Deferred Tax Liability Accounting

A deferred tax liability is a liability to future income tax. For any given accounting period the amount of income a business is taxed on is set out in its tax return, and is based on rules established by the tax authorities. This income is not necessarily the same as the accounting income shown in the financial statements of the business which have been prepared under GAAP rules.

When it is anticipated that future taxable income will be greater than future accounting income as a result of temporary timing differences, the business needs to account for this potential liability and does so under the heading of deferred tax liabilities.

Temporary and Permanent Differences

Differences between taxable income and accounting income can be either temporary or permanent, only temporary differences affect the deferred tax liability.

Temporary Timing Differences

Temporary timing differences always reverse in some future accounting period and therefore can create a situation where future taxable income is greater than future accounting income. This temporary nature creates the need to provide for a future tax liability referred to as a deferred tax liability, as payment is deferred until some future period.

Permanent Timing Differences

Permanent differences never reverse and therefore only affect the current accounting period. Since they do not impact future accounting periods they do not have any impact on deferred tax liabilities. For example, an expense which is not allowable for tax purposes but is included in the financial statements, would create a situation where the taxable income is greater than the accounting income resulting is an higher tax expense. Since the expense will always be non-allowable the situation would never reverse and the permanent difference will not impact deferred tax.

Deferred Tax Calculation Example

To see the effect of temporary timing differences on the calculation of the deferred tax liability consider the following example. Suppose a business purchases equipment at a cost of 4,000 which is subject to the following tax depreciation and book depreciation rates.

The particular values are not relevant here, the purpose is to show that there is a difference between how the tax authorities calculate depreciation (allowances) and how the financial statements include depreciation.

Tax depreciation v Book depreciation
Tax Dep. Book Dep.
Year 1 1,600 1,000
Year 2 1,200 1,000
Year 3 720 1,000
Year 4 480 1,000
Total 4,000 4,000

For the purposes of this example, the tax depreciation is the amount allowed under the tax authority rules, and the book depreciation is the amount of depreciation included in the financial statements using GAAP rules (in this case straight line depreciation over a 4 year useful life).

It should be noted that the cumulative depreciation over the 4 years is the same, totaling 4,000.

Consider now what happens in each of the four years.

Year 1 Deferred Tax Liability

In each year it is assumed that the business has income before depreciation and tax of 9,000, and that the tax rate remains at 25%.

The table below shows the difference in treatment between the calculations in the tax return submission and that in the accounts.

Year 1 – Deferred tax liability
Tax Return Accounts
Income 9,000 9,000
Depreciation 1,600 1,000
Pre-tax income 7,400 8,000
Income tax (25%) 1,850 2,000
Net income 5,550 6,000

The calculation shows that the tax for the year payable to the tax authorities is 1,850 which is lower than the tax expense shown on the financial statements of 2,000. The difference of 150 arises from the fact that the tax depreciation is 600 higher than the book depreciation, as shown below.

Tax depreciation = 1,600
Book depreciation = 1,000
Difference in depreciation = 1,600 - 1,000 = 600
Difference in tax = 25% x 600 = 150

The temporary timing difference of 150 is a tax liability which will need to be paid in the future as the timing differences will reverse (see years 3 and 4 below).

Deferred Tax Liability Journal Entry

The movement of 150 is accounted for as a deferred tax liability with the following journal entry.

Deferred tax liability journal entry
Account Debit Credit
Tax expense – current 1,850
Tax expense – deferred 150
Income tax payable 1,850
Deferred tax liability 150
Total 2,000 2,000

The income tax payable account has a balance of 1,850 representing the current tax payable to the tax authorities. The balance on the deferred tax liability account is 150 representing the future liability of the business to pay tax on the income for the period.

The effect of accounting for the deferred tax liability is to apply the matching principle to the financial statements by ensuring that the tax expense (2,000) is matched against the pre-tax income for the accounting period (8,000) while still recognizing that only 1,850 is currently payable to the tax authorities.

It should be noted that the tax expense shown in the accounts (2,000) is the total of the current tax (1,850) and the deferred tax (150).

Year 2 Deferred Tax Liability

The process continues with year 2. Again for simplicity assume the income before depreciation and tax is 9,000 and the tax rate 25%.

Year 2 – Deferred tax liability
Tax Return Accounts
Income 9,000 9,000
Depreciation 1,200 1,000
Pre-tax income 7,800 8,000
Income tax expense 1,950 2,000
Net income 5,850 6,000

The calculation shows that the current tax payable to the tax authorities is 1,950, which is lower than the tax expense shown on the financial statements of 2,000. The difference of 50 arises from the fact that the tax depreciation is 200 higher than the book depreciation, as shown below.

Tax depreciation = 1,200
Book depreciation = 1,000
Difference in depreciation = 1,200 - 1,000 = 200
Difference in tax = 25% x 200 = 50

The temporary timing difference of 50 is a tax liability which will need to be paid in the future as the timing differences reverse (see years 3 and 4 below).

Deferred Tax Liability Journal Entry

The movement of 50 is accounted for as a deferred tax liability with the following journal entry.

