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.
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..
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. 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. 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. 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..
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. 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.
- 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 depreciationAccelerated Method Of DepreciationAccelerated depreciation is a way of depreciating assets at a faster rate than the straight-line method, resulting in higher depreciation expenses in the early years of the asset's useful life than in the later years. The assumption that assets are more productive in the early years than in later years is the main motivation for using this method. . The depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. 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 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. 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)
- The difference in the timing of revenue and expense recognition principleExpense Recognition PrincipleThe Expense Recognition Principle is an accounting principle that states that expenses should be recorded and compiled in the same period as revenues. in the income statement and tax return;
- Specific revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions. and expenses are recognized in the income statement but never on the tax return or vice versa.
- Assets or liabilities have different carrying amountsCarrying AmountsThe carrying amount or book value of asset is the cost of tangible, intangible assets or liability recorded in the financial statements, net of accumulated depreciation or any impairments or repayments. Accordingly, the carrying amount may differ from the market value of assets. (net value of assets or liabilities in the balance sheet) and tax basesTax BasesTax base refers to the total value of the income or assets of an individual or firm which is taxable by the government or the relevant taxing authority. This taxable amount is used to evaluate the tax liability of the individual or company..
- Gain or loss recognition in the income statement differs from the tax return.
- Tax losses from the 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 DTL
- DTL is created when revenues or expenses are recognized in the income statement before they are taxable. For example, a firm often knows the earnings of a subsidiary before any distributions, i.e., dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity. are made. Eventually, DTL will reverse when the taxes are paid.
- Since there is always a difference between tax laws and accounting rulesAccounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. , a company’s earnings before the taxes mentioned in the income statement can be higher than its taxable income on a tax return, resulting from deferred tax liability. It 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. It 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, it is the amount of taxes that a company has underpaid and which will be made up in the future. It 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 that has earned net income for a specific year understands the fact that it has to pay corporate income taxesCorporate Income TaxesCorporate tax is a tax levied by the government on the profits earned by a company at a fixed rate each year and is calculated in accordance with specific tax regulations.. Since the tax liability is applicable for the current year, it must reflect an expense for the same period. But in this scenario, the tax will not be 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
- 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
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. 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 –