Deferred Tax Liabilities

Definition of Deferred Tax Liabilities

Deferred tax liability is the amount of tax liability accrued during the current year but will be paid in subsequent years, which arises due to difference in between books profit and taxable profits of an entity occurring due to the timing difference in accounting treatment of any transaction and as prescribed in taxation laws or if an entity recovers the carrying amount of any asset/ liability or it has any unused tax losses/ credits.

Explanation

Deferred tax liability (DTL) is the temporary difference between the actual profit and the booked profits (profits determined as per GAAP and as per income tax laws). There are certain P&L items that create this difference which may be either permanent difference or timing difference. The permanent difference does not lead to the creation of DTL. While timing difference leads to the creation of difference of accrual of tax and its payment. In simple terms, it can be stated that the current income tax paid is lower than the income tax expense charged in books of accounts which leads to the creation of DTL. Being a liability in nature, it is certain that the company has an obligation for payment in future. Therefore, DTL is the amount of income tax payable in the future due to temporary differences that can be reversed in a subsequent period of time.

How Does It Work?

Certain expenses and incomes recognized in the company’s books of account will be having different taxation treatment. While some income may be charged during the current year while some may be charged in future. Also, there are certain expenses (Depreciation being most common) where exist different charging mechanism. If any income is stated in books on which tax will be charged in future, or any expense is charged higher in determining taxable profits, it will lead to the creation of DTL or reduction of Deferred Tax Assets(DTA).

During next year, this DTL will be charged (reversed) in the company’s books when relevant income/ expense gets recognized in income tax laws as income/ expense.

How to Create Deferred Tax Liability?

Let’s understand the concept with the help of the following example-

Consider a company with the following details: –

1. Total Company Revenue – $20,00,000
2. Expenses (excluding depreciation) – $10,00,000
3. Only capital Asset of $4,00,000. Depreciation rate – 20% -as per books & 30% for tax purposes.

So Deferred tax liability would be created as under –

• Step 1 – Make a comparison chart for both financial and tax reports.
• Step 2- Mark revenues in each case as given by the reports.
• Step 3 – Deduct all expenses from the revenue.
• Step 4 – Calculate depreciation expenses according to both methods and deduct them from the revenue.
• Step 5 – Arrive at gross profit.
• Step 6 – Calculate the tax in the financial and tax report.
• Step 7 – The difference in tax will be the deferred tax liability and will be recorded.

Particulars	Tax Report	Financial Report	Difference
Revenue	20,00,000	20,00,000	–
Expenses	(10,00,000)	(10,00,000)	–
Depreciation	(1,20,000)	(80,000)	40,000
Gross Profit	8,80,000	9,20,000	40,000
Tax@30%	(2,64,000)	(2,76,000)	12,000

Here the tax as per books is $2,76,000 and tax as per tax report is $2,64,000. This disagreement creates a deferred tax liability of $12,000, recorded in books as Deferred tax liability. Current income tax expense will be $2,76,000, out of which $2,64,000 will be recognized as immediately payable and the balance to be recognized as deferred tax liability.

Similarly, other transactions lead to the creation of DTL as follows: –

• Income recognized in books but not in taxable profits during a current financial year.
• Certain expenses are allowed on a cash payment basis recognized in taxable profits determination during the current FY but will be recognized in books later on.

Examples of Deferred Tax Liability

Following are the examples are given below:

Example #1

Ascertain Deferred tax, current tax expense and tax payable liability from the following mentioned details.

Particulars	Books	Tax purpose
Revenue	10,00,000	10,00,000
Other expenses	5,00,000	5,00,000
Depreciation	1,00,000	2,00,000

Income Tax rate – 30%

Solution:

Deferred tax liability is calculated as follows: –

Particulars	Books	Tax purpose	Affects DTL?
Revenue	10,00,000	10,00,000	No
Other expenses	5,00,000	5,00,000	No
Depreciation	1,00,000	2,00,000	Yes
Profits before tax	4,00,000	3,00,000	–
Tax @ 30%	1,20,000	90,000	–
Profit after tax	2,80,000	2,10,000	–

• Tax expense to be charged in P&L A/c – $1,20,000
• Tax Payable – $90,000
• Deferred tax liability – $30,000 (1,20,000 -90,000)

Example #2

Calculate DTL from the following info.

