 Hello and welcome to this session in which we'll discuss the third taxed asset. What is a deferred taxed asset? For one thing, we know it's an asset. What is an asset? Well, an asset is something that's gonna give you benefit in the future, something that's gonna benefit you. Well, benefit you as a result of what? Well, it's the result of deferring some tax deduction. In other words, you're gonna have a difference, a temporary difference, not permanent, a temporary difference, and that difference is the result of a tax basis of an asset or a liability and the carrying value of that amount on the financial statement that will result in a future taxable deductible amount. Hold on a second. Could you explain this a little bit slower? Yes, yes, I can. So you have an item, either an asset or a liability for the purpose of this example, I'm gonna use a liability. Let's assume you have a warranty expense slash liability. How does it work for gap purposes? So let's assume we are looking for gap. For gap purposes, when you have a liability for an estimated warranty, you will debit an expense and you credit a liability. This is what you do. You debit an expense and you credit a liability before you incur any expenditure, before you incur the cash expenditure, before you service that client. For tax purposes, for that particular year, when you estimated your liability, you don't do anything for tax. Why? Because if you did not really incur the item, if you did not really pay for the warranty, you have no expense. Therefore, what's gonna happen, you have a liability for gap, which is a liability for book purposes, and no liability for IRS purposes. There's a difference between those two. This amount, whatever that amount is, which will work in example, and the IRS amount, which is zero. As a result of those two differences, we're going to create future deductible amount. In the future, when the customer comes back and you actually service them, you will have an expense for tax purposes, and as a result, you will have a deduction. But what's gonna happen for now, we are going to record this future deductible amount as a deferred taxed asset. This is what a deferred taxed asset is. It represent an increase in taxes refundable or saved. So in the future, what we are telling the investors, in the future, we're gonna have actual cash expenses, which we're accounting for them now under the gap purposes, but in the future, they're gonna be savings for tax purposes. As a result of this temporary difference that existing at the end of the current year. The best way to illustrate this concept is to actually look at some figures. During 20X1, ARM estimated its warranty cost related to the sale of its smart TVs to be 400,000 over the next two years. So Adam says, I'm gonna have a estimated warranty expense of 400,000. For book purposes, Adam recognized the warranty expense and its related estimated liability for warranties of 400,000. So let me show you the entry that Adam will make for financial accounting purposes. For financial accounting purposes, Adam will debit warranty expense, Adam will debit estimated warranty liabilities 400,000, 400,000. Adam is expected to service 100,000 of the warranty in 20X2 and 320X3. So Adam thinks that in 2020X2, 100,000 will have to service the warranties and remaining 300,000 will be in X3. That makes sense because the longer the TVs are out there, the more likely to break. Now, what would Adam do for tax purposes? For tax purposes for X1, this is 20X1, for tax purposes, no entry. So what did we do here? Well, for per books, for gap purposes, we have a liability of 400,000. For the tax return, we have no liability and no expense for that matter, assuming no customers came back for that year. So the liability is zero, the estimated liability. We have a difference in those two liabilities, book difference of 400,000. As a result, we have a future deduction. As a result, we are going to have a third tax asset. So the question for this will be compute taxable income, compute income taxes payable, compute income tax expense and prepare the journal entries for this exercise. Before we do so, you must be either an accounting student or a CPA candidate if you're watching me. Please take a look at my website, farhatlectures.com. I don't replace your CPA review course. Please, by not any means. The fact that you are watching me and you have a CPA review course or you are taking an accounting course, it means you are looking for additional help. I can help you. I have resources, multiple choice, true, false, lectures. My courses and my resources are aligned with your course per chapter. My CPA review material is aligned with your Becker, Roger, Gleam, Wiley, Miles, whatever course you are taking. I give you access to 1,500. Previously released, AI CPA questions with detailed solution. If you have not connected with me on LinkedIn, please do so, take a look at my LinkedIn recommendation. Like this recording on YouTube, share it with other. If it's helping you, it's gonna help other people. Just share it like it, it helps me as well. Connect with me on Instagram, Facebook, Twitter and Reddit and please join me on my group me account CPA exam, support group where you can have discussion with other CPA candidate and I do participate