Updated July 15, 2023
Definition of Deferred Tax Liabilities
Deferred tax liability is the tax liability accrued during the current year. Still, it will be paid in subsequent years, which arises due to the difference 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). Certain P&L items create this difference, which may be either permanent or timing. The permanent difference does not lead to the creation of DTL. While timing difference leads to the creation of difference of the 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, leading to the creation of DTL. Being a liability in nature, it is certain that the company has an obligation for payment in the future. Therefore, DTL is the income tax payable in the future due to temporary differences that can be reversed in a subsequent period.
How Does It Work?
Certain expenses and incomes recognized in the company’s books of account will have different taxation treatments. At the same time, some income may be charged during the current year, while some may be charged in the future. Also, there are certain expenses (Depreciation being the most common) where exist different charging mechanisms. If any income is stated in books on which tax will be charged in the 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: –
- Total Company Revenue – $20,00,000
- Expenses (excluding depreciation) – $10,00,000
- 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 using 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 the 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 is recognized in books but not 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 later in books.
Examples of Deferred Tax Liability
Example #1
Ascertain Deferred tax, current tax expense, and tax payable liability from the following 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:
Calculation of Deferred tax liability is 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 the other 1 lakh will lead to the 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 the effects 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 analyzing 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 the company is carrying on. 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. In contrast, its reversal indicates increased cash outflow.
Deferred Tax Liability vs Deferred Tax Asset
When a timing difference causes the payment of additional taxes during a current financial year, it creates deferred tax assets. The deferred tax assets will provide benefits in the future by reducing tax cash payments. Companies create deferred tax assets when their financial statements show lower profits than taxable ones. The difference between the two amounts necessitates the creation of a deferred tax asset, which is then reported in the non-current asset section of the balance sheet. Conversely, when a timing difference leads to reduced cash tax payments in the current financial year, it gives rise to deferred tax liabilities. These liabilities occur when taxes are accrued in the current period but paid in the subsequent period. Deferred tax liabilities are created when the financial statements report higher profits than the taxable profits and are reported in the non-current liability section of the balance sheet.
Advantages
- 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 the 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 and machinery procurements. This, in turn, have a favorable impact on investors’ mind as they will perceive the company as having high growth prospects in the future and in turn, starts 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 reverses DTL. 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 a deferred tax liability. Along with examples and advantages. You may also have a look at the following articles to learn more –
