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REG CPA Practice Questions: Calculating Temporary Differences on Schedule M-3
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May 3, 2024
In this video, we walk through 5 REG CPA exam practice questions teaching how to calculate temporary 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-temporary-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 00:48 Question 1: Temporary Differences Definition and Bad Debt Expense 03:18 Question 2: Temporary Difference in Depreciation 05:15 Question 3: Warranty Expenses 06:30 Question 4: Rental Income Received in Advance 07:52 Question 5: Putting It All Together 10:32 Pillar Topics
View Video Transcript
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Welcome to another reg walk-through video
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I'm Logan, and in today's video, we're going to be going over Schedule M3 temporary differences
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And we're going to be doing that, the Super Fast CPA way, which is diving straight into questions to learn the material
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If you don't know much about our strategies and you want to learn more, make sure you go to superfast CPA.com and check out our free one-hour webinar training
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We teach the key ingredients to passing the CPA exam. You don't want to miss it
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Again, it's only one hour long. It's free. out. The link will be in the description and it will look like this. Also, if you like the idea of
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going through questions as your learning material, be sure to check out our Superfast CPA app where we have
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five-question mini quizzes that you can easily access on your phone throughout the day to continue
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learning. With all that said, let's dive straight into the questions. Okay, here's question one
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A corporation using the accrual basis of accounting reports $500,000 of accounts receivable at year
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end. Based on past experience and current economic conditions, the company estimates that 5% of
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the receivables will not be collected. Following Gap, the company records bad debt expense accordingly
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By the end of the year, the company has only written off $15,000 of specific receivables
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that were deemed uncollectable. What is the correct way to report bad debt expense on
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Schedule M3 of the tax return? Well, we don't really know how the M3 works or what temporary
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differences are at the beginning of this video. So let's go ahead and go straight into the answer to
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start learning how it works. Okay, and the answer is that it would be a temporary difference of $10,000
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in which book deductions exceed tax deductions. So let's learn what this all is. Temporary differences
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are discrepancies between the timing of income and expense recognition in financial statements and on
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tax returns. Under accounting principles like Gap, certain items may be recorded in one period
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while for tax purposes these items are recognized in a different period
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These differences are temporary because they will eventually reverse, aligning book and taxable income over time
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They lead to deferred tax assets or liabilities on the balance sheet, representing the taxes that will be saved or owed in the future when the differences settle
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And in this situation, there is a temporary timing difference between the recognition of bad debt expense under Gap, which uses the allowance method
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and the tax treatment, which uses the specific write-off method. The estimated debt expense for financial accounting purposes is $25,000, which was the 5% of the $500,000
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whereas the actual amount written off and deductible for tax purposes is $15,000, resulting in a temporary
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difference of $10,000. So for tax purposes, they only were able to deduct $15,000, whereas on the book, there was $25,000
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So there's that temporary difference between the book and tax. And this has kept track of on the Schedule M3, which is..
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basically a more elaborate Schedule M1. So now we know what a temporary difference is
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and we know that when it comes to bad debt expense for tax purposes you can only recognize the bad debt expense that actually happened the things that actually fell through whereas for book purposes you may be recorded it in a different
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way, so you have to have that temporary difference on the Schedule M3
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So let's go ahead and go to the next question to learn about another temporary difference
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that might show up on the M3. Okay, here is question two
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XYZ Corporation purchased a piece of equipment for $600,000 at the beginning of the year
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The company uses the straight line method of depreciation over a 10-year useful life with no salvage value
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For tax purposes, the company opts to use an accelerated method of depreciation that allows a $120,000 deduction in the first year
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What should XYZ Corporation report on its Schedule M3 regarding the depreciation of the equipment
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Okay, we learned what temporary differences were in the first question, and right now, there's obviously a difference between the book and the tax depreciation
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I think you could figure this out. So go ahead and pause the video, think through this
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and choose which answer you think would be correct. And when you're ready, come back and we will
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look at the answer. Okay, so it would be a temporary difference of $60,000 since tax depreciation
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exceeds book depreciation. So let's think about this. The difference between the straight line
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depreciation expense recorded in the financial statements. So in the financial statements
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it was $60,000, which is $600,000 divided by 10 years. And the accelerated tax depreciation taken
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which was $120,000 in the first year. This is a temporary difference because over the life of the
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asset, the total amount of depreciation will equalize between the book and tax records
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with more depreciation taken for tax purposes upfront and less in later years. So this is something
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important to think about. In the end, tax depreciation and book depreciation end up in the same place
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They end up with the same amount of depreciation taken. However, different amounts of depreciation
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can be taken in different years. So that's where that temporary difference comes in. And it's temporary
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because, again, in the end, the full depreciation will eventually be taken. And in this case
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since $60,000 was on book, but $120,000 was on tax, that's why there's that $60,000 temporary
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difference where there was more depreciation on the tax return than on the book. Okay, let's go ahead and go
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to the next question. Here's question three. In its financial statements for the year ended December 31
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year one, ABC manufacturing company estimated future warranty obligations of $50,000 for products sold
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during the year. This estimate was based on historical data and industry standards. During year one
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ABC paid $30,000 towards fulfilling warranty claims. How should ABC report these warranty expenses
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on its Schedule M3? Okay, this is fairly similar. It's a new topic, but again, similar to the
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previous two. So pause the video, do your own calculation, and when you're ready, come back, and we'll
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look at the answer. Okay, and here is the answer. A temporary difference of $20,000 where book
