Hello I'm professor Brian Bushee, welcome back. IN this video we're going to re-explore some topics we looked at earlier in the course but at the time we ignored taxes. We don't have to ignore taxes anymore so we're going to take a look at how taxes work on the statement of cash flows and we're going to look at how taxes work in marketable securities account. I can't wait, let's get started. When we talked about the statement of cashflows earlier in the course, we talked about how we were going to ignore taxes. And that was actually the correct approach because all operating activity line items on the statement of cashflows are shown pre-tax. Now let me bring up an operating section cash flow statement from an earlier video. Net income is, of course, after tax. But by operating activity line items, I mean things like depreciation, the doubtful account expense, the changes in accounts receivable, inventory, prepaids, payables, wages, so forth. All those lines are shown pre-tax. And we can do that because all of the tax effects are going to reflect it in two line items: one for the change in deferred taxes during the year and another for the changes in income tax payable. Those two line items take care of all of the tax effects for the operating activities. >> It has always bothered me that you could add Net Income plus Depreciation because the former was after-tax, and the latter is pre-tax. I just thought this was one of the many over-simplifications that you are famous for. But, are you saying that this is actually correct? >> Yes, this is the rare example of an over simplification that's actually correct. As I'll show you on the next slides, because we adjust for tax effects else where, it's okay to start with after-tax net income, and add back pre-taxed depreciation expense. So let's take a look at an example of how taxes work on the statement of cash flows in the operating section. So let's say a company decides to change its depreciation assumptions for the finance statement, and so their book or financial statement depreciation expense increases by $100 in 2011. Their pre-tax income will go down by $100 because if your depreciation expense goes up, pre-tax income has to go down. That will mean that income tax expense goes down by $35 because if pre-tax income goes down 100, income tax expense goes down by 35% of that. And net Income will go down by $65. So that's the $100 pre-taxed income reduction minus a $35 reduction in income tax expense. Net Income only goes down by $65. Your tax depreciation is unaffected. So while you change the assumptions for your financial statements you can't change theme for our tax purposes. Which means your taxable income doesn't change and your income tax payable doesn't change. Which creates a problem because our income tax expense is going down. Income tax payable to the government's not changing. What we need to do is balance out these differences with a reduction in the Deferred Tax Liability of $35. So the way the journal entries would look for these changes is, first of all, we debit depreciation expense. For 100 to recognize we're increasing depreciation expense. And we credit accumulated depreciation for 100 because that's where the depreciation expense is stored up over time in that contra asset. And normally up to this point in the course we would stop here and be done, but now that we know taxes we also have to go and do the tax journal entry. So as we saw income tax expenses going down by 35. So we credit income tax expense to reduce the expense by 35, and of course, the $100 reduction in the expense times 35%. And that's balanced off by a debit to deferred tax liability. We reduce the liability by 35 through the debit to balance this journal entry. >> What the lamb are you doing? Did you just create a negative liability? Shouldn't this be a deferred tax asset? >> No, this is not creating a negative liability. Remember, this is a change in depreciation assumptions. So presumably there is already been some depreciation, which we see in the cashflow statement. And so there's already a deferred tax liability there. We're just reducing the existing deferred tax liability. So let's take a look at how to put those journal entries into the cash flow statement, to revise the cash flow statement. So I've brought up the cash flow statement from before, but now I have a column for old 2011, so that's before we make the change in depreciation. And new 2011, which is what it will look like after we make this change in depreciation assumptions. So, first, focusing on net income, we saw that the net effective of the increase in depreciation expense was that net income went down by 65 That's the after tax effect. So it goes down from 5071 to 5006. Depreciation goes up by a 100 so the depreciation that we add back, the depreciation expense added back, goes from 7191 to 7291. And then the deferred tax liability went down by 35. If a liability goes down, we subtract it in the indirect method, the operating section. So deferred tax assets go down from 587 to 552 when we subtract out that 35. There's no change in income tax payable because our changed depreciation for the books did not effect taxes that we owe the government. So there's no change here. After we make these changes notice that the bottom line cash from operations is the same. All the changes cancel out. So two points from this is one, if we change a non cash expense, it can't have any effect on cash operations. And the second is, we were able to just do depreciation add back on a pre tax basis because