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:

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

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

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

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

$$\text{Deferred tax liability}=\text{Taxable temporary difference}\times \text{Future enacted tax rate}$$

The taxable temporary difference is the amount by which accounting income exceeds taxable income in the current period. Multiplying it by the tax rate that will apply when the difference reverses gives the deferred tax liability.

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 treatment of deferred taxes.

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 result in deferred tax liabilities because the tax books are on a cash basis. These payments are not yet incurred in the accounting books, hence recognized as assets while recognized as expenses in the tax books.

Accounting for deferred tax liabilities

Deferred tax liabilities are computed as follows:

Taxable temporary difference	XX
Multiply: future enacted tax rate	%
Deferred tax liability	XX

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

The deferred tax liability computed above is booked as follows:

Account	Debit	Credit	Financial statement element
Deferred tax expense	XXX		Expense
Deferred tax liability		XXX	Liability
To record deferred tax liability

The company then has to follow the source of the deferred tax liability in the subsequent periods to ensure that any reversals of temporary difference are accounted for.

For example when the rent accrued in the accounting books in Year 1 was already collected in year 2, any deferred tax liabilities recorded on it from Year 1 should be reversed in year 2, as follows:

Account	Debit	Credit	Financial statement element
Deferred tax liability	XXX		Liability
Deferred tax expense		XXX	Expense
To record reversal of temporary differences recognized in prior year

Deferred tax liability example

Achievable Co. buys machinery for $150,000. The company is being depreciated for 5 years for accounting purposes while 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

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.