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expenses exceed tax deductions. So let's read about this as well. The correct answer reflects
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the fact that ABC Manufacturing Co recognizes an expense of in its financial statements for expected future warranty obligations But for tax purposes the company can only recognize the actually paid out during the year leading to a temporary difference that
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will reverse as future warranty payments are made. So similar to the first question
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warranty expenses can only be deducted on the tax return when they're actually paid. So that's
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why there's that difference between the book and the tax deduction. And that's pretty much all
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there is for that. So let's go ahead and go to the next question. All right, here's question four
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JKL properties leased a building on December 1, year 1, receiving a full year's rent of $120,000 in advance
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By the end of year 1, JKL has recognized one month of rent income for financial reporting purposes
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How should JKL properties report this transaction on its Schedule M3? Okay, so this is a little bit different because this is income instead of an expense
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but it's very similar. I think you can figure this out. So take a second, pause the video, come back when you're ready, and we will look at the answer
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Okay. And here's the answer. You probably got that right. So there's a temporary difference of $110,000
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where taxable income exceeds book income. So for book purposes, only $10,000, which is $120,000 divided by that
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12 months, is recognized as income in year one since it was only December. Whereas for tax purposes
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the full $120,000 is recognized when received, creating a temporary difference that will reverse as
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the income is recognized in the financial statements over the lease term. So for
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rent, if you receive rent in advance, for tax purposes, you have to recognize that income in that
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year. Whereas for book, you can recognize that over the least term. And that creates a temporary
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difference on the Schedule M3 that you want to keep track of as the years go on. Okay, that was question
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four. Let's go ahead and go to the last question to kind of put it all together. All right, here's
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question five. We have learned about multiple different temporary differences and how they work in this
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video. So let's get into this one and you should be able to figure this out. During the fiscal year
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DEF Corporation reported the following on its financial statements. Depreciation expense using the
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straightline method of $100,000, estimated warranty expense based on historical data of $50,000
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and rent received in advance for the next fiscal year, and that was for $60,000. For tax purposes
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DEF used an accelerated method for depreciation resulting in $150,000 of depreciation expense
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they deducted actual warranty expenses paid totaling $25,000. DEF's pre-tax book income before these considerations was $500,000
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Based on the information provided, what is DEF Corporation's taxable income for the fiscal year
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Okay, so again, you've learned about all you would need to know for this question
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So pause the video, figure out the calculation and what the taxable income would be
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and when you're ready, come back, and we will look at the answer. Okay, here is the answer, $535,000 of taxable income
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So let figure that out So we start with the pre book income of and then we figure out the temporary differences So depreciation expense had more on the tax return because it was greater than the book depreciation Warranty expense was less on the tax return because they put aside
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$50,000 in book, but they actually only recorded $25,000 throughout the year as an actual expense
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And then they received $60,000 in advance, but it was for the next fiscal year
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so they're not even considering that income until the next fiscal year
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But on the tax return, all $60,000 of that is recognized. So let's go do the calculation
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$500,000 pre-tax income. You subtract the additional depreciation on the tax return
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So that brings us to $450,000. And then you add back the warranty expense that wasn't actually recognized on the tax return
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And that gives you $475,000. And then finally, all of that rent received in advance is
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recognized in the current year. So you add that to the taxable income as well, giving you $535,000 of
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taxable income. And that's the end of those questions. Obviously, there's a lot more temporary
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differences that you can run into in real life. However, for the CPA exam, these are some of the most
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common temporary differences that you will run into when it comes to the M3. And to finish out the
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video, we're going to do one more part of the super fast CPA strategy, which is something called
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Pillar Topics. Now, the idea behind Pillar Topics is, as you're going through the questions
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or after you've gone through the questions during your study session, you take a second
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and you think about the things that you saw in those questions, and you pull out the three
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or four topics that were continually brought up throughout the questions, the things that were
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obviously important and that you needed to know for the CPA exam according to your review
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course. So let's go ahead and look at the Pillar Topics for this video. And here are the
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pillar topics for this subject. So temporary differences arise because of differences in timing and
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recognition between book and tax. They are temporary because in the end it all matches up. You know
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the depreciation is all going to be taken and match up in the end, even though there's differences
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in timing and how much is taken. Some common temporary differences would be depreciation, like I said
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bad debt expense, rental income, and warranty expenses. Of course, there are other temporary differences
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and maybe there will be some extra ones that you notice from your review course
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but these are some of the most common ones that you need to know for the CPA exam. And then finally, temporary differences are tracked on an M3
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which is kind of like a more advanced M1, and we'll be learning about M1s in other videos
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And those are the pillar topics, and that's the end of the video. To finish out, just one more reminder about the Super Fast CPA Training webinar on our website
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Make sure you check that out. It will save you so much time, and again, it's only one hour and it's free
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Also, if you liked going through the multiple choice questions as your main learning material
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make sure you check out our Superfast CPA app that has five question mini quizzes that you can easily access throughout your day to continue practicing
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Thanks for watching. If you liked this video, make sure to like and leave a comment on it on YouTube
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I hope this was helpful, and I will see you in the next video
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