Deferred Tax Liabilities

Deferred Tax Liabilities Definition

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

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Source: Deferred Tax Liabilities (wallstreetmojo.com)

These liabilities are created when income tax expense (income statement item) is higher than taxes payable (tax return), and the difference is expected to reverse. It is the amount of income taxes payable in future periods due to temporary taxable differences.

Deferred Tax Liabilities Definition

Deferred Tax Liabilities Explained

Deferred Tax Liabilities 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., dividendsDividends Dividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more are made. Eventually, these tax liabilities will reverse when the taxes are paid.

Since there is always a difference between tax laws and accounting rulesAccounting Rules Accounting 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. read more, 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.

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. Deferred tax liabilities will result in future cash outflows when the taxes are paid. It can happen when the expenses or losses are tax-deductible before they are recognized in the income statementIncome Statement The 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.

These tax liabilities 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 financial statementFinancial Statement Financial 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. If these liabilities are expected to reverse in the future, they are considered a liability; otherwise, it will be considered equity.

These tax liabilities are expected to reverse, i.e., 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 a company has underpaid 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 Taxes Corporate 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.read more. 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.

Reasons

Deferred tax liabilities are important to calculate as these allow firms and entities to know the taxes that are yet to be paid. The reasons for which these liabilities are computed have been listed below:

The difference in the timing of revenue and expense recognition principleExpense Recognition Principle The Expense Recognition Principle is an accounting principle that states that expenses should be recorded and compiled in the same period as revenues.read more in the income statement and tax return;
Specific revenueRevenue Revenue 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.read more and expenses are recognized in the income statement but never on the tax return or vice versa.
Assets or liabilities have different carrying amountsCarrying Amounts The 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.read more (net value of assets or liabilities in the balance sheet) and tax basesTax Bases Tax 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.read more.
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.

How To Calculate?

In general, accounting standards (GAAP and IFRS) differ from the tax laws. It results in the difference in income tax expenseIncome Tax Expense Income 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 Assets A 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 are below:

Income Tax Expense= taxes payable + Deferred Tax Liabilities – Deferred Tax Assets

Deferred Tax Liabilities Video Explanation

Examples

Let us consider the following instances to understand the concept better:

Example 1

A good example is when a firm uses an accelerated depreciation method for tax purposes and a straight-line method of depreciationStraight-line Method Of Depreciation Straight 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 method for financial reporting. A deferred tax liability considers that the company will pay more income tax because of the transaction that has happened in the current period, for example, installment sale receivableInstallment Sale Receivable An 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 Reporting Financial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making.read more purposes (as reported to the shareholders). We have not changed the income and expenses numbers 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 the straight-line depreciation method – year 1 – $333, year 2 – $333, and year three 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 Depreciation Accelerated 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. read more. The depreciationDepreciation Depreciation 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. read more 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, using two different kinds of depreciation for financial reporting and tax purposes results in deferred taxes.

Calculation of Deferred Tax Liability

Income Tax Expense= taxes payable +Deferred Tax Liabilities – Deferred Tax Assets

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

Year 1 – Deferred Tax Liabilities = $350 – $300 + 0 = $50
Year 2 – Deferred Tax Liabilities = $350 – $300 + 0 = $50
Year 3 – Deferred Tax Liabilities = $350 – $450 + 0 = -$100

Cumulative Deferred Tax Liability on the Balance SheetBalance Sheet A 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 Deferred Tax Liabilities = $50
Year 2 cumulative Deferred Tax Liabilities = $50 + $50 = $100
Year 3 cumulative Deferred Tax Liabilities = $100 – $100 = $0 (note the effect reverses in year 3)

Example 2

In May 2023, the International Accounting Standards Board (IASB) published a report on the amendments to be made to one of the significant income tax accounting standards, which allow firms to avoid complexities resulting from the implementation of the global tax reform laws.

This amendment advocated and announced a temporary yet compulsory exemption to deferred taxes accounting for the figures that result from the Pillar Two model implementation. Pillar Two rules were introduced by the Organization for Economic Cooperation and Development (OECD) in 2021.

The Pillar Two model includes multinational companies that are subject to pay taxes at a minimum rate of 15% on the profits generated.

Effects

The deferred tax liabilities change with the changing tax rates. This change affects the taxation process to a great extent. Let us check the effects in a listed form below:

When the tax rate changes affects deferred tax liabilities, they are adjusted to reflect the transition to the new rate, and deferred tax liabilities in balance sheet change as the new tax rate is the rate expected to be in force when the associated reversals occur.
An increase in the tax rate will increase both firms’ deferred tax liabilities and assets in their income tax expense. A decrease in the tax rate will decrease a firm’s DTA and 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 + deferred tax liabilities – deferred tax assets. If rates increase, the increase in these liabilities are added to the tax payable, and the increase in the deferred tax assets are subtracted from the tax payable to arrive at income tax expense.

Deferred Tax Liabilities vs Deferred Tax Assets

Companies financial statements have many classifications, but the most important of all are assets and liabilities. Hence, when a tax is applied, it is on both these elements of the statement. Depending on the tax implications on them both, the deferred taxation is classified into deferred tax assets and liabilities.

For firms, it is important to derive the distinctions between them and be aware of them for more clarity. Listed below are the differences between the two. Let us have a quick look at them:

Tax liabilities and tax assets are opposite terms. While deferred tax assets arise from the overpayment or advance payment of the taxes applied, its liabilities counterpart implies the delayed payment or underpayment of applicable taxes.
The deferred tax liabilities on the balance sheet raises the burden of the firms that owe them, while the deferred tax assets offset the tax burdens to be borne in the future.

Deferred Tax Liabilities