Definition
A Deferred Tax Liability is a tax that a business owes, but is not yet required to pay. It arises when there is a discrepancy between the company’s accounting and tax carrying values, the measurable difference being due to temporary differences. They will eventually translate into income tax payable for the future accounting periods.
Phonetic
The phonetics of the keyword “Deferred Tax Liability” is: – Deferred: Dih-furd- Tax: Taks- Liability: Lyuh-bil-i-tee
Key Takeaways
<ol><li>Deferred Tax Liability is a tax that a business owes, but has not yet paid to a tax authority. It is created when there is a discrepancy between the company’s accounting income and its actual taxable income. Businesses use this tax to reconcile these differences by deferring the tax payment to future periods.</li><li>Deferred Tax Liability often arises due to differences in depreciation methods used by the company and the Internal Revenue Service (IRS). This could also be due to prepaid expenses which are tax-deductible only when used.</li><li>It is recorded on the company’s balance sheet as a liability. Over time, as the company pays off its tax bill, the deferred tax liability will decrease. Any changes in tax laws or regulations could potentially impact the amount of deferred tax liabilities a company reports.</li></ol>
Importance
Deferred Tax Liability is a critical term in business/finance as it represents an obligation to pay taxes in the future. It arises when a company’s fiscal tax is lower than its accounting profit. This situation often occurs due to differences in company depreciation methods or when a company decides to postpone certain expenses that could be written off in the current period. Understanding Deferred Tax Liability is essential for businesses in forecasting future tax obligations, proper financial planning and analyzing a company’s financial health. It also allows investors to make informed decisions, as it is part of the company’s total liability. Overall, this term plays a significant role in shaping a company’s future financial strategy and obligations.
Explanation
Deferred Tax Liability is an important tool for matching the timing of income and expense recognition for financial reporting and tax purposes. It accounts for the differences between the actual tax paid and the tax assessed on the income statement due to discrepancies between when income is recognized by an entity and the Internal Revenue Service (IRS). This occurs due to the difference in rules set by accounting standards and the tax regulations governing when certain items should be recognized as income or expenses.Its primary function is to anticipate future tax implications associated with certain transactions that have already occurred. For instance, a company may be allowed to depreciate assets faster for tax purposes than it does for accounting purposes. This would lead to lower taxable income early on, but higher taxable income in later years. We record this as a deferred tax liability, which ultimately serves as an anticipation of increased future tax payments. This gives investors a more accurate picture of a company’s future earnings and liabilities as it provides a forecast of the company’s future obligation to the IRS.
Examples
1. Depreciation: Companies often use different methods of depreciation for their financial reporting and their tax reporting. For financial reporting purposes, they may use the straight-line depreciation method which spreads out the depreciation evenly over the useful life of the asset. But for tax purposes, they can use an accelerated depreciation method like the Modified Accelerated Cost Recovery System (MACRS) which allows for larger depreciation expenses in the early years of the asset. This can lead to deferred tax liability as the company is postponing tax payment due to higher depreciation in the early years as per MACRS.2. Prepaid Expenses: A company pays its insurance premium for the next two years, but for tax purposes, can only recognize the insurance expense for the current year. This creates temporary differences because the company can deduct the prepaid amount on their financial statements but have to wait to deduct it on their tax return, leading to a deferred tax liability.3. Inventories: Sometimes, companies use different methods of inventory valuation for accounting and tax purposes. For example, a business might use Last-In-First-Out (LIFO) for tax reporting, but First-In-First-Out (FIFO) for financial reporting. Using the LIFO method often results in lower taxable income (as it assumes the cost of latest inventory items first), hence, lower taxes in the initial years. This increases a company’s deferred tax liability as the tax on the income that’s deferred will have to be paid in future years.
Frequently Asked Questions(FAQ)
What is a Deferred Tax Liability?
A Deferred Tax Liability is a tax that a business owes, but is not due to be paid until a future date. It usually occurs when there is a discrepancy between the tax amount the company thinks it owes and what the IRS calculates.
How is a Deferred Tax Liability created?
A Deferred Tax Liability is typically created when a business takes a deduction on its income statement before it can take that deduction on its tax return. It can also be the result of differences in depreciation methods used by the company and the IRS.
How does a Deferred Tax Liability impact a company’s balance sheet?
A Deferred Tax Liability is recorded on the balance sheet as a liability. While it doesn’t require an immediate cash outflow, it represents future tax payments that the company will have to make, thus reducing future net income.
Can a Deferred Tax Liability become an asset?
In general, a Deferred Tax Liability cannot become an asset because it represents a future tax payment. A Deferred Tax Asset, on the other hand, represents a future potential reduction of taxes.
How can a business reduce its Deferred Tax Liability?
Businesses can reduce their Deferred Tax Liability by matching their accounting methods with tax filing methods, accelerating taxable income into the current year, or deferring accounting expenses to future years.
Is Deferred Tax Liability the same as Income Tax Payable?
No, they are not the same. Income Tax Payable is the tax owed in the current period, whereas a Deferred Tax Liability is the tax that is due to be paid in future accounting periods.
Can a Deferred Tax Liability be negative?
No. If a business has overpaid its taxes or has deductions or credits it can carry forward, it instead has a Deferred Tax Asset, not a negative Deferred Tax Liability. It represents potential tax savings in the future.
Is Deferred Tax Liability a non-current liability?
Yes, Deferred Tax Liability is typically considered a non-current liability as it will not be fully realized and paid off within a year’s time. It is expected to be settled in future accounting periods.
Related Finance Terms
- Income Tax Expense
- Financial Reporting
- Income Recognition
- Balance Sheet Account
- Temporary Differences
