What is a deferred tax liability (DTL)?
A deferred tax liability is an amount shown on a company’s balance sheet that represents taxes the company will owe in the future because of temporary timing differences between accounting rules and tax rules. It does not mean the company avoided taxes; it means recognition (for accounting) and payment (to tax authorities) occur in different periods.
Key concept and simple formula
– Temporary difference: the amount by which pre-tax accounting income differs from taxable income for a period because of different timing rules (not permanent differences like fines or tax-exempt income).
– Basic formula (single-period view):
Deferred tax liability = statutory tax rate × (Accounting income before tax − Taxable income)
This assumes accounting income > taxable income (if taxable income > accounting income the result may be a deferred tax asset instead).
Why DTLs arise (common causes)
– Differences in depreciation methods: accounting often uses straight-line depreciation; tax rules may allow accelerated depreciation. Accelerated tax depreciation lowers taxable income today and raises it later, creating a DTL.
– Installment sales: under accounting rules revenue may be recognized when goods are delivered, but tax law may recognize income when cash is received.
– Revenue recognition timing: advances, long-term contracts, and other timing mismatches.
– Other temporary differences created by timing differences for allowances, reserves, or tax carryforwards (when they reverse into taxable income).
How they are recorded (high level)
– When accounting tax expense for the period is higher than current tax payable, the difference is recorded as a deferred tax liability.
– Typical journal entry (when accounting tax expense > current tax payable):
Debit Income Tax Expense
Credit Current Tax Payable (amount actually due now)
Credit Deferred Tax Liability (difference)
Worked numeric example (installment sale)
Assumptions
– Company sells furniture for $1,000 (recognized in accounting income this year).
– Customer will pay $500 this year and $500 next year (tax law recognizes income when cash is received).
– Statutory tax rate = 20%.
Step-by-step
1. Accounting income this year (before tax): $1,000.
2. Taxable income this year (cash received): $500.
3. Temporary difference = Accounting income − Taxable income = $1,000 − $500 = $500.
4. Deferred tax liability = 20% × $500 = $100.
Income tax accounting for the year
– Accounting tax expense = 20% × $1,000 = $200.
– Current tax payable = 20% × $500 = $100.
– The company records: debit Income Tax Expense $200; credit Current Tax Payable $100; credit Deferred Tax Liability $100.
– Next year, when the $500 cash is received and becomes taxable, the deferred tax liability is reduced (reversed) as the tax payable increases.
Is a deferred tax liability “good” or “bad”?
– Neutral: a DTL is neither inherently good nor bad. It simply reflects timing differences in when income or deductions are reported for accounting versus tax purposes.
– Practical implications:
– Cash timing: a DTL signals that the company will face higher tax cash outflows in the future (when the temporary difference reverses).
– Analysis: investors should not treat DTL as immediately available cash. Large or growing DTLs merit review of the underlying causes and expected reversal timing.
– Transparency: examine footnotes—they
they should disclose the origin of the timing differences, the enacted tax rate used to measure the liability, and the expected reversal period. Good footnotes also state whether deferred taxes are presented as current or noncurrent and explain any significant changes from prior periods.
How deferred tax liabilities are measured (short version)
– Temporary difference = Book (accounting) basis of an asset or liability minus its tax basis. A temporary difference reverses over time and creates future taxable amounts.
– DTL = Temporary difference × Enacted future tax rate. Use the tax rate expected to apply when the difference reverses.
– If a tax rate is changed by law before the reversal, update the DTL and book a one‑time adjustment to income.
Worked example — depreciation timing
Assumptions:
– Company buys equipment with cost $1,000.
– Accounting (book) depreciation: straight‑line over 5 years → $200/year.
– Tax depreciation: accelerated, $600 in year 1, remaining $400 over later years.
– Enacted tax rate: 25%.
Year 1:
– Book expense = $200 → accounting profit includes $200.
– Tax expense (taxable deduction) = $600 → taxable income lower by $400 compared with book income.
– Temporary difference (book basis − tax basis) at year end = $1,000 − (tax basis after deduction) ??? Simpler: the amount by which tax expense differs = $400.
– DTL = $400 × 25% = $100.
Journal entries (simplified):
1) To record current tax payable when tax return shows taxable income:
Dr. Income tax expense (current) $150
Cr. Income taxes payable $150
(Numbers depend on full income; here illustrative.)
2) To record deferred tax arising from timing difference:
Dr. Income tax expense (deferred) $100
Cr. Deferred tax liability $100
What happens later
– In later years, tax depreciation falls below book depreciation. The temporary difference reverses (taxable income > book income), producing higher current tax payable. The deferred tax liability is reduced (Dr. Deferred tax liability, Cr. Income tax expense or Income taxes payable depending on timing).
Example: tax law change
If the enacted tax rate falls to 20% while a $400 temporary difference still exists, remeasure the DTL: $400 × 20% = $80. A $20 tax benefit is recorded immediately (Dr. Deferred tax liability $20; Cr. Income tax expense $20). The remeasurement reflects law in force at the reporting date.
Presentation differences (GAAP vs IFRS)
– U.S. GAAP (ASC 740): deferred tax liabilities and assets are generally presented as noncurrent on the balance sheet.
– IFRS (IAS 12): deferred tax is
: presented as noncurrent on the statement of financial position as well. Both frameworks therefore put deferred tax outside current assets/liabilities, but they differ in certain recognition, measurement and disclosure rules.