we take care of the tax effect in the change inferred taxes. Another applied example that I want to look at is how taxes relate to what we did with marketable securities earlier in the course. So marketable securities are when we buy. The stocks or bonds of other companies as an investment or as a way to try and make money. So gains or losses on marketable securities are only taxed when they're sold. And then the tax is going to be based on the difference between what you bought it, the purchase price, and what you sold it for, the sales price. So that's the tax treatment for gains or losses on marketable securities, they only happen when they're actually sold. But when we did the trading securities method for marketable securities we saw that we had to mark our marketable securities to market value. And we had unrealized gains or losses that went on to the income statement. Well that creates a problem, because we have gains or losses that go on the income statement and will affect income tax expense, but are not yet taxed for our tax return, creates a tax temporary difference and so we're going need a differ tax asset or liability in this situation. For available for sale securities it's a little bit more complicated even than that, so we also had to mark the How marketable securities to market value. We had unrealized gains and losses. These were stored up in accumulated other comprehensive income. But remember accumulated other comprehensive income has to be carried after tax. It's like retained earnings that has to reflect an after tax number. So what we're going to have to do is create a deferred tax asset or a liability to reflect the tax effect of the unrealized gains or losses that we put into AOCI. >> I am desperately and hopelessly lost by what you just said. Will I have to carry this loss with me for the next twenty years? >> No, in fact I'll try to clarify this for you on the next few slides by going into a couple detailed examples. So let's look at a couple examples to see how this works. First we're going to focus on trading securities and deferred taxes. So let's say that at quarter end, Bott Bank has an investment in TK stock that's now worth $129. Bott, Bott bought? Bott bought the stock for $100. [LAUGH] So Bott purchased the stock for $100 during the quarter. At quarter end, it's gone up to $129. Under trading securities we have to increase the balance in marketable securities so we debit marketable securities by 29 and then we credit a gain on investments that goes onto the income statement. So remember, trading securities, this unrealized gain or loss in this case unrealized gain, goes on the income statement. Now we're going to take this further and do the tax part of the journal entry. So Bott has to debit income tax expense of 10 because they have an extra 29 of revenue or 29 of gain. Their income tax expense is going to go up by 29 times 35% or 10. They're going to credit a Deferred Tax Liability of 10 and it's going to be Deferred Tax Liability because there's no tax owed the government yet, so there's no income tax payable involved. Income Tax Payable is only going to happen when we actually sell the security Then we owe the government taxes. So the way to view this deferred tax liability of 10 is we're sitting on this gain on investment. If we eventually sell the stock with that gain we're going to have to pay taxes on it. So this deferred tax liability is estimating those future taxes we'll have to pay. Now Bott is going to sell its TK stock. The stock price has gone down a little bit, and so they can only sell it for $109. So the journal entry is Bott gets $109 of cash. So they debit cash 109. They get a loss on investment of 20, because the marketable securities we carried at 129 on the balance sheet in the most recent quarter end. So remember under trading securities, this loss when you sell the securities that goes on the income statement is the difference between what the marketable securities were valued at on the last balance sheet date and the cash that you receive. And then we have to go on and do the tax part. So we debit the deferred tax liability for 10. So basically this zeroes out the deferred tax liability. We don't need it anymore because we're closing out the transaction. We credit income tax expense of 7. Now it's a negative tax expense because we lost $20. If we lose (20 x 0.35) it's going to shelter $7 of tax expense or tax expense goes down by 7 because we had a loss. [SOUND] Then what we owe the government is $3 in taxes because from the governments point of view are gain was 109, what we sold it for minus 100, what we purchased for, so that's $9 realized gain times 35% is $3 that we owe the government. And as you can see, everything balance, the Deferred Tax Liability helped balance out the income tax expense on the books and what we actually owe the government. And again, notice that the income tax payable is based on this realized gain, which is computed using the original purchase price of 100. >> I see a $20 loss on investment, but yet we have to pay $3 in taxes. Can I recommend to you the name of a financial planner that will help manage your tax strategy? >> No, I'm fine tax planning-wise, but thank you for the suggestion. I agree it looks weird to have a loss on the income statement but yet we're paying taxes. But remember, last quarter when we marked this to market we booked a huge gain on the income statement, and over these two quarters on the income statement first we had an income tax expense of 10, then a negative tax expense