What Is a Deferred Tax Liability?
A deferred tax liability is an entry on a company’s balance sheet that reflects taxes which are owed but not yet due for payment. This liability occurs due to a timing difference between the accrual of the tax and its actual payment.
For instance, imagine a sale conducted on an installment basis where the taxes won’t be due until a future date. This creates a difference in tax recording and actual payment date.
Key Takeaways:
- A deferred tax liability indicates a future obligation to pay taxes.
- This liability arises when events that generate taxes are deferred to future periods.
- An example includes earnings on investment accounts like a 401(k), where taxes are due upon withdrawal.
How Deferred Tax Liability Works
Deferred tax liability represents a future tax commitment on a company’s balance sheet. It is calculated based on the company’s anticipated tax rate and the difference between taxable income and accounting earnings before taxes.
Although it appears that such companies have “underpaid” their taxes, this isn’t the case. They simply acknowledge a payment not yet due.
Take, for instance, a company that generates net income in a certain year, knowing it will eventually owe corporate income taxes. Even though the tax liability applies to the current year, the payment occurs in the following year. Thus, the tax expense is recorded as a deferred liability to bridge the timing gap.
Examples of Deferred Tax Liability
Depreciation Differences:
Deferred tax liabilities often stem from different depreciation treatments under tax laws versus accounting rules. For long-lived assets, financial statements might use a straight-line depreciation method, while tax returns can use an accelerated method. This leads to higher accounting profits and creates a deferred tax liability until the accelerated method catches up.
Imagine a company using $100 straight-line depreciation in financial statements compared to $200 accelerated depreciation for tax purposes. The deferred tax liability would be $100 x the company’s tax rate.
Installment Sales:
Another source is installment sales, where revenue is recognized on the sale of items paid over time. Financial statements allow recognizing full income upfront, while tax laws recognize income as installment payments are received. This timing difference creates a deferred tax liability.
Is Deferred Tax Liability a Good or Bad Thing?
A deferred tax liability demonstrates reserved funds for future tax payments, affecting a company’s available spending cash. However, this reserve ensures the company meets tax obligations rather than presenting an immediate financial concern, unless misused for other expenditures.
Calculation Example of Deferred Tax Liability
Consider a case where a company sells furniture for $1,000 plus 20% sales tax, payable in installments over two years. Financial records would show the entire $1,000 sale immediately, whereas tax records would split it into two $500 yearly installments, leading to a deferred tax liability of $500 x 20% = $100 each year.
Related Terms: installment sale, depreciation, net income, financial statements.
References
- U.S. Securities and Exchange Commission. “Traditional and Roth 401(k) Plans”.
- Financial Accounting Standards. “Summary of Statement No. 109”.
- Internal Revenue Service. “Business Taxes”.
- Internal Revenue Service. “Publication 537 (2020), Installment Sales”.
