Deferred tax liabilities

A deferred tax liability arises from a taxable temporary difference - either when accounting revenue is recognized before it becomes taxable, or when an expense is deducted for tax purposes before it’s recognized in the accounting books:

$$\text{Accounting revenues}>\text{Tax revenues}$$

$$\text{Accounting expense}<\text{Tax-deductible expense}$$

In both cases, current accounting net income ends up higher than current taxable income:

$$\text{Accounting net income}>\text{Taxable income}$$

$$\text{Deferred tax liability (balance)}=\text{Cumulative taxable temporary difference}\times \text{Future enacted tax rate}$$

$$\text{Deferred tax expense (current period)}=\text{Current period’s temporary difference}\times \text{Future enacted tax rate}$$

More generally, deferred tax expense equals the change in the DTL balance during the period; if a new tax rate is enacted, the existing balance is remeasured at that rate.

DTL vs. DTA: A deferred tax liability arises when a taxable temporary difference makes accounting income higher than taxable income in the current period, meaning more tax will be owed in a future period. When accounting income is lower than taxable income instead, the result is a deferred tax asset (covered in the next chapter). This chapter follows US GAAP: both US GAAP and IFRS classify deferred tax balances as noncurrent, but IFRS recognizes a deferred tax asset only when it’s probable that future taxable profit will be available to use it, while US GAAP recognizes the asset in full and then reduces it with a valuation allowance if realization isn’t more likely than not.

Examples of deferred tax liabilities

Examples of situations leading to the recognition of deferred tax liabilities are as follows:

Income recognized in accounting income but not in taxable income

1. Investments in equity securities that are accounted for under equity method. Any undistributed earnings are included in accounting income in advance of the actual distribution to the parent which results in higher revenues in accounting.

2. Accrued rent that is recognized as an accounting income due to the straight-lining of rent, while the cash payment was received at a subsequent period. It will be included in the tax income on a cash basis which can result in higher net income during the year of accruals.

3. Investments recognized at fair value that are revalued at fair value at the end of the period have unrealized holding gains that are not yet taxable until its actual disposal.

Expenses deducted in taxable income but not in accounting income

1. The use of accelerated depreciation methods on PPE (for example SYD and the double declining balance) in the taxable income, can result in higher depreciation expense in the tax books compared to the accounting books that use the straight-line method. This results in deferred tax liabilities being recognized at the earlier years of the asset when the depreciation expenses are higher.

2. Prepaid expenses can result in deferred tax liabilities because tax rules may allow the deduction when the payment is made, while for accounting purposes the payment is capitalized as an asset and expensed over time as it’s incurred.

Accounting for deferred tax liabilities

The taxable temporary difference can be computed in different ways depending on its source (i.e., rent, depreciation, etc.), but it is generally the difference between the amount of income or expense recognized under accounting compared to the amount recognized for tax purposes.

Total income tax expense on the income statement equals current tax expense (taxable income × current rate, recorded as income taxes payable) plus deferred tax expense. Under US GAAP, deferred tax liabilities are classified as noncurrent on the balance sheet.

Permanent differences - such as municipal bond interest or fines, which are never taxable or deductible - don’t reverse in a future period, so they create no deferred tax at all; they only affect the current period’s tax calculation.

The company then has to track any reversals of temporary difference in later periods - for example, rent accrued in the accounting books in Year 1 but collected in cash in Year 2 causes the related deferred tax liability to reverse in Year 2. The worked example below shows this reversal pattern in Years 4 and 5.

Deferred tax liability example

Achievable Co. buys machinery for $150,000. The machinery is depreciated straight-line over 5 years for accounting purposes and over 3 years for tax purposes. The tax rate is 20%.

Solution

You’ll notice that tax rules often allow assets to be depreciated over a shorter life for tax purposes than for accounting purposes (or use an accelerated method like double-declining balance). Either approach front-loads the tax depreciation expense, so the resulting temporary difference creates a deferred tax liability because the accounting income is higher than taxable income in the early years, when tax depreciation exceeds book depreciation.

The best way to determine the deferred tax impact of transactions with multiple years of tax impact would be to summarize the differences between the accounting income and tax income for all years affected like how we did below:

	Year 1	Year 2	Year 3	Year 4	Year 5
Accounting depreciation: Straight-line (5 years)	$30,000	$30,000	$30,000	$30,000	$30,000
Tax depreciation: Straight-line (3 years, shorter tax life)	$50,000	$50,000	$50,000	-	-
Difference in depreciation expense	($20,000)	($20,000)	($20,000)	$30,000	$30,000
Temporary difference: Accounting income is higher (lower) compared to tax income by:	$20,000	$20,000	$20,000	($30,000)	($30,000)
Multiply: Tax rate	20%	20%	20%	20%	20%
Deferred tax impact	$4,000	$4,000	$4,000	($6,000)	($6,000)

The same journal entry is recorded at the end of each of Year 1, Year 2, and Year 3, using that year’s $4,000 deferred tax impact:

Account	Debit	Credit	Financial statement element
Deferred tax expense	4,000		Expense
Deferred tax liability		4,000	Liability
To record deferred tax liability (recorded identically in years 1, 2, and 3)

For Year 4 and Year 5, the journal entry “writes off” part of the deferred tax liability previously booked, using each year’s $6,000 reversal:

Account	Debit	Credit	Financial statement element
Deferred tax liability	6,000		Liability
Deferred tax expense		6,000	Expense
To record reversal of deferred tax liability (recorded identically in years 4 and 5)

The balance of the deferred tax liabilities in the balance sheet at the end of each year would be as follows:

	Year 1	Year 2	Year 3	Year 4	Year 5
Deferred tax liability	$4,000	$8,000	$12,000	$6,000	$0

To see how the deferred piece fits into total income tax expense, consider Year 1 on its own. Assume Achievable Co.'s pretax accounting income for Year 1 is $100,000. Since tax depreciation exceeds book depreciation by $20,000, taxable income is $80,000. Current tax expense is $80,000 × 20% = $16,000, owed as income taxes payable. Adding Year 1’s $4,000 deferred tax expense gives total income tax expense of $20,000 - exactly 20% of the $100,000 pretax accounting income. The combined Year 1 entry is:

Account	Debit	Credit	Financial statement element
Income tax expense	20,000		Expense
Income taxes payable		16,000	Liability
Deferred tax liability		4,000	Liability
To record Year 1 total income tax expense

Ultimately, the deferred tax liabilities would result in zero as the differences recorded in the earlier years are reversed or realized into the taxable income. Questions on the exam could focus on different areas of the computation so it is best for candidates to know how to account for the deferred tax impact of transactions until the end of the transaction.