of 7, which is a total tax of 3, which is exactly what we ended up paying to the IRS. So it's just a temporary difference that all works out by the end of the transaction by the time we sell the stock. Now let's take a look at how this works for available for sale securities. And a little warning this one gets complicated. So at quarter end Meyer Co's investment in TK stock is now worth $129. So during the quarter, Meyer bought the stock for $100. The stock has gone up to $129, so there's been a mark-to-market gain of 29 unrealized at quarter end. So the journal entries are again debit marketable securities to increase the marketable securities to market value from $100 up to $129. But since available for sales treatment we don't put this on the income statement instead we credit Accumulated Other Comprehensive Income or AOCI. So this is what we saw before in the earlier videos. But now we want to try to tackle the tax affect, and what we are going to do is debit AOCI. To reduce AOCI by 10, the 10 is the 29 times 35%, so it's the implicit tax affect on this unrealized gain. And then we're going to credit the deferred tax liability to represent this tax affect that we´re showing in AOCI but, that doesn´t really exist in terms of the government because we´re not paying any taxes to the government. So instead of debiting income tax expense, the way to think about this, is we´re debiting AOCI so that what goes into AOCI, is both the gain of 29 that we get at quarter end. And, the tax affect of that gain, of ten, which is a net effect of 19. And again the equivalent would be if this was on the income statement we would have had 29 of revenue, a $10 tax expense, there would have been a net income effect of 19. That net income effect of 19 would have ran into retained earnings as an after-tax number. We're just trying to replicate that here by creating this extra debit to AOCI and credit to deferred tax liability. >> Professor, I believe that I have had enough. Can we stop with the tax lectures and move on to something else, thank you. >> Boy, I wish I could stop here. But that would be one heck of a cliff hanger, because we have to go to the next part which is selling the security to see how all this stuff ends. Wait, where are you going? Come back, I've gotta do the last part of the example. So now let's go ahead and sell this investment and see how it works under the available for sale method. So at quarter end, Meyer Company sells its TK stock for $109. So the journal entry is they get 109 dollars of cash. So they debit cash for 109. We take the marketable securities off the balance sheet at 129 which is where they were at the last balance sheet date. We had stored up 29 unrealized gains in AOCI, we debit AOCI to remove those gains which is something we looked at earlier in the course and then to get this to balance, we need a gain on investment of 9. And remember for available for sale securities, the gain that we book on the income statement, this 9, represents the difference between the Sales price of 109 and the original purchase price of 100. And we show that realized gain on the income statement now because AOCI took care of all the unrealized gains, stored them up during the interim period. So if our realized gain on the income statement is 9, that's the same gain that's going to be taxed for tax purposes. So we're going to debit income tax expense for 3. That's the gain of 9 x 0.35. That's exactly what we owe the government. So there's no difference in the timing of taxes in books here with this gain so we have income tax payable, we have a credit of 3. The last step is we created the deferred tax liability of 10. We have to remove it because the transaction with the security is done and the balance is to take it out of ALCI and what that accomplishes is if you look at the T account, we debited AOCI or removed the 29 of unrealized gains. We credit AOCI to remove the 10 of the deferred taxes. It zeroes out the AOCI account which which is where it needs to be. The transaction with this stock is done and so AOCI has to go to 0 because there's nothing more stored up in that account. That's how the deferred taxes work with available sales securities. >> So, is the deferred tax liability simply a placeholder in this situation? It really does not seem to serve any important purpose. >> Exactly, the deferred tax liability in this case is nothing but a placeholder. It's simply needed to put the unrealized gains into AOCI on an after tax basis. So when we pull those gains out, we get rid of the deferred tax liability, because we don't need it anymore. And I wanted to introduce this topic because when we talk about AOCI later in the course, we'll see that there are other items that go into AOCI. And it's going to have the same kind of after-tax treatment where you're going to need this deferred tax to make it all work. >> Professor, I heard a rumor that next week's topic is stockholders' equity. Does that mean the return of par value? >> [LAUGH] Yeah, the rumor is true. Par value will make an appearance again next week. Clearly you guys are done with taxes. I'm done with taxes. Let's wrap this up so that we can move on next week to stockholder's equity. Okay, so that's going to wrap up all of the material that I wanted to cover with income taxes. We still have the 3M video coming up where we'll look at a real financial statement, but that's the only thing between us and a very happy French guy who's going to see accounting for stockholder's equity next week. I'll see you then. >> See you next video.
