you can comfortably go over this problem comfortably, what I explain to you because I can give you this problem, ask you four different questions. I can ask you A, A was one of the answers. If you want to, B was one of the answers, C was one of the answers and obviously we were looking for D. So any of these could be an answer depending on what you are being asked. In other words, you have to truly understand this topic inside out and know exactly what they are asking you and answer the question properly. Once again, I'm gonna offer you my website where I can explain these material in depth that's gonna help you understand the topic. Once you get to your CPA review course, you will, it will be a smooth ride and as a result, you'll pass the exam. Remember, the CPA exam is a lifetime investment. Don't shortchange yourself. Give me a chance for a month. Try it, you don't like it, you cancel. Try it, you like it, you keep it. Study hard, good luck, the CPA is worth it and of course, stay safe.