Deferred tax liability (DTLs) is an important concept in accounting and taxation, reflecting the timing differences between when income is recognized for accounting purposes and when it is recognized for tax purposes. This article provides an overview of deferred tax liabilities, including their definition, calculation, common sources, and illustrative examples.

So, what is a deferred tax liability?

A deferred tax liability is an entry on a company’s balance sheet that shows taxes owed but not yet due. It arises from timing differences between when taxes are recognized and when they are payable. For instance, it may occur in cases like installment sales, where the tax is recorded now but payment is delayed until a future date.

A deferred tax liability on a company’s balance sheet indicates a future tax payment the company is obligated to make. It is calculated by multiplying the anticipated tax rate by the difference between taxable income and accounting earnings before taxes. This liability represents taxes that the company has “underpaid” but will settle in the future, reflecting a payment that is not yet due, rather than an unmet tax obligation.

For instance, if a company reports net income for the year, it recognizes that corporate income taxes will be owed. Although the tax liability pertains to the current year, it will not be paid until the following calendar year. To address this timing difference between accrual and cash payments, the tax is recorded as a deferred tax liability.

A common source of deferred tax liability arises from the differing treatment of depreciation expenses under tax laws and accounting standards. For financial reporting, companies typically use the straight-line method for long-lived assets, while tax regulations permit accelerated depreciation. This results in lower depreciation expenses for financial statements compared to tax calculations, leading to higher accounting income than taxable income. Consequently, the company records a deferred tax liability based on this difference. As the company continues to depreciate its assets, the gap between straight-line and accelerated depreciation decreases. Over time, the deferred tax liability is gradually reduced through a series of offsetting accounting entries.

Example 1

Consider a company called ABC Manufacturing, which purchases machinery for $100,000 with a useful life of 10 years. For financial reporting purposes, ABC Manufacturing employs the straight-line method of depreciation, which calculates an annual depreciation expense of $10,000. This is derived by dividing the cost of the machinery by its useful life: $100,000 divided by 10 years.

However, for tax purposes, ABC Manufacturing opts for an accelerated depreciation method, specifically the Double Declining Balance method. In the first year, this approach results in a depreciation expense of $20,000, calculated as two times the straight-line rate (20%) applied to the full cost of the machinery. At the end of Year 1, ABC Manufacturing reports an accounting income before taxes of $50,000. After accounting for the straight-line depreciation expense of $10,000, the taxable income becomes $40,000. Conversely, using the accelerated depreciation method for tax purposes reduces the taxable income to $30,000 after accounting for the $20,000 depreciation expense.

This discrepancy between accounting income and taxable income creates a difference of $20,000. With a tax rate set at 30%, ABC Manufacturing recognizes a deferred tax liability of $6,000 on its balance sheet at the end of Year 1. This amount reflects taxes that will be owed in the future due to the timing differences in how expenses are recognized under different accounting methods.

As ABC Manufacturing continues to depreciate its machinery in subsequent years, the gap between the straight-line and accelerated depreciation will gradually narrow. Consequently, this will lead to a reduction in the deferred tax liability over time as offsetting entries are made in future periods.

This example illustrates how variations in depreciation methods can generate a deferred tax liability that represents future tax obligations stemming from timing differences in expense recognition.

Example 2

Another example of deferred tax liability can be seen in installment sales. In this scenario, when a company sells products on credit to be paid off in equal future installments, it recognizes the entire revenue from the sale immediately under accounting rules. However, tax laws dictate that the company must recognize income only as the installment payments are received.

For instance, consider a company that sells furniture for $1,500 plus a 15% sales tax, with the customer making monthly payments over three years. In its financial records, the company records the full sale of $1,500 at the time of sale. In contrast, for tax purposes, the revenue is recognized as $500 per year for three years.

This creates a temporary positive difference between the company’s accounting earnings and taxable income. Specifically, in the first year, the company recognizes $1,500 in revenue for accounting but only $500 for tax purposes. The deferred tax liability arises from this difference; it would amount to $75, calculated as $500 (the taxable income recognized) multiplied by 15% (the sales tax rate). Thus, the deferred tax liability reflects taxes owed in the future due to this timing difference in income recognition.

Conclusion

A deferred tax liability occurs when a company recognizes taxes that are owed but not payable until a future date. It is calculated as the company’s expected tax rate multiplied by the difference between taxable income and accounting earnings before taxes. Deferred tax liabilities commonly arise in scenarios such as installment sales and varying depreciation methods.

This material is intended solely for informational purposes and should not be relied upon without seeking specific professional advice on the matter. Should you have any questions regarding this topic, please feel free to contact our team at info@ke.andersen.com or +254 20 5100263.

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