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Level I CFA: FRA Income Taxes-Lecture 3 - YouTube
Channel: IFT
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recognition and measurement of current
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and deferred
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tax current taxes payable or recoverable
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are based on current tax rates
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deferred taxes should be measured at the
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tax rate that is expected to apply
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when the asset is realized or the
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liability is
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settled this is a fairly obvious concept
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but i will
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illustrate it anyway let's say you have
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two periods period one and period two
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the tax rate in this period is 40
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percent
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and the government has already announced
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that the tax rate
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in the next period is 30 percent
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the tax payable for this period will be
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based
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on the current rate of 40 percent
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the deferred tax assets
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that will be realized over here need to
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be
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calculated based on the 30
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rate similarly deferred tax liabilities
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need to be recognized or calculated
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based on the rate
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which will be in effect when the
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liability
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is settled all unrecognized
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deferred tax assets and liabilities must
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be reassessed
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on the appropriate balance sheet date
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and measured against their probable
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future economic benefit this again is a
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fairly straightforward point
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where let's say a company is recording a
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deferred tax
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asset at the end of period one
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now when recording the deferred tax
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asset the company needs to assess
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whether the deferred tax asset of say 15
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is still reasonable or not just as an
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example
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if the profitability in the foreseeable
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future
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is going to be very low or the company
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is actually expecting
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losses then we need to make an
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adjustment because this deferred tax
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asset might not be realized so
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given the situation at this point in
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time and given our assessment of what
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is likely to happen we have to adjust
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the deferred tax asset accordingly
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and the same concept applies with
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deferred tax
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liabilities from a testability
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perspective a couple of
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items that i want to highlight let's say
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you come to this point and there is a
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certain deferred tax
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liability which you do not believe
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will be reversed anytime soon for
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example we might have a deferred tax
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liability because of straight line
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depreciation versus accelerated
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depreciation
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but you foresee that the company will be
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growing for the next few years
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and because of that the
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depreciation amounts will continue to
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increase and we will not have a reversal
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if that is the case then as an analyst
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what you can do
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is take the deferred tax liability and
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categorize that
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as equity many people get
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confused about this but i'll give you a
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silly little
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example that will help you understand
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why we do this
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let's say that you take a loan
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from your parents and after
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a few months it becomes obvious
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to you and your parents that this loan
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is not going to be
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returned so effectively what you can
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then do
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is treat that loan as your
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equity because it's not going to be
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returned the same concept applies over
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here
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something is shown as a liability but
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given the current situation this
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liability is not going to be paid off
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it's not going to be
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settled so essentially that liability
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can be treated as
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equity another testable point
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if there is uncertainty about the timing
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and amount of tax payments
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then analysts should treat deferred tax
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liabilities as neither liability nor
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equity so in the ratio analysis that you
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do
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you effectively remove
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this amount
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measurement of dta and valuation
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allowance if a deferred tax asset will
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not be realized
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because of insufficient future taxable
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income
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to recover the tax asset
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then the dta must be reduced
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i have alluded to this earlier that
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let's say you have period one at the end
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of period one you have a certain
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deferred tax
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asset but you do not think there will be
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sufficient profitability
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in the next few years for you to realize
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this
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deferred tax asset then this deferred
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tax
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asset must be reduced
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under u.s gaap what we need to do is the
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following
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we have a deferred tax asset let's say
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the amount
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is 100. to reduce the deferred tax asset
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we use a contra
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account called the valuation allowance
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which is a lot like depreciation if you
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want to reduce your deferred tax
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asset you increase the valuation
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allowance
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let's say the valuation allowance is
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initially zero you
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increase that to 20. since this
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is a contra account it reduces the value
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of
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the asset the deferred tax asset in this
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case
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so our deferred tax asset becomes 80.
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next year for example we are even less
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sure about profitability then we can
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increase
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our valuation allowance to 30 which
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means that
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the net deferred tax asset comes down to
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70. so notice as i said earlier
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this is a lot like depreciation where
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depreciation is a contra account that
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goes with
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your long-term tangible assets similarly
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valuation allowance is what goes with
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deferred tax assets if you get a
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question
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on valuation allowance on the exam you
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can
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think of it in terms of depreciation
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notice that if depreciation goes up
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that means that your income comes down
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similarly if valuation allowance goes up
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that means that your net income comes
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down depreciation is shown as
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a expense on the income statement
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so if a company starts with accumulated
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depreciation of 10
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from 10 the accumulated depreciation
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goes to 20
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then that difference of 10 shows up as a
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depreciation expense similarly if you
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have a valuation allowance of 20
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from 20 this goes to 30
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the difference of 10 shows up as
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a loss on the income statement so again
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the treatment of valuation allowance and
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depreciation
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is the same i am telling you this
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because
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people generally understand depreciation
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and do not get confused when they see
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a depreciation oriented question on the
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other hand
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valuation allowance is not so familiar
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so
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when you see a question with valuation
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allowance you might get confused
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to overcome that confusion just solve
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the problem as if you are working with
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depreciation rather than
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valuation allowance
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here is another sort of question that
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you can get with valuation allowance so
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do this before looking at the solution
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with questions like this it is important
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to
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organize your data based on years
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what's happening with valuation
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allowance is that
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it is coming down even though your
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deferred tax
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asset is going up valuation allowance
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coming down
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is a positive sign this means that
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expectations of future earning power has
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increased if expectations of future
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earnings power had decreased then we
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would be
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increasing our valuation allowance which
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would be
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reducing the deferred tax asset
