Deferred Tax Liability & How to Calculate: Meaning, Example, & Formula
If you are a business owner, then it is paramount for you to know what deferred tax liability is. In this article, we will talk about deferred tax liability. We will start with deferred tax liability meaning and the reasons by which deferred tax liability is created. Then we will look at the deferred tax liability formula. Then we will look at the difference between deferred tax liability and deferred tax asset. Then we will discuss a deferred tax liability example to help clarify the concept and end by understanding if it's a good thing.
What Is A Deferred Tax Liability?
The corporation is left with an obligation known as deferred tax obligation when taxes become due and are not paid within one accounting period. The difference in timing between the tax accrual date and the day the payments are made to the tax authorities causes this burden.
In other words, the tax liability must be carried forward to the following year to account for any taxes not paid in the current year if a business must pay taxes for a financial transaction that hasn't yet been finished.
In short, a deferred tax liability develops when a corporation and the tax department take opposite stances on accounting financial events. Such a financial obligation, however, first manifests itself in the profit and loss account before being reflected on a company's balance sheet.
Reasons That Lead To The Creation Of Deferred Tax Liability
- Businesses typically transfer present gains into the future, intending to pay fewer taxes. Doing this causes deferred tax liability for the company. This makes it possible to invest more money rather than paying taxes to the government.
- Specific revenue and expenses are recorded in the income statement but aren't included on the tax return, or vice versa; according to the principle of the timing of revenue and expense recognition in the income statement and tax return, we can see the formation of a deferred tax liability.
- Double-counting the numbers can lead to deferred tax liability. For instance, most corporations maintain numerous versions of their financial statements for internal use and distribution to the public and tax authorities. This is especially true since important concepts like revenue, expense, and asset depreciation differ significantly between the tax code and accepted accounting principles.
Deferred Tax Liability Formula
Income Tax Expense= taxes payable + Deferred Tax Liability – Deferred Tax Asset
Deferred Tax Liability Formula = Income Tax Expense – Taxes Payable + Deferred Tax Assets
Calculation Of DTL
A deferred tax liability can be manually estimated by identifying approaches that are handled differently by a corporation and the tax agency. A discrepancy between the two financial reports is produced via these routes, leading to a deferred tax liability. Additionally, it should be emphasized that the appropriate deferred tax rate is based on the difference between the tax liabilities shown in the two financial reports rather than a different rate.
Difference Between Deferred Tax Liability And Deferred Tax Asset
The discrepancy between what a firm can deduct as tax and the tax present for accounting purposes is known as deferred tax liability. A corporation may have to pay more income tax in the future due to a current transaction if it has a deferred tax liability.
A deferred tax asset is any asset that lowers the corporation's future tax obligations. On the other hand, deferred tax assets show up when taxes have already been paid or carried forward but have not yet been reflected on the income statement. The value of deferred tax assets is determined using the distinction between book and taxable income. For instance, deferred tax may arise if the tax authority records revenue or expenses at a different period than an accounting standard requires.
Example Of Deferred Tax Liability
Let's use the mobile phone manufacturing company XYZ as an example. The business XYZ thinks Rs. 60,000 manufacturing machines will last three years and pays a 30% profit tax. Nonetheless, the annual depreciation of Rs. 20,000 for the following three years would be included in the regular financial accounting. As a result, income is lowered by Rs. 20,000, and taxes are cut by Rs. 6,000 each year.
But let's say that the tax accounting permits depreciation in such a way that the first year's depreciation is Rs. 30,000, the second year is Rs. 20,000, and the third year is Rs. 10,000. The corporation can deduct Rs. 30,000 in the first year, giving it a tax savings of Rs. 9000.
Even though doing so results in a tax liability of:
Rs. 9,000 – Rs. 6,000
(the tax that the corporation should have paid based on accounting) – Rs (the tax that it paid).
A deferred tax liability of Rs. 3,000 has been produced in this scenario. The business must make up for this liability in its upcoming tax-related operations.
Is Deferred Tax Liability A Good Or Bad Thing?
Taxes accrued but not yet paid are listed as deferred tax liabilities. This balance sheet line item sets aside funds for an anticipated future expense. This lowers a company's available cash flow, which is not necessarily bad. The funds have been set aside for paying the company's outstanding taxes. It can become problematic if the corporation uses the money for something else.
To sum up, the deferred tax liability is produced when taxable income (as reported on the tax return) is less than pre-tax income (as noted on the income statement). The discrepancy is anticipated to reverse in subsequent years. DTL is most frequently produced when the income statement uses straight-line depreciation and the tax return uses the accelerated depreciation technique. DTL will result in future financial outflows when the taxes are paid.