Deferred Tax Liability

A deferred tax liability is a liability recognized when tax paid in current period is lower that tax that would be payable if calculated under accrual basis. It arises when tax accounting rules defer recognition of income or advance recognition of an expense resulting in a decrease in taxable income in current period that would reverse in future.

Financial statements are prepared in accordance with accounting standards but income tax payable is worked out based on income tax rules of the tax authorities such as IRS. There exists many differences in the accounting principles and tax rules. First, there are income items which are exempt from tax such as interest on municipal bonds, etc. Second, there are expense items which are not allowed as deduction such as fines, etc. These two differences are called permanent differences i.e. these are the differences between accounting and tax rules which will always exist. Third and the most important difference is the timing difference in recognition of income or expense items. For example, income tax rules allow depreciation expense under the MACRS method, which is an accelerated depreciation method, but many corporations charge depreciation on straight-line method for accounting purpose. This third type of differences are called temporary differences.

Example

Your company’s EBITDA is $25 million, tax-exempt interest income is $1 million and depreciation expense under straight-line method is $3 million. EBITDA worked out using tax laws is also $25 million. However, it allows depreciation expense of $5 million as a deduction. Assume, a tax rate of 40%.

Your income before tax under financial accounting rules is $23 million (i.e. EBITDA of $25 million + tax-exempt interest expense of $1 million – depreciation of $3 million). Your financial accounting income on which income tax shall apply is $22 million i.e. after removal of exempt income. If you apply the 40% tax rate, your income tax obligation under matching concept and accrual basis equal $8.8 million (i.e. $22 million multiplied by 40%). Your taxable income i.e. the amount at which you have to pay the corporate tax is $20 million (i.e. EBITDA of $25 million - $5 million of MACRS depreciation). Your income tax payable worked out using tax rules amounts to $8 million (i.e. $20 million multiplied by 40%).

Due to generosity of tax rules, your income tax payable current year is lower by $0.8 million because they allowed you higher deduction on account of depreciation expense. However, this won’t last long because cost of asset is the same for both financial accounting and tax accounting. In future periods, the taxable income will be higher because MACRS depreciation will be lower than the straight-line depreciation. This would result in income tax payable to be higher than the income tax that applies under accrual basis. Recognition of deferred tax liability in current period helps us match the future tax obligation that results from financial accounting transactions that occurred today.

Journal entries

The deferred tax liability would be recognized using the following journal entry:

Account Dr Cr
Income tax expense $8,800,000
Income tax payable $8,000,000
Deferred tax liability $800,000

In future periods, when the deferred tax liability would be used up, the following journal entry needs to be posted:

Account Dr Cr
Deferred tax liability $800,000
Income tax expense $800,000

Written by Obaidullah Jan, ACA, CFA and last modified on