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presentation and disclosure this is a
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very long-winded segment
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in the curriculum what i will do is
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highlight some of the most important
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points
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and then also illustrate how
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some of the information is presented in
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the sorts of questions that you might
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get in terms of presentation and
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disclosure one obvious item is that
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companies are required to disclose the
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deferred tax
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assets and deferred tax liabilities
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the basic number needs to be shown on
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the
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face of the balance sheet and then
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details
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need to be shown in the footnotes for
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example
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with the deferred tax asset you might
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have a net value of 20
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but where this 20 is coming from needs
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to be
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shown in the footnotes for example here
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with deferred tax assets we might have
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accrued expenses
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10 so that's one component
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tax loss carry forward is also
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contributing to your deferred tax asset
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then we have a valuation allowance of
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one and your net deferred tax asset
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is 20. with deferred tax liabilities you
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might have a situation like this where
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part of the deferred tax liability is
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coming because
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of the difference between straight line
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and accelerated depreciation
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part might be coming because of
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retirement plans and so on
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you don't really need to understand the
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details all you need to know is that
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there might be
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several components that contribute to
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a deferred tax liability
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sometimes you will see the term net
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deferred
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tax liability this generally refers to
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deferred tax liability minus deferred
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tax
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assets the term net deferred tax asset
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you need to be careful about
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sometimes the curriculum uses this term
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as
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the deferred tax asset minus the
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valuation allowance
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but at times the term net
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deferred tax asset might refer to the
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fact that
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deferred tax assets are greater than
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deferred tax
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liabilities and you are being given the
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difference between the two
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you have to read the question very
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carefully to understand
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the context the next question is where
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must information be
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presented under ifrs deferred tax assets
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or liabilities
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are classified as non-current under u.s
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cap the classification
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is based on the underlying asset or
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liability
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section 8 comparison of u.s gaap and
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ifrs
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again the curriculum gives us a long
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laundry list that is available in
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exhibit five
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i'll just make some high level points
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because i don't think this material is
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overly testable by and large the
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accounting treatment
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under usgap and ifrs is fairly similar
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but there are differences here are some
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that i want to highlight
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as you have seen in earlier readings
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upward
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revaluation are prohibited under u.s
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gaap
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but permitted under ifrs
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the valuation allowance concept is u.s
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gaap
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specific in other words with u.s gaap as
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we've discussed if you have a deferred
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deferred tax asset equal to 100
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if you want to reduce this then you set
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up a
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valuation allowance whereas with ifrs
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you can
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directly change the deferred tax
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asset classification as current or
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non-current as we've seen under ifrs
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the classification is non-current
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whereas under u.s cap the classification
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depends on the
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underlying asset or liability so again
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i think this is the core material if you
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want to be totally rigorous
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you look at exhibit five but i can
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assure you
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if you go through all of exhibit five
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you will find it extremely confusing
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but don't worry too much i think the
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probability
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of being tested on that material is
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extremely remote
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because most of the items that you will
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see in exhibit
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five are items that you will be studying
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at level two
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that brings us to the end of this
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reading i will
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highlight the elements that you need to
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be most careful about
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terminology is important you need to
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understand
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all the terms that i have used in this
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lecture so for example
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accounting profit relative to taxable
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income
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you need to understand how deferred tax
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liabilities and assets are created
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you need to understand the difference
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between tax base
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and carrying amount this formula is
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important
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the deferred tax liability is carrying
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amount minus tax base
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into tax rate if you get a negative
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number that means that you have a
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deferred tax
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asset the income tax
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expense is equal to income tax payable
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plus
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change in deferred tax liability this
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really should be net deferred tax
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liability where we have
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the final value for the net deferred tax
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liability minus the
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beginning value as i discussed in the
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lecture
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if you are given deferred tax liability
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and deferred tax
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assets separately then you do change in
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deferred tax
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liability minus the change in deferred
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tax
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asset if there is a decrease in the
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income tax rate then both your deferred
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tax liabilities
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and deferred tax assets come down if
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there is
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a increase in the income tax rate then
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your
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deferred tax liabilities and assets go
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up you need to understand the concept of
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temporary versus permanent differences
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deferred tax assets and liabilities are
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only created because
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of temporary differences when you have
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a permanent difference then that changes
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the effective
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tax rate and the effective tax rate is
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given
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by the income tax expense
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divided by the pre-tax income
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and this comes purely from the income
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statement which is
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a financial reporting concept
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as usual i will suggest that you read
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the summary
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review all the learning objectives the
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learning objectives
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mention several ratios or the fact that
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you need to be aware of the
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impact on ratios now i've not talked
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about ratios
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because i've seen generally few
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questions related to ratios
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but as long as you understand what's
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happening to deferred tax assets and
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deferred tax
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liabilities and so on and if you
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recognize what's happening to
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income tax expense then you can
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automatically figure out what's
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happening with
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ratios the examples in this
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reading can be quite long and cumbersome
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you can read them once if you want but
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if you find that the example
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is rambling too much don't get concerned
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because
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the actual exam questions are likely to
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be
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reasonably straightforward most of the
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practice problems
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are a very good indication of what you
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will get
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on the exam so do those carefully
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and then as i often say practice from
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other sources also
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because the more you practice the better
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you will understand this material
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and the better you will do on the final
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exam
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you
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