Deferred Tax Liabilities

Deferred Tax Liabilities Meaning

Deferred Tax Liabilities is the liability which arises to the company due to the timing difference between the accrual of the tax and the date when the taxes are actually paid by the company to the tax authorities i.e., taxes get due in one accounting period but are not paid in that period.

In simple words, Deferred tax liabilities are created when income tax expense (income statement item) is higher than taxes payable (tax return), and the difference is expected to reverse in the future. DTL is the amount of income taxes that are payable in future periods as a result of temporary taxable differences.

Deferred Tax Liability

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Source: Deferred Tax Liabilities (wallstreetmojo.com)

They are created when the amount of income tax expense is higher than the taxes payable. It can happen when the expenses or losses are tax-deductible before they are recognized in the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more.

Deferred Tax Liability - 1

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Source: Deferred Tax Liabilities (wallstreetmojo.com)

Deferred Tax Liabilities Formula

In general, accounting standards (GAAP and IFRS) differ from the tax laws of a country. It results in the difference in income tax expenseIncome Tax ExpenseIncome tax is levied on the income earned by an entity in a financial year as per the norms prescribed in the income tax laws. It results in the outflow of cash as the liability of income tax is paid out through bank transfers to the income tax department.read more recognized in the income statement and the actual amount of tax owed to the tax authorities. Due to this difference, deferred tax liabilities and assets are created. The income tax expense equation that equates, tax expenses recognized in the income statement and taxes payable to the tax authorities and changes in deferred tax assetsChanges In Deferred Tax AssetsA deferred tax asset is an asset to the Company that usually arises when either the Company has overpaid taxes or paid advance tax. Such taxes are recorded as an asset on the balance sheet and are eventually paid back to the Company or deducted from future taxes.read more and liabilities is below:

Income Tax Expense= taxes payable + DTL – DTA

Deferred Tax Liabilities Example

A good example is when a firm uses an accelerated depreciation method for tax purposes and the straight-line method of depreciationStraight-line Method Of DepreciationStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more for financial reporting. A deferred tax liability keeps into account the fact that the company in the future will pay more income tax because of the transaction that has happened in the current time period, for example, installment sale receivableInstallment Sale ReceivableAn installment sale is a revenue recognition method. The seller allows the buyer to make payment in installments over the specified period without fully transferring risk and rewards at the time of sale. The seller recognizes the revenue and expense while collecting cash rather than at the time of sale.read more.

Below is the company’s income statement for financial reportingFinancial ReportingFinancial Reporting is the process of disclosing all the relevant financial information of a business for a particular accounting period. These reports are used by the stakeholders (investors, creditors/ bankers, public, regulatory agencies, and government) to make investing and other relevant decisions. read more purposes (as reported to the shareholders). We have not changed the income and expenses numbers so that to highlight this concept.

Here we assumed that the Asset is worth $1,000 with a useful life of 3 years and is depreciated using straight-line depreciation method – year 1 – $333, year 2 – $333, and year 3 as $334.

Example
  • We note that the Tax Expense is $350 for all three years.

Let us now assume that for tax reporting purposes, the company uses an accelerated method of depreciation. The depreciation profile is like this –  year 1 – $500, year 2 – $500 and year 3 – $0

Deferred Tax Liability Example 1
  • We note that the Tax Payable for Year 1 is $300, Year 2 is $300, and Year 3 is $450.

As discussed above, when we use two different kinds of depreciation for financial reporting and tax purposes, it results in deferred taxes.

Calculation of Deferred Tax Liability.

Income Tax Expense= taxes payable + DTL – DTA

Deferred Tax Liability Formula = Income Tax Expense – Taxes Payable + Deferred Tax Assets

  • Year 1 – DTL = $350 – $300 + 0 = $50
  • Year 2 – DTL = $350 – $300 + 0 = $50
  • Year 3 – DTL = $350 – $450 + 0 = -$100

Cumulative Deferred Tax Liablity on the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more in our example will be as follows

  • Year 1 cumulative DTL = $50
  • Year 2 cumulative DTL = $50 + $50 = $100
  • Year 3 cumulative DTL = $100 – $100 = $0 (note the effect reverses in year 3)

Reasons 

Breaking Down DTL

Effect of Tax Rate Changes

  • When the tax rate change DTL is adjusted to reflect the transition to the new rate, DTL values on the balance sheet must be changed as the new tax rate is the rate expected to be in force when he associated reversals occur.
  • An increase in the tax rate will increase both firms deferred tax liabilities and assets in its income tax expense. A decrease in the tax rate will decrease a firm’s DTA and its income tax expense.
  • Changes in the balance sheet values of deferred tax liabilities and assets need to be accounted for the change in the tax rate that will affect income tax expense in the current period.
  • Income tax expense= taxes payable + DTL – DTA. If rates increase, the increase in the DTL is added to tax payable, and the increase in the DTA is subtracted from the tax payable to arrive at income tax expense.

Deferred Tax Liabilities Video

Conclusion

To summarize, if taxable income (on the tax return) is less than pre-tax income (on the income statement) and the difference is expected to reverse in the future years, the deferred tax liability is created. DTL will result in future cash outflows when the taxes are paid. DTL is most commonly created when an accelerated depreciation method is used on the tax return, and straight-line depreciation is used on the income statement. For an analyst, this line item of the financial statementThe Financial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more is essential as if the DTL is expected to reverse in the future, then they are considered as a liability; otherwise, it will be considered as equity.

This article has been a guide to what is Deferred Tax Liabilities and its meaning. Here we discuss the formula to calculate Deferred Tax Liabilities along with practical examples. Here we discuss the effect of changes in tax rates on DTL. You may learn more about accounting from the following articles –

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Comments

  1. Davide says

    Many thanks for this, very helpful to understand a concept not always explained clearly enough. Keep up the good work!

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. Sampson Nkrumah Sarkodie says

    Found this review helpful

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