Hello, I am professor Brian Machay, welcome back. In these next two videos, we're going to talk about how these temporary differences create deferred tax assets and deferred tax liabilities. I flipped a coin a few minutes ago, deferred tax assets won the toss and elected to defer to the second video so we are going to start with deferred tax liabilities. Let's get started! Before we jump into how temporary differences work, I want to quickly review some of the terminology. So remember, temporary differences are differences between income tax expense on the financial statements for the books, and income tax payable to the government that reverse over time. So remember, income tax expense is adjusted pre-tax income times the statutory tax rate, where adjusted pre-tax income is based on GAAP rules or IFRS rules and excludes permanent differences. Now, I want to mention here for convenience, I'm just going to say pre-tax income instead of adjusted pre-tax income, the next few videos. It saves space on the slide, it saves me from having to say adjusted pre-tax income a lot. And as it turns out, when we're really focusing on the effect of temporary differences, adjusted pre-tax income and pre-tax income are going to move in the same direction relative to the taxes paid to the government. So for convenience in the next few videos, I'm just going to use pre-tax income instead of adjusted pre-tax income. This income tax expense is the expense that of course goes on the income statement. Income tax payable is going to be the taxable income times the statutory rate, where taxable income is what we calculate based on the tax code rules set by the government. And income tax payable will ultimately be the tax that we pay to the government. Now income tax expense and income tax payable will almost never be the same because of these temporary differences. The temporary differences are going to be stored in the deferred tax assets and liabilities. And throughout these videos, we're going to use a statutory tax rate of 35% in all calculations unless I give you another rate. And the 35% is the current statutory rate in the US. >> Are you certain that we should use the statutory rate? My sister. >> Yes, Ivy, I am here. >> Julie! Welcome! You got here early. Do you want to join the class? >> Here, take my seat. I have to wash my car and go surfing today. >> So, professor, I always tell my sister that she should use the effective tax rate for tax calculations. What do you have to say about that? >> Hey, it's nice to finally meet you. Nice to put a face to the name. We've been hearing a lot about you through the course, and I'm really happy to have you in class today. So, don't take offense by this but you are completely and totally wrong. No, no, no, no, no. Do not use the effective tax rate to do these calculations. The effective tax rate reflects the impact of permanent differences. When we're talking about temporary differences, we don't want to use a tax rate that's biased by things that have nothing to do with what we're talking about. Always, always, always use the statutory rate for these calculations. And I have friends in Hong Kong, and they've told me that they use the statutory rate for the calculations in Hong Kong as well. We're going to first take a look at deferred tax liabilities. Deferred tax liabilities arise from temporary differences where initially tax rules require bigger expenses or small revenues than GAAP. Now what we mean by initially is at the start of whatever transaction generates the temporary difference. So for instance, if you buy a new piece of equipment, you´re going to depreciate that different for book and tax, and so initially we´re talking about the first years of depreciation. Now in those first years, there are bigger expenses on the tax return. Bigger expenses mean that taxable income is less than pre-tax income. Or flipping it around pre-tax income is greater than taxable income. That means that income tax expense has to be greater than income taxes payable. Both income numbers are multiplied by 35%, so that means that more pre-tax income means more income tax expense. We're going to create a deferred tax liability which is going to represent the obligation to make higher tax payments in the future. So let me show you how this works. So we're going to have income tax expense and let's just say it's 100, I'm making these numbers, so we debit income tax expense for 100. Income tax expense is greater than income taxes payable, so we credit income taxes payable the liability which shows that we owe the government for, let's say, 90. We're going to credit a deferred tax liability, create a deferred tax liability for the difference, 10, which is going to represent that obligation to pay that extra 10 in taxes in the future. So we saved 10 in taxes, now we're going to pay 10 extra in taxes in the future. So, in the future GAAP is going to require bigger expenses or smaller revenues than tax rules, so it's a temporary difference, it reverses. Pre-tax income will now be less than taxable income. Income tax expense will be less than income taxes payable. Less pre-tax income means less income tax expense on the financial statements. And we'll see the journal entry reverse. So we've got debit income tax expense for say 90, credit income tax payable for 100. Now the expense is less than the payable and so we're going to debit deferred tax liability for 10 which reverses out this temporary difference. And basically represents the fact that we've now