So now we want to talk about temporary differences between accounting income,

or US GAAP, and the tax code. So temporary differences are items that are recognized both by GAAP
and by the tax code, but they're recognized in different periods.

We're going to do two examples of this--first of which we're familiar with, which is depreciation
expense. So GAAP uses straight-line depreciation, whereas the tax code uses accelerated
depreciation. So tax depreciation tends to be more in the early years, and later in the--

And less in the later years. And then we'll do an example of deferred revenue, where,

remember, with GAAP, we only earn income when we've both earned it and it's collectible--

so when we've done the work for [Link] the tax code, on the other hand,

because it's a cash system, as soon as it sees the cash come in, it's going to want to tax that.

So first we want to talk about deferred tax [Link] tax liabilities arise, or begin,

or they increase when there's a timing difference that leads to pre-tax income under GAAP

being temporarily greater than taxable incomeunder the tax [Link] the example we're going to look
atis depreciation expense.

So because we use straight-line depreciation under GAAP,depreciation expense is going to be lower

under GAAP than it is for tax, which uses accelerated [Link] what's going to happen is
because you get the greater taxdeductions early on, you pay less taxes early on,and then you're
going to pay more taxes later [Link] we're going to look at an example of this, which this Cooke
Company bought a $100,000 asse tat the beginning of 2010.

For financial reporting, the asset life was two years.

The disproportion rate was straight-line for financial reporting, and the salvage value was 0.

For tax reporting, we're going to assume accelerated depreciation, so the asset life is one year.

Depreciation rate is we get to write off all of the asset in the first year,

and then that will leave no depreciation deduction for the second year, and again, the salvage value

is 0.

So what's Cooke's depreciation expense for financial reportingpurposes?

So this is review.

So the depreciable base is $100,000.

We're depreciating over two years with no salvage value.

So $100,000 divided by 2 years is going to be $50,000 in depreciation expense

in 2010, and then $50,000 more in [Link] tax purposes, we're doing an accelerated depreciation,

so we're writing off the whole asset in the first year.

So we've got $100,000 worth of depreciation in 2010, which is our first year, and then we'll
have no depreciation in 2011, which is our second [Link] we want to just go through.

In this example, we're going to assumethat Cooke has income, before depreciation and taxes,

of $100,[Link] this is true for both financial reporting and for tax reporting, and this is true in both
2010 and 2011.

Again, we're going to assume that the tax rate is 35%.

So for financial reporting, what's our income before taxes?

Well, it's $100,000 income minus the $50,000 in depreciation, so we got $50,000 in income before
taxes.

So what's our tax expense, then?Well, our tax expense is $50,000 times 35%,

or 17 and 1/2 thousand dollars-- so $50,000 income before taxes

times the 35% tax [Link] let's do tax reporting.

So how much is income before taxes for tax reporting?

We got $100,000 in income, but we got $100,000

in depreciation expense, so we haveno income for tax purposes.

That means we have no income to tax. 35% of 0 is 0 cash taxes.

Now let's see how this plays out in the balance sheet equation.

So cash we're going to recognize [Link] that we pay no cash taxes.

So no cash taxes [Link], we're assuming that cash taxes are all

paid during the fiscal year, essentially--although, in practice, there will be

a little bit of taxes [Link] we're going to run this all through cash.

What's our tax expense?Again, for financial reporting, our tax expense

is 17 and 1/2 thousand dollars, and then to balance the balance sheet equation here, we're going to
create a deferred tax liability of 17 and 1/2 thousand dollars.

So this deferred tax liability estimates taxes expected to be paid in the future,

and it's kind of like a long-term [Link] we're recognizing the fact that in the future,

because we didn't pay any taxes this year,in some future year-- which is going to be next year in this

example--we're going to have to pay 17 and 1/2 thousand extra taxes.

So let's see what happens, now, in the second year, which is 2011.

So again, we're assuming the company has income,before depreciation and taxes, of $100,000,

and that's true for both financial reportingand for tax reporting.

So for financial reporting, we'regoing to look exactly the same in.

2011 so we're going to have $100,000 worth of income,$50,000 worth of depreciation expense,
gives us $50,000 net income before [Link] tax expense is 35% of this $50,000 worth of net
[Link], where things are going to change is for tax reporting.

So how much income are we going to have for tax reporting?

Remember, we used all of our depreciation tax deduction up last year, so we have no deduction this
year,

so we're going to have a full $100,000 of income before taxes for tax reporting.

We're going to pay 35% of that, or $35,000, in cash taxes.

And then when we look at our balance sheet equation entry,first of all, we want to keep track of
cash.

So cash is going to go down $35,[Link]'re going to pay the government $35,000 in taxes.

Tax expense is going to be the same--this 17 and 1/2 thousand dollars.

And then to have the balance sheet equation balance,our deferred tax liability is going to go away,

and is basically telling us we paid an extra 17 and 1/2thousand dollars in taxes in 2011.

And in some sense, these were taxesthat we "owed," in quotation mark, from 2010.

So that's our example, in two periods,of a deferred tax liability.

Now, obviously, assets' lives are not always two [Link] years makes for a neat example.