Up next in 10
REG CPA Practice Questions: Calculating Permanent Differences on Schedule M-3
2K views
May 3, 2024
In this video, we walk through 4 REG CPA exam practice questions teaching how to calculate permanent differences on schedule M-3. Important Links Link to the free study training webinar mentioned in the video: https://www.superfastcpa.com/strategic-study See the full post for this video: https://www.superfastcpa.com/reg-cpa-practice-questions-explained-calculating-permanent-differences-on-schedule-m-3/ See the other REG walkthrough videos here: https://www.superfastcpa.com/free-reg-cpa-practice-question-walkthroughs/ 00:00 Intro 00:50 Question 1: Municipal Bond Interest 03:37 Question 2: Fines, Penalties, and Lobbying Activities 05:35 Question 3: Life Insurance Premiums 06:57 Question 4: Putting It All Together 08:43 Pillar Topics
View Video Transcript
0:00
Welcome to another reg walkthrough video
0:02
I'm Logan, and in today's video, we're going to be going over Schedule M3 permanent differences
0:07
And we're going to be doing that the Super Fast CPA way, which is diving straight into questions to learn the material
0:13
If you haven't heard much about our strategies, and if you want to learn more, make sure you go to superfast CPA.com and sign up for our free one-hour training webinar
0:21
where we go over the key ingredients to passing the CPA exam. Again, it's one hour, it's free, and it will save you so much time in your study process
0:30
check it out. The link will be in the description and it will look like this. Also, if you like the
0:34
idea of going through questions to learn the material, be sure to check out our Superfast CPA app
0:39
where we not only have audio notes and review notes, but also five question mini quizzes that you
0:44
can easily access throughout your day to continue learning. With all that said, let's dive straight
0:49
into the questions. All right, here is question one. During the financial year, Lumenex Corporation
0:54
reported book income of $650,000, which included $70,000 of municipal, bond interest that is tax exempt. Luminex also recorded a federal income tax expense of $250,000 and
1:06
$4,000 of interest expense associated with the debt to acquire the municipal bonds. For schedule M3
1:12
purposes, what amount should Luminex Corporation report as its taxable income? All right, this is the first
1:18
question of the video. We don't really know how M3 calculations work or what permanent differences are
1:23
so let's go ahead and dive into the answer to start learning. Okay, and the answer is $834,000. So let's
1:29
learn all about all of this. Municipal bonds are debt securities issued by states, cities
1:35
counties, and other governmental entities to fund public projects such as roads, schools, and
1:40
infrastructure. The interest income earned on these bonds is typically exempt from federal income
1:45
taxes, and in many cases, state and local taxes for residents of the issuing state. For corporations
1:51
this tax exemption has accounting implications. When reconciling book income to taxable income
1:56
the tax-exempt interest must be subtracted from book income on Schedule M3, as it is not subject to federal income taxes
2:04
Conversely, interest expenses incurred to purchase or carry these municipal bonds are not tax deductible
2:11
and thus must be added back to book income for tax purposes. So right there we learned municipal bond interest and any tax-exempt interest is not taxable
2:20
so it will be taken out of your taxable income. To reconcile book income to taxable income for Schedule M3
2:27
tax municipal bond interest is subtracted from book income as it does not contribute to taxable income Interest expenses on debt to acquire municipal bonds are not deductible for tax purposes and must be added back And then finally this is one more thing
2:40
Federal income tax is not a deductible expense for taxes. So that is also added back
2:45
And that makes sense. You know, maybe at the beginning of the year you made payments for federal income taxes
2:50
for the previous tax year. You counted those as expenses. But for tax purposes, you cannot count federal income tax expenses as deductible
2:59
So you have to add those. back. So here's the calculation. Book income of $650,000. You take away the tax-exempt municipal bond
3:06
interest, $70,000. You add back the interest expense to carry municipal bonds, which was $4,000
3:12
and then you also add back the federal income tax expense of $250,000 because you can't deduct that
3:18
and that gives you the taxable income of $834,000. All right, that gave us a basic idea of
3:24
municipal bond interest and some of these permanent differences that happen in an M-PRA
3:29
three, let's go to the next question to learn a little bit more about what permanent differences
3:34
are and also learn about another type of permanent difference. Okay, here's question two
3:39
Jupiter Manufacturing, a C corporation, has the following transactions recorded in its financial
3:44
statements for the current fiscal year. Pre-tax book income of $500,000, fines for noncompliance
3:50
with environmental regulations recorded as an expense amount to $25,000, and expenses related
3:56
to lobbying activities total $15,000. Jupiter Manufacturing also received $20,000 in tax-exempt interest income from municipal bonds
4:06
What is Jupiter Manufacturing's taxable income for Schedule M3 purposes? Okay, so we know about tax-exempt interest, so we know how that will affect this
4:15
but we haven't learned how fines work or expenses for lobbying activities
4:20
So let's go ahead and go to the answer to see how those work as well. So first off, we're going to get a bit of a better explanation
4:26
of what permanent differences are on an M3. So when preparing an M3, permanent differences are adjustments
4:32
made to the book income that do not reverse over time. Non-deductible expenses such as fines for
4:38
non-compliance and lobbying activities are added back to book income while tax-exempt interest income
4:44
is subtracted because it's not taxable. So the general idea behind permanent differences on an M3
4:50
are that they're just that. They are permanent. They will not be reversed. They are not included
4:55
as a deduction or as income in your taxable income. And so knowing that, we can easily go to this
