REG CPA Practice Questions Explained: Calculating Temporary Differences on Schedule M-3

Calculating Temporary Differences on Schedule M-3

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In this video, we walk through 5 REG practice questions about calculating temporary differences on schedule M-3. These questions are from REG content area 5 on the AICPA CPA exam blueprints: Federal Taxation of Entities.

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How To Calculate Temporary Differences on Schedule M-3

Temporary differences on the IRS Form M-3 are the variances between tax and book income that result from different timing in recognizing revenues and expenses. These differences will eventually reverse over time, affecting taxable income in future periods. The M-3 is used to reconcile these differences for corporations. Here’s an overview some of the common temporary differences:


There’s often a difference between book depreciation (usually straight-line) and tax depreciation (which may be accelerated or involve bonus depreciation). This results in higher tax deductions early on and lower deductions later compared to book depreciation.

Example: A corporation purchases machinery for $100,000 and uses the straight-line method for book purposes with a 10-year life, resulting in a $10,000 annual depreciation expense. For tax purposes, it uses an accelerated method that allows a $20,000 deduction in the first year. This results in a temporary difference of $10,000 in the first year, which will reverse in subsequent years as the total depreciation taken for tax catches up to the book depreciation.

Warranty Expenses:

For financial statements, warranty expenses may be estimated and recorded based on sales and historical data (accrual basis). For tax purposes, the deduction is only allowed when the expense is actually paid (cash basis), leading to a temporary difference between book and taxable income.

Example: A company sells appliances and estimates based on past data that warranty repairs will cost $50,000, which it records as an expense in its financial statements. During the tax year, only $30,000 in actual repairs were made and thus deductible. The $20,000 difference between the accrual and actual expenditures represents a temporary difference that will reverse as additional warranty costs are incurred and deducted in future periods.

Rent Income:

Rent received in advance is recorded as unearned revenue and recognized over time in the financial statements. However, for tax purposes, it is recognized when received. This creates a temporary difference between the time the income is reported on the financial statements and when it is reported on the tax return.

Example: A property management company receives $120,000 in December for a one-year lease starting the same month. It recognizes $10,000 in rent income in its financial statements for December and defers the rest. For tax purposes, the entire $120,000 is recognized as income when received, creating a $110,000 temporary difference that will reverse month by month over the next year as the rent is recognized in the financial statements.

Bad Debt Expense:

The allowance method used for financial reporting recognizes estimated bad debt expenses. For tax, the direct write-off method is used, and bad debts are only deductible when deemed uncollectible, causing a temporary difference.

Example: A retailer records $5,000 as bad debt expense in its financial statements based on the expected uncollectibility of accounts receivable using the allowance method. During the year, $3,000 of specific accounts are written off as uncollectible for tax purposes. The $2,000 difference between the book and tax bad debt expenses is a temporary difference, which will reverse in future years as more debts are written off for tax purposes.

    When preparing the M-3, corporations must adjust their book income to account for these and other temporary differences. The goal is to arrive at the taxable income that will be reported on the tax return. Over the life of the assets or liabilities that give rise to temporary differences, the total amount recognized for financial accounting purposes will equal the total amount recognized for tax. Deferred tax assets or liabilities on the balance sheet reflect the net tax impact of these differences expected to reverse in future periods.

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