paid this higher tax obligation that we knew we were going to have in the future. >> Really? This looks like a regular liability. You have an obligation today that you have to pay in the future. What is so special about a "Deferred Tax" liability anyway? >> Well the big difference is that a deferred tax liability has the word tax in it. And any time anyone hears the word tax, their eyes glaze over and they start to not pay attention. But you should snap out of that and view this as just a regular liability. So when you see a deferred tax liability, view it as an obligation to make future payments of extra taxes and those extra taxes are as a result of the fact that you saved some taxes to date. So by saving taxes now it's created an obligation to pay extra taxes for the future and that's pretty much the definition of a liability. Okay, let's do an example. So Brey Company buys a $120,00 machine on January 1, 2010. For book purposes, it estimates the machine will have a three year useful life with no salvage value. For tax purposes, the MACRS schedule dictates a depreciation schedule of $80,000, $27,000, and $13,000 in the three years. So over the three year life. >> What is a MACRS schedule? >> We certainly do not have anything called a MACRS schedule in Hong Kong. >> So MACRS is the name of the depreciation schedules that we have in the US. It stands for Modified Accelerated Cost Recovery System. I think I had said that in the prior video. Even though you don't have the same acronym MACRS in Hong Kong, there are still tax depreciation schedules in every country. In fact, I just Googled a few seconds ago and found that there were, what is it, rates of depreciation as prescribed by the Board of Inland Revenue, which is the depreciation schedule used in Hong Kong. So every country has some kind of depreciation schedule. And oftentimes it's accelerated to provide these kinds of tax savings for companies. So on the left side of the screen or the debit side of the screen, we're going to keep track of what's going on in the books where they're using straight line depreciation. So for 2010, we're going to assume that earnings before taxes, depreciation, amortization is 100,000. Then we'll subtract the 40,000 of depreciation expense, 40,000 is the straight line method of depreciation. $120,000 minus no salvage value divided by 3-year life is $40,000 per year. If we subtract that $40,000 from $100,000, we get pre-tax income of $60,000. Then we'll take that pre-tax income times 35%, to get income tax expense of 21,000. On the right side or the credit side of the screen, you'll see MACRS method. This is what we're using for tax purposes. So we'll assume again for the purpose of this example that our earnings before taxes and depreciation is a 100,000. We'll subtract the depreciation expense 80,000 which is what's dictated by the MACRS schedule to get a taxable income of only 20,000. We take that taxable income times 35% to get income tax payable of 7,000. So income tax payable is what we're going to eventually have to pay the government based on the MACRS depreciation schedule. So now I'm going to put up the pause sign and have you try to do the journal entry to record income tax expense, income tax payable, and the difference between the two. Okay, so we're going to debit income tax expense 21,000 so that income tax expense shows up on the income statement. We're going to credit income tax payable for 7000. That income tax payable is what we're going to pay the government based on our tax return. Our debits don't equal our credits so we need something to make this balance. And so what we're going to do is credit a deferred tax liability for 14,000, that's going to represent the obligation to eventually pay the government the 14,000 of tax savings we got today. So we were able to save 14,000 worth of tax savings today, at some point we'll have to pay that back. And then what I'm going to do throughout the example is keep track of our deferred tax liability T-account so we can see how this develops over time, and so now we have a credit entry of 14,000 in that T-account. >> I have a feeling that I have seen this journal entry before. Wait, oh yeah. This looks like the entry last week. The one where we debited Interest Expense, credited Cash, and plugged bonds payable. Really. Are we recycling our journal entries? >> Yeah, I'm glad you noticed that. Accountants basically have four or five tricks and we keep applying those tricks over and over and over again. One of them is contra assets. We use that one quite a bit and you'll see that one again soon. This is another example of our trick, where we have to debit an expense based on accrual accounting practices. We credit cash based on how much cash we owe. The two numbers don't equal, and so then we use a liability to basically plug the difference, to store up the difference between the expense and the cash. It's an old trick and it's one that we'll use again and again and again. Then in 2011, the books are going to look the same Brey company. We're going to assume the same 100,000 of earnings before taxes and depreciation, of course that might now happen in practice, but it makes it easier to see assuming 100,000. Depreciation expense is the same because it's straight line which gives us the same pre-tax income and the same income tax expense. On the tax return, on the right side, again we'll assume the same pre-depreciation, pre-tax income, 100,000. Depreciation expense is now only 27,000. because the MACRS schedule has it dropped substantially in year two, which means their taxable income shoots up to 73,000, that's 100 minus 27. We take 73,000 times 35%, and our income tax payable is 25,550. So why do you try to do the journal entry for income expense, income tax payable? 