Particulars	Books	Tax purpose
Revenue	10,00,000	8,00,000
Other expenses	5,00,000	5,00,000
Depreciation	1,00,000	1,00,000

Out of $2,00,000 difference in income. $1,00,000 is non-taxable

Inc. Tax rate is 30%

Solution:

Calculation of DTL is as follows –

Particulars	Books	Tax purpose	Affects DTL?
Revenue	10,00,000	8,00,000	Partially yes
Other expenses	5,00,000	5,00,000	No
Depreciation	1,00,000	2,00,000	No

Here, $1,00,000 is non-taxable i.e. a permanent difference. It will not create DTL while other 1 lakh will lead to creation of $30,000 DTL ($1,00,000 x 30%)

Effects of Deferred Tax Liability

Once the cause of deferred tax liability is understood, it is necessary to understand and forecast its effects that the business will bear in future operations. Deferred tax liability will have a powerful impact on the cash flow. With the increase in deferred tax liability, there is an inflow of cash, while on the other hand, with the decrease in deferred tax liability, there is an outflow of cash. Understanding and analysing the changes in deferred tax liabilities helps us to know the future trends of such balances. These trends are indicators of the type of business being carried on by the company. If the deferred tax liabilities are growing, it suggests that the business is capital intensive. Usually, it affects the working capital of the company. The creation of DTL means reduced cash outflow at present. While its reversal indicates increased cash outflow.

Deferred Tax Liability vs Deferred Tax Asset

When the timing difference leads to payment of additional taxes during a current financial year, it leads to the creation of deferred tax asset. As the name suggests, it will provide benefit in future in the form of reduced tax cash payments. These are created when the financial statements’ profits are lower than the profits reported in the taxable profits. The difference between the two will generate a need to create a deferred tax asset. These are reported under in the non-current asset section of the balance sheet. On the other hand, timing difference leading to reduced cash tax payment during the current financial year leads to the creation of deferred tax liabilities as taxes get accrued in the current period but are paid in the next period termed as deferred tax liability. These are created when the financial statements’ profits are more than the profit in the tax reports and reported under the non-current liability section of the balance sheet.

Advantages

Some of the advantages are given below:

• One of the major advantages of deferred tax liability is it leads to saving of current cash outflow. This, in turn, directly affects an entity’s working capital. Due to the time value of the money concept, any cash income received today or cash outflow deferred today will be better than receiving income/ processing payment in future at a later date.
• High deferred tax liabilities can denote a company being in capital building mode, i.e. increased capital expenditure as government offers higher tax benefits on the new plant, machinery procurements. This, in turn, have a favorable impact on investors mind as they will perceive the company as having high growth prospects in future and in turnstarts investing in the company. Such investments will lead to easier access to large funds at a cheaper cost.

Conclusion

Deferred tax liability can be defined as an obligation arising on companies due to timing differences in recording and recognizing certain income and expenses whereby taxable income is understated compared to books profits. Tax outflow during the current financial year will be low due to the low taxable income reported. In the upcoming accounting period, when such an item of income, expenses gets recognized, it leads to DTL’s reversal. While it’s an obligation to be settled in the future, it does offer certain benefits like a reduced working capital requirement. This is reported under the non-current liability section of the entity’s balance sheet.

Recommended Articles

This is a guide to Deferred Tax Liabilities. Here we also discuss the definition and how to create deferred tax liability? along with examples and advantages. You may also have a look at the following articles to learn more –

1. Deferred Tax Asset
2. Short Term Assets
3. Assets Example
4. Accounting Profit vs Economic Profit