Key practical differences and rules (concise)
– Initial-recognition exception. If a temporary difference arises on initial recognition of an asset or liability in a transaction that (a) is not a business combination and (b) does not affect taxable profit (or tax loss) at that time, neither GAAP nor IFRS recognizes deferred tax for that difference. Record deferred tax for other temporary differences.
– Valuation/allowance for deferred tax assets (DTAs). Under U.S. GAAP (ASC 740) a valuation allowance is recorded if it is “more likely than not” (greater than 50% probability) that some portion or all of the DTA will not be realized. Under IFRS (IAS 12) an entity recognizes a DTA only to the extent that it is probable that future taxable profits will be available against which the deductible temporary differences can be utilized. Practical consequence: both require future-profit assessments, but the specific wording and judgment practices differ.
– Offsetting (net presentation). Both frameworks allow offsetting deferred tax assets and liabilities only when they relate to the same taxable entity and the same taxation authority and when there is a legally enforceable right to set off (practical effect: you generally cannot net between jurisdictions).
– Taxes on undistributed earnings of subsidiaries. IFRS generally recognizes deferred tax for temporary differences related to investments in subsidiaries, associates and joint ventures unless the parent can control the timing of the reversal and it is probable the difference will not reverse in the foreseeable future. U.S. GAAP requires a similar assessment of
U.S. GAAP requires a similar assessment of whether undistributed earnings of subsidiaries should give rise to deferred tax liabilities, but the mechanics and evidence thresholds differ from IFRS. Under both frameworks the key question is whether the parent company can control the timing of any repatriation and whether the earnings are expected to be remitted (reverse the temporary difference) in the foreseeable future. In practice:
– Under IFRS (IAS 12), a deferred tax liability for an investment in a subsidiary, associate or joint venture is recognized for all temporary differences except when the parent can control the timing of the reversal and it is probable (more likely than not) that the difference will not reverse in the foreseeable future.
– Under U.S. GAAP (ASC 740), an entity must evaluate whether earnings of a foreign subsidiary are indefinitely reinvested. If management asserts—and can support with evidence—that undistributed earnings will be indefinitely reinvested, no deferred tax liability is recognized. If the assertion is not supported, a DTL is recognized.
Key practical differences to keep in mind
– Burden of proof: U.S. GAAP places emphasis on the entity’s assertion plus persuasive evidence of indefinite reinvestment. IFRS emphasizes the probability assessment that reversal will not occur.
– Evidence and documentation: Under U.S. GAAP, companies commonly document dividend policy, capital requirements, local law or regulatory restrictions, and business plans to support an indefinite-reinvestment assertion.
– Measurement: Both frameworks measure deferred taxes using enacted tax rates expected to apply at reversal. Changes in tax law affect measurement when enacted.
Checklist: evaluating whether to recognize deferred tax for undistributed earnings
1. Identify temporary difference: compute book basis of investment minus tax basis of investment.
2. Determine applicable enacted tax rate(s) for jurisdiction(s) where tax would be payable.
3. Assess control and intent:
– Can the parent control timing of distribution? (legal, contractual restrictions)
– Is it probable (IFRS) or supportable by evidence (U.S. GAAP) that earnings
will be distributed to the parent or otherwise become taxable on reversal?
– Consider the subsidiary’s dividend policy, cash needs, regulatory or contractual restrictions, and any board resolutions.
– Evaluate intercompany loan and legal arrangements that might limit or permit repatriation.
4. Estimate timing: when would a distribution (or other taxable event) realistically occur? Timing affects which enacted tax rate applies and whether a DTL is measured now.
5. Compute the liability if recognition is required: temporary difference × enacted tax rate expected at reversal (see Measurement below).
6. Document the conclusion and supporting evidence in the tax footnote.
Measurement and accounting — quick rules
– Definition (recap): a deferred
tax liability (DTL) is the tax that will become payable in the future because the carrying amount of an asset or liability in the financial statements exceeds its tax base. In practice, you compute a DTL only for taxable temporary differences — amounts that will increase taxable income when the carrying amount is recovered or the liability is settled.
Measurement — the rule of thumb
– Amount to record: temporary difference × enacted tax rate expected to apply when reversal occurs.
– “Temporary difference” = carrying amount (book value) − tax base. A positive result that will produce future taxable amounts creates a DTL.
– Use the tax rate that is enacted (or substantively enacted under IFRS) for the period(s) when the temporary difference reverses. If tax law changes, remeasure the DTL prospectively and recognize the effect in profit or loss except when the underlying item is recorded in other comprehensive income (OCI); then the tax remeasurement also goes to OCI.
Worked numeric example (fixed asset)
– Cost of plant asset: $100,000.
– Financial reporting (book) depreciation: straight-line over 5 years = $20,000 per year.
– Tax depreciation: accelerated; year 1 deduction = $40,000.
– End of year 1:
– Carrying amount (book) = 100,000 − 20,000 = 80,000.
– Tax base = 100,000 − 40,000 = 60,000.
– Temporary difference = 80,000 − 60,000 = 20,000 (taxable temporary difference).
– If the enacted tax rate expected on reversal is 25%: DTL = 20,000 × 25% = $5,000.
– Typical journal entry at year end to record deferred effect:
– Debit Income Tax Expense (Deferred) $5