'Kay, so we're going to debit income tax expense for 21,000. That goes on the income statement. We credit income tax payable. We create the liability for what we owe the government of 25,550. Here our credits are greater than our debits, so we need a debit to defer tax liability. We reduce the deferred tax liability by 4550, and so that goes on the debit side. And so what you see see here is the temporary differences are starting to reverse. And as the temporary differences reverse, we reduced it for a deferred tax liability so now the balance would be something like 9,450. Then in 2012 for the straight line method, we're going to again assume everything the same. Same earnings before taxes and depreciation. Same depreciation expense because it's straight line, gives us the same pre-tax income, times 35% gives us that tax expense of 21,000. For the MACRS method, we'll assume again the taxable income before depreciation and taxes is 100,000. Now the depreciation expense has dropped to 13,000 under the MACRS schedule which makes our taxable income rise to 87,000. 87,000 times 35% is 30,450. So why don't you try to do the journal entry to record the income tax expense and income tax payable? So again we debit income tax expense for 21,000. That goes on the income statement. We credit income tax payable for the 34,450 that we owe the government. And to make this balance, we need a debit to the deferred tax liability of 9,450, which is the number that zeros out the deferred tax liability. So by the end of the life of the machine, the temporary difference has fully reversed. We've paid back all the tax savings that we got in the first year. And now there's no more deferred tax liability. >> Sister, would you take the present value of the deferred tax liability in Hong Kong? It seems that the professor simply added up the future tax payments to get the original DTL. >> Why yes! We always take the present value of future cash flows when valuing a liability. Did you not learn time value of money in this course? >> Yes, we did learn time value of money. It just turns out that under US GAAP and under IFRS used in many countries around the world including Hong Kong, the rules state that we don't use present value for deferred tax liabilities, or deferred tax assets which we'll see later. The deferred tax liabilities just reflect the nominal dollars, the actual dollars we owe. We don't discount them to present value. Now we will have to take into account changes in tax rates that might happen in the future, so we're going to see that later on. But just by rule, we don't take into account present value when doing these, and that's just the way that it is. So let's wrap up this example by making one more point. If we add up the depreciation expense and the income tax expense on the books, we have a total of 120,000 depreciation expense over the three years and a total income tax expense of 63,000. Now on the right side if we add up the depreciation expense and income taxes payable, lo and behold, we get the same totals. So under both tax and books, we recognized 120,000 of depreciation expense over three years. And our income tax payable also came out to be 63,000 the same as the income tax expense. This is the classic example of a temporary difference. The timing of the depreciation expense and tax expense is shifted across time, but the totals are the same between the books and taxes. So, the difference between tax reporting and financial reporting with temporary differences, doesn't mean that you pay more or less tax, or have more or less expense. All it's doing is shifting those expenses, and those taxes across time. >> Really? So everything is the same in the end. >> Why does it matter whether the taxes are paid sooner or later? >> Well, it matters whether we save taxes today or in the future because of the time value of money, which we just said we ignore for deferred tax liabilities but which we don't ignore in the real world. You would always rather save a dollar of taxes today than save it in the future because as we talked about a dollar today is going to be worth more than a dollar in the future. Another way you could think about it is you save taxes today, you can use that money to invest in some kind of investment, and basically get a return on that investment, which not only covers the amount taxes that you have to pay in the future, but gives you a little bit extra. So, the reason why the US government has accelerated depreciation for equipment is basically to encourage investment. By giving this tax break on the first years of depreciation, it encourages companies to go out and buy new equipment, to invest in the economy, and then they can get the benefit of these tax savings, which are worth more today than tax savings would be worth more in the future because of the time value of money. So that wraps up our look at deferred tax liabilities, where we're able to save some taxes today. We have to pay more taxes in the future but that's a good thing because of the time value of money. In the next video, we'll look at deferred tax assets which is the opposite situation, not so good, because we pay extra taxes today which gives us some tax savings in the future. See you then. >> See you next video.
