Deferred Tax Liability Definition: How It Works With Examples

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Deferred Tax Liability Definition: How It Works With Examples

What Is a Deferred Tax Liability?

A deferred tax obligation is a balance-sheet entry that represents taxes that are owing but are not required to be paid until a later date.

The obligation is postponed owing to a time gap between when the tax was incurred and when it is required to be paid. It may, for example, depict a taxable transaction, such as an installment sale, that occurred on a certain day but the taxes will not be payable until a later date.

Key Takeaways

  • A deferred tax liability is a commitment to pay future taxes.
  • The requirement arises when a firm or person postpones an occurrence that would otherwise necessitate the recognition of tax costs in the current period.
  • Earning returns in a qualified retirement plan, such as a 401(k), for example, reflects a deferred tax burden since the retirement saver will have to pay taxes on the saved income and profits upon release.

How Deferred Tax Liability Works

A firm’s deferred tax obligation on its balance sheet signifies a future tax payment that the company is required to make.

It is calculated by multiplying the anticipated tax rate by the difference between the company’s taxable income and accounting earnings before taxes.

Deferred tax obligation is the amount of taxes that a corporation “underpaid” that will be made up later. This does not imply that the corporation has not met its tax responsibilities. Rather, it acknowledges a payment that has not yet been made.

For example, a corporation with net income for the year is aware that it must pay corporate income taxes. Because the tax due is for the current fiscal year, it must include a cost for the same time period. However, the tax will not be paid until the next calendar year. Tax is recorded as a deferred tax obligation to correct the accrual/cash timing disparity.

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Examples of Deferred Tax Liability

The disparity in depreciation expenditure classification under tax legislation and accounting standards is a typical source of deferred tax obligation.

Depreciation expenditure for long-lived assets is normally computed using a straight-line technique for financial statement purposes, however tax restrictions enable corporations to utilize an accelerated depreciation method. Because the straight-line technique yields less depreciation than the accelerated method, a company’s accounting income is momentarily greater than its taxable income.

The difference between the company’s accounting profits before taxes and taxable income is used to calculate the deferred tax obligation. As the corporation continues to depreciate its assets, the gap between straight-line and accelerated depreciation closes, and the amount of deferred tax obligation is steadily reduced via a series of offsetting accounting entries.

Installment Sales

An installment sale is another typical source of deferred tax burden. This is the income reported when a corporation sells its items on credit with the intention of repaying it in equal installments in the future.

Accounting regulations enable the corporation to recognize full revenue from the installment sale of general products, however tax laws require the income to be recognized when installment payments are received.

As a result, the corporation has a temporary positive difference between its accounting profits and taxable income, as well as a deferred tax obligation.

Is Deferred Tax Liability a Good or Bad Thing?

A record of taxes incurred but not yet paid is known as deferred tax obligation. This balance-sheet line item sets aside money for a predicted future cost.

This diminishes a company’s available cash flow, which isn’t always a negative thing. The funds have been designated for a particular purpose, namely the payment of taxes owed by the corporation. If the money is spent on anything else, the firm may be in jeopardy.

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What Is an Example of Deferred Tax Liability?

A delayed tax obligation develops when regular corporate accounting principles deviate from the government’s accounting techniques. Fixed asset depreciation is a frequent example.

Companies often use a straight-line depreciation approach to disclose depreciation in their financial accounts. Essentially, this depreciates the item equally over time.

However, for tax reasons, the corporation will employ accelerated depreciation. The asset depreciates at a faster pace in its early years when this strategy is used. A corporation may record $100 in straight-line depreciation in its financial statements vs $200 in accelerated depreciation in its tax books. As a result, the deferred tax obligation would be equivalent to $100 multiplied by the company’s tax rate.

How Is Deferred Tax Liability Calculated?

A corporation may offer a piece of furniture for $1,000 plus 20% sales tax, with the consumer paying in monthly payments. This will be paid over two years by the consumer ($500 + $500).

The corporation will report a $1,000 sale in its financial records.

It will be reflected in its tax records as $500 every year for two years.

The deferred tax liability would be $500 x 20% = $100.

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