Deferred tax liability journal entry
Account Debit Credit
Tax expense – current 1,950
Tax expense – deferred 50
Income tax payable 1,950
Deferred tax liability 50
Total 2,000 2,000

The income tax payable account has a balance of 1,950 representing the current tax payable to the tax authorities.

The balance on the deferred tax liability account is now 200, which is the beginning balance from year 1 (150) plus the movement for the year (50). This balance represents the cumulative difference between the tax depreciation and the book depreciation calculated as follows.

Cumulative tax depreciation = 1,600 + 1,200 = 2,800 
Cumulative book depreciation = 1,000 + 1,000 = 2,000
Difference in depreciation = 2,800 - 2,000 = 800
Difference in tax = 25% x 800 = 200

Year 3 Deferred Tax Liability

In year 3 the situation changes, the tax depreciation is now lower than the book depreciation and the temporary timing differences start to reverse. Again for simplicity assume the income before depreciation and tax is 9,000 and the tax rate 25%.

Year 3 – Deferred tax liability
Tax Return Accounts
Income 9,000 9,000
Depreciation 720 1,000
Pre-tax income 8,280 8,000
Income tax expense 2,070 2,000
Net income 6,210 6,000

The calculation shows that the current tax payable to the tax authorities is 2,070, which is higher than the tax expense shown on the financial statements of 2,000. The difference of 70 arises from the fact that tax depreciation is 280 lower than the book depreciation, as shown below.

Tax depreciation = 720
Book depreciation = 1,000
Difference in depreciation = 720 - 1,000 = -280
Difference in tax = 25% x -280 = -70

The temporary timing differences which created the deferred tax liabilities in years 1 and 2 are partially reversed in year 3 as the book depreciation is now higher than the tax depreciation.

Deferred Tax Liability Journal Entry

The movement of -70 is accounted for as a reduction in the deferred tax liability with the following journal.

Deferred tax liability journal entry
Account Debit Credit
Tax expense – current 2,070
Tax expense – deferred 70
Income tax payable 2,070
Deferred tax liability 70
Total 2,140 2,140

The income tax payable account has a balance of 2,070 representing the current tax payable to the tax authorities.

The balance on the deferred tax liability account is now 130, which is the beginning balance from year 2 (200) less the movement for the year (-70). This balance represents the cumulative difference between the tax depreciation and the book depreciation calculated as follows.

Cumulative tax depreciation = 1,600 + 1,200 + 720 = 3,520 
Cumulative book depreciation = 1,000 + 1,000 + 1,000 = 3,000
Difference in depreciation = 3,520 - 3,000 = 520
Difference in tax = 25% x 520 = 130

Year 4 Deferred Tax Liability

Finally, in year 4 the reversal of the temporary timing differences is completed. Again for simplicity assume the income before depreciation and tax is 9,000 and the tax rate 25%.

Year 4 – Deferred tax liability
Tax Return Accounts
Income 9,000 9,000
Depreciation 480 1,000
Pre-tax income 8,520 8,000
Income tax expense 2,130 2,000
Net income 6,390 6,000

The calculation shows that the current tax payable to the tax authorities is 2,130, which is again higher than the tax expense shown on the financial statements of 2,000. The difference of 130 arises from the fact that the tax depreciation is 520 lower than the book depreciation, as shown below.

Tax depreciation = 480
Book depreciation = 1,000
Difference in depreciation = 480 - 1,000 = -520
Difference in tax = 25% x -520 = -130

The temporary timing differences which created the deferred tax liabilities in years 1 and 2 continue to be reversed in year 4 as the book depreciation is again higher than the tax depreciation.

Deferred Tax Liability Journal Entry

The movement of -130 is accounted for as a reduction in the deferred tax liability with the following journal.

Deferred tax liability journal entry
Account Debit Credit
Tax expense – current 2,130
Tax expense – deferred 130
Income tax payable 2,130
Deferred tax liability 130
Total 2,260 2,260

The income tax payable account has a balance of 2,130 representing the current tax payable to the tax authorities.

The balance on the deferred tax liability account is now zero, which is the beginning balance from year 3 (130) less the movement for the year (-130). This balance represents the cumulative difference between the tax depreciation and the book depreciation calculated as follows.

Cumulative tax depreciation = 1,600 + 1,200 + 720 + 480 = 4,000
Cumulative book depreciation = 1,000 + 1,000 + 1,000 + 1,000 = 4,000
Difference in depreciation = 4,000 - 4,000 = 0
Difference in tax = 25% x 0 = 0

The deferred tax liability account now has a balance of zero as all of the temporary timing differences have reversed and there is no future liability for the business to pay.

Total Tax Payable

It should be noted that the timing differences are temporary, in this example the total tax expense of the business over the 4 years (8,000) is the same using both the tax return calculations and the accounts calculations. This is demonstrated in the table below.

Tax expense comparison
Tax Return Accounts
Year 1 1,850 2,000
Year 2 1,950 2,000
Year 3 2,070 2,000
Year 4 2,130 2,000
Total 8,000 8,000

The deferred tax liability is normally shown as a long term liability on the balance sheet of the business.

Deferred Tax Liability Accounting June 2nd, 2017Team

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