5:01
calculation and understand why it gets to because the fines are not deductible So you have to add that expense back to your book income And then the lobbying expenses also not deductible You add it back And then the tax
5:17
exempt municipal bond interest, like we learned in the previous question, is not taxable. So you
5:21
subtract that. So far, we've learned the general idea behind permanent differences and some of the
5:26
most common ones that you're going to deal with on the CPA exam. Let's go to the final two questions
5:31
to learn a little bit more and get this to stick a bit better. Okay, here's question three. Cedar Grove Enterprises, a calendar year C corporation, reported a book
5:40
income before federal income taxes of $450,000. Within its financial statements, it recorded a $40,000
5:47
expense for life insurance premiums, where Cedar Grove is the beneficiary. So basically, it's paying
5:52
$40,000 of life insurance premiums for some of its officers type thing. No proceeds from life insurance
5:58
were received during the year. What is Cedar Grove's current year taxable income? Okay, so just one
6:04
more thing, it's probably a permanent difference, so you can probably assume that since this
6:09
was an expense, it's going to have to be added back. So let's go ahead and go to the answer just
6:13
to clarify that. Okay, so $490,000. When reconciling book income to taxable income
6:19
permanent differences such as life insurance premiums, where the corporation is the beneficiary
6:23
are added back because they are not deductible. No adjustment is needed for life insurance
6:27
proceeds because none were received. And by the way, if this had had life insurance proceeds
6:33
typically those are not taxable. So in the same way that the life insurance premium expenses are not
6:39
deductible, the life insurance proceeds if they did receive them are typically not taxable. So just
6:45
pointing that out there for you. And that makes the calculation really easy. Since it's not deductible
6:50
you add the $40,000 back to get the taxable income. Okay, now let's go to the last question and
6:55
pretty much let's put it all together. Okay, here's question four. Atlas Corporation, a calendar year
7:00
taxpayer and a C corporation has provided the following details from its financial records for the
7:05
current year. Pre-tax book income of $800,000, paid $60,000 for life insurance premiums where Atlas Corporation
7:12
is the beneficiary, incurred penalties of $25,000 for late payment of environmental fees, and earned
7:19
$35,000 in tax exempt interest from municipal bonds. For Schedule M3 reporting, what is Atlas Corporation's
7:25
taxable income considering the permanent differences only? All right, so this is the last question
7:30
of the video, you've learned how all of these work, so take a second, pause the video if you
7:34
need to, figure out what the correct answer is and when you're ready come back, and we will look
7:38
at the answer Okay here the answer So when preparing Schedule M3 permanent differences must be accounted for to reconcile book income to taxable income Life insurance premiums where the corporation is the beneficiary are not deductible and penalties are also not deductible
7:53
Thus, both should be added back to book income. Tax exempt interest, on the other hand, is not taxable and should be subtracted from book income
8:00
So, again, pretty simple. You add back the non-deductible life insurance premiums and the non-deductible penalties, and then you subtract the tax-exempt interest
8:09
that gives you the total of $850,000. So permanent differences aren't super complicated. There could be a
8:16
lot more to them. But specifically for the CPA exam, you just need to understand that there are
8:21
certain things that are considered permanent differences on the schedule M3. And the most common ones are the
8:26
ones we've gone over. Live insurance premiums, municipal bond interest, fines and penalties and things like
8:33
that are the most common thing that you're going to deal with. So that's why we went over those in this
8:37
video. Let's finish out the video by doing one more part of the super fast CPA strategy, which is
8:41
something called pillar topics. Now, the idea behind pillar topics is as you're going through
8:46
the problems to learn the material, and as you're going through the questions to learn the material
8:52
you take a second and you think about the things that you learned from those questions. You think
8:56
about the topics that came up multiple times that were obviously important. These are the things that
9:00
you saw, you know, three or four times throughout the questions, and you know that it is something
9:04
you need to know for the exam according to your review course. So let's go ahead and look at the
9:08
pillar topics from what we've learned today. Okay, here are the pillar topics. Permanent differences on an
9:14
M3 are exactly that permanent. They will never be reversed even with time. Municipal bonds and any tax exempt
9:20
interest is a permanent difference that will be taken out of taxable income, so it's not taxable
9:25
Fines and penalties and fees are also not deductible, so those will be added back to your taxable
9:30
income. They're not an expense you can take for tax purposes. And then life
9:34
insurance premiums on behalf of officers are also not deductible. And by the way, on the reverse of
9:40
that, typically life insurance proceeds are also not taxable. That was a quick explanation of permanent
9:45
differences on a Schedule M3. Thanks for watching. I want to give everyone one more reminder about our
9:50
superfast CPA training webinar that we have on our website. Make sure you go check that out. It's one
9:55
hour that will save you so much time and struggling with your exam study process. Also, if you like
10:01
going through the questions as your main learning material, make sure you check out
10:04
our super fast CPA app where we have five question mini quizzes that you can easily take throughout
10:09
your whole day to continue learning on the go. If you like this video, make sure to like it and leave a
10:15
comment in the YouTube video. I hope this was helpful and I will see you in the next video
#Accounting & Auditing
#Business Education
#Tax Preparation & Planning