in those discussion as well. So let's start by computing taxable income. So you have to understand what is taxable income? Taxable income is an IRS term. Taxable income is what? Is how much your income subject to taxation? Income taxes table is how much you have to pay the IRS? Well, let's take a look at who we are giving. Assume financial income is half a million and the tax rate is 20%. You are not giving taxable income, but you should be able to compute taxable income. Let's see how we compute taxable income. You have financial income of $5 million right here. Financial income is gap 5 million. What else are we giving? We are giving the fact that you deducted of this, to get to this half a million, you deducted 400,000 as a warranty expense and the journal entry is right here. You deducted 400,000. Now this 400,000 should not be deducted for tax purposes. So what do you need to do to financial income? Add to your financial income the temporary difference of 400,000. Notice you deducted. I'm gonna put it as a minus here. Then a parentheses. So you see the minus versus the plus. So you deducted this to get to your gap income to go from gap income to IRS income, you're gonna have to add it. Now we find out your IRS income is 5.4 million. What does that mean? It means you have to pay taxes on the 5.4 million, 20% tax rate. You have a tax bill of 1 million and 80,000. This is your income taxes payable. And this is your taxable income because they can ask you for either or. So we can figure out taxable income, figure out income taxes payable. Now what is your income tax expense? We're gonna see on the next slide and we haven't looked at the third tax asset. So let's take a look and compute the third tax asset. This is what we expect. We expect in X2, this is X1, we expect in X2 100,000 to reverse. In other words, 100,000 to be deductible for tax purposes. When this is deductible, it's gonna give us $20,000 in tax savings. In X3, the remaining 300,000 to be tax deductible times 20%, it's gonna give us tax savings of 60,000. Let's prepare the journal entry for X1. Remember for X1, it doesn't matter what year. And when you are preparing the journal entry, the first entry you make is income taxes payable. What you have to pay to the IRS is 1,080,000. The next thing you compute is your third tax asset or the third tax liability. Here we have the third tax asset because we're gonna have future savings of how much of 80,000. So we're gonna debit, it's an asset, the third tax asset of 80,000. Now what's left is your income tax expense. What is your income tax expense? Your income tax expense is if you have the third tax asset. So you have, you have to pay the IRS now 1,080,000. In future years, you are going to save 80,000. Therefore your income tax expense for now is a million. Again, it's a plug. It's the debit is a plug. This is your income tax expense. Simply put, this 1 million has a current portion and a deferred portion. The current portion is the 1 million. The current portion and the deferred portion is 80,000. You have a deferred tax savings. So let's take a look at 20X2. What would happen in 20X2? Let's assume for the sake of illustration, your income taxes payable happens to be, I don't know, 800,000. I just made up this number. Now you are going to reduce your deferred tax asset. It's gonna reverse of 20,000. Now what's your income tax expense? Your income tax expense is 820, which is what you have to pay to the IRS. 800,000 plus 20,000 is 820. Here's what I want you to see. I hope, and I hope you are familiar with T accounts because this is where the value of T accounts comes into place. In year one, in X1, here's what happened in X1. In X1, if we look at your deferred tax asset, and this is important to see, your deferred tax asset went from zero, went up from zero to 80,000, okay? Went from zero to 80,000. The corresponding expense, as a result, if this is a debit, the corresponding expense is a credit to expense. So your expenses went down by 80,000. So notice here, 1,000,000, 80,000, you have to pay to the IRS, but your expense was 80,000 less. In X2, in X2, let's take a look and see what happened in deferred taxed asset. In X2, your starting balance was 80. Now we have to reduce it by 20. So now your remaining is 60, which is the 60 here. So now what happened, your deferred taxed asset was a credit. The corresponding debit is the income tax expense of 20,000. So your income tax expense, the corresponding, let me put the corresponding entry in a different color, the corresponding expense, if this was a credit, this must be a debit of 20,000. And that's why you have an additional 20,000 and income tax expense. What should you do now? To learn more about deferred tax asset, deferred tax liability, go to Farhat Lectures and work MCQs and through faults. Now this is only the start of this discussion. We're gonna have to have prior balances. We're gonna look at different tax rate in future years. There's a lot to learn. We're just starting this. So hang in there. You're gonna be fine. As I said, if you are listening to me, you're either a student or a CPA candidate, invest in yourself. Don't shortchange yourself. The CPA exam is worth it. Your accounting courses are worth it. Good luck, study hard, and of course, stay safe.