What are some examples of a deferred tax liability?

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What are some examples of a deferred tax liability?

In the United States, rules enable businesses to keep two sets of records for financial and tax reasons. Because the principles governing financial and tax accounting vary, there are transitory discrepancies between the two sets of accounts. This might result in deferred tax obligation if the amount of tax owing under tax accounting is less than the amount due under financial accounting. When depreciating fixed assets, recognizing revenues, and valuing inventory, deferred tax obligation often occurs.

Tax liabilities differences are merely transient mismatches between a reported amount of income and its tax basis: Accounting disparities occur when there are variations between taxable and pretax financial income, or when the bases of assets or liabilities vary for financial accounting and tax reasons. Money owed on current accounts receivable (AR), for example, cannot be taxed until it is collected, but the sale must be recorded in the current period.

Because these disparities are only transitory, and a corporation intends to settle its tax burden (and pay more taxes) in the future, a deferred tax liability is recorded. In other words, for taxes due in future years, a deferred tax obligation is recorded in the present quarter.

Common Situations

Depreciation of fixed assets is a typical occurrence that results in deferred tax obligation. Tax regulations permit the use of the modified accelerated cost recovery system (MACRS) depreciation technique, however most businesses utilize the straight-line depreciation method for financial reporting.

Deferred tax obligation is computed by subtracting the company’s taxable income from its account profits before taxes and multiplying the result by the estimated tax rate. Consider a corporation with a 30% tax rate that depreciates a $10,000 asset put in operation in 2015 over a 10-year period. The corporation records $1,000 of straight-line depreciation in its financial accounts and $1,800 MACRS depreciation in its tax books in the second year of the asset’s service. The $800 differential is a one-time difference that the corporation hopes to eradicate by year 10 and pay greater taxes after that. On its financial accounts, the corporation notes $240 ($800 30%) as a deferred tax obligation.

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Differences in revenue recognition give rise to deferred tax liabilities. Consider a corporation with a 30% tax rate that sells a $10,000 product but gets payments from its client in installments over the following five years – $2,000 each year. For financial accounting reasons, the firm recognizes the whole $10,000 income at the moment of sale, but for tax purposes, it only registers $2,000 based on the installment approach. This results in a $8,000 temporary discrepancy that the corporation hopes to liquidate during the following five years. The corporation records $2,400 ($8,000 × 30%) in deferred tax obligation on its financial accounts.

The tax legislation in the United States permits businesses to value their inventory using the last-in-first-out (LIFO) approach, while other businesses use the first-in-first-out (FIFO) technique for financial reporting. Temporary disparities between tax and financial accounts emerge during times of increased expenses and when the company’s inventory takes a long time to sell, resulting in deferred tax obligation.

Consider an oil firm with a 30% tax rate that produced 1,000 barrels of oil in year one at a cost of $10 per barrel. Due to increased labor expenses, the firm produced 1,000 barrels of oil at a cost of $15 per barrel in year two. If the oil business sells 1,000 barrels of oil in year two, it records a financial cost of $10,000 under FIFO and a tax cost of $15,000 under LIFO. The $5,000 is a one-time differential that results in a $1,500 deferred tax obligation ($5,000 30%).

Recognition and De-recognition

Only if the future tax due event is “more likely than not” to occur may a deferred tax position be recorded. When deferred tax obligations are recognized, they may be considered as either equities or liabilities. Typically, equity classifications come from a corporation employing accelerated depreciation for tax reasons but not for financial reporting.

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In cases where the more-likely-than-not factor for a deferred tax obligation is no longer correct, the corporation must effectively cancel out the benefits of the deferral and declare its implications in the first reporting period after the change. As long as the de-recognition of the obligation causes meaningful changes in the profit and loss statement or income statement, the corporation may need to conduct a write-down to rectify past financial statements.

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