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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.
What are Deferred Tax Liabilities?
Deferred tax liabilities are created when income tax expense (income statement item) is greater than taxes payable (tax return) and the difference is expected to reverse in the future. DTL is the amounts of income taxes which are payable in future periods as a result of taxable temporary differences.
Deferred tax liabilities are created when the amount of income tax expense is greater than the taxes payable. This can happen when the expenses or losses are tax deductible before they are recognized in the income statement.
Deferred Tax Liabilities Meaning
Before discussing deferred tax liabilities it is important to understand certain concepts, which will help us understand why DTL is created. In general accounting standards (GAAP and IFRS) differs from the tax laws of a country. This result in the difference in income tax expense 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 assets and deferred tax liabilities is below:
Income Tax Expense= taxes payable + DTL – DTA
Deferred Tax Liabilities Example
A good deferred tax liabilities example is when a firm uses an accelerated depreciation method for tax purposes and the straight-line method of depreciation 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 receivable.
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Let us see the deferred tax liability example.
Below is the company’s income statement for financial reporting purposes (as reported to the shareholders). We have not changed the income and expenses numbers so that to highlight the deferred tax liability 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.
- We note that the Tax Expense is $350 for all the 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
- 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 for 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 Sheet 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 for Deferred Tax Liability
- The difference in the timing of revenue and expense recognition in the income statement and tax return.
- Certain revenue and expenses are recognized in the income statement but never on the tax return or vice versa.
- Assets or liabilities have different carrying amounts (net value of assets or liabilities in the balance sheet) and tax bases.
- Gain or loss recognition in the income statement differs from the tax return.
- Tax losses from prior period may offset future taxable income.
- Financial statement adjustments may not affect the tax return or may be recognized in different periods.
Breaking Down Deferred Tax Liability
- DTL is created when revenues or expenses are recognized in the income statement before they are taxable. For example, a firm often recognizes the earnings of a subsidiary before any distributions i.e. dividends are made. Eventually, DTL will reverse when the taxes are paid.
- Since there is always a difference between tax laws and accounting rules a company’s earnings before the taxes mentioned in the income statement can be greater than its taxable income on a tax return, resulting from deferred tax liability. Deferred tax liability is the future tax payment a company is expected to pay to the tax authorities.
- DTL is expected to reverse i.e. they are caused by temporary differences and result in future cash flows when the taxes are paid. A deferred tax liability is most often created when an accelerated depreciation method is used on the tax return and straight-line depreciation is used on the income statement.
- In simpler terms, the deferred tax liability is that amount of taxes which a company has underpaid and which will be made up in the future. This does not mean that the company has not fulfilled its obligation rather the fact is paying the obligation on a different timetable.
- For example, a company which has earned net income for a specific year understands the fact that it has to pay corporate income taxes. Since the tax liability is applicable for the current year it must reflect an expense for the same time period. But in this scenario, the tax will not be actually paid until the next calendar year. To rectify this cash timing difference the company records the tax as the deferred tax liability.
Effect of Tax Rate Changes on the Deferred Tax Liabilities
- When the tax rate change DTL are adjusted to reflect the change 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
To summarize, if taxable income (on tax return) is less than pre-tax income (on the income statement) and the difference is expected to reverse in the future years, a deferred tax liability is created. DTL will result in the 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 statement is very important as if the DTL is expected to reverse in the future then they are considered as liability otherwise it will be considered as equity.
This has been a guide to what is Deferred Tax Liabilities, its meaning, formula along with practical examples and calculations. Here we discuss the effect of changes in tax rates on DTL. You may learn more about accounting from the following articles –