Taxes that are due but won’t be paid until a later time are recorded as deferred tax liability on a company’s balance sheet. It is created when there are momentary discrepancies between book tax and actual income tax. Deferred tax assets and liabilities can be produced through a variety of transactions that can temporarily differ between pre-tax book income and taxable income. Read more to understand deferred tax liability and how deferred tax calculation is done in detail.
- Deferred tax liability are future tax obligations that develop when a company or individual delays an event that would otherwise cause tax expenses to be recorded in the current period.
- Earning returns in a qualified retirement plan, like a 401(k), for instance, represents a delayed tax burden as the retirement saver will have to pay taxes on the saved income and profits when they withdraw the money.
How Does Deferred Tax Liability Work?
A deferred tax calculation can be understood as ones that are due but won’t be paid until a later time are recorded as deferred tax liability on a company’s balance sheet. Needed to a gap in time between when the tax was accrued and when it is due to be paid, the responsibility is delayed. For instance, deferred tax liability could represent a taxable transaction, like an installment sale, that occurred on a specific day but for which the taxes are not payable until a later time.
A future tax payment that a firm is required to make is shown as a deferred tax liability on its balance sheet. It is computed by multiplying the difference between the company’s taxable income and accounting earnings before taxes by the projected tax rate for the year. Deferred tax liability is a particular amount of tax that a corporation has not paid but will be paid in the future. This doesn’t imply that the business hasn’t paid its taxes on time. Instead, it acknowledges a payment that has not yet been due.
For instance, a business that had net income for the year is aware that it must pay corporate income taxes. The tax liability must include an expense for the same time period because it pertains to the current year. However, the tax liability will not be paid in full until the following year. Tax is recorded as a deferred tax liability to address the accrual/cash timing discrepancy.
Deferred Tax Liability Example
The different ways that tax legislation and accounting standards treat depreciation expenses is a common source of deferred tax liability. While tax laws permit businesses to employ an accelerated depreciation approach, the depreciation expense for long-lived assets is normally calculated using a straight-line technique for financial statement purposes. A company’s accounting income momentarily exceeds its taxable income because the straight-line technique results in less depreciation than the under-accelerated method.
The difference between the company’s accounting earnings before taxes and its taxable income is where the deferred tax liability is calculated. The difference between straight-line and accelerated depreciation decreases as the company continues to amortize its assets, and the amount of deferred tax liability is steadily reduced through a series of offsetting accounting entries.
Another prominent source of delayed tax liabilities is an installment sale. This is the revenue reported when a company sells its items on credit to be paid off in equal amounts in the future. Under accounting regulations, the company is able to recognize full income from the installment sale of general products, whereas tax laws require companies to record the income when installment payments are completed. Due to this, the company’s accounting earnings and taxable income temporarily diverge positively, resulting in a deferred tax liability.
Timing discrepancies or transient inconsistencies in accounting might lead to deferred tax. Given below are the most generic forms in which deferred tax may develop for any firm.
A Deferred Tax Asset
When a tax liability has been settled or carried forward but has not yet been recorded on the income statement, deferred tax assets are created. The difference between book income and taxable income is used to calculate the value of deferred tax assets. For instance, if the tax authority records revenue or expenses at a different period than required by an accounting standard, a case of deferred tax may result. Any deferred tax asset is important in decreasing the company’s future tax liability.
- Situations That Could Result In Deferred Tax Assets
The causes that result in deferred tax assets are listed below:
- Even before they are needed to be recognized, expenses are considered by the taxing authorities.
- Even before it should be acknowledged, earned income is taxed.
- Deferred tax assets and liabilities have distinct tax laws or bases.
Did you Know
A deferred tax asset is produced whenever there is a discrepancy between the income reported on the tax return and the income in the business’s accounting records (income per book).
How to Calculate Deferred Tax Liability?
Follow these steps to determine deferred tax calculation:
- List out all the liabilities and assets in a table
- Calculate the bases of the Tax
- Identify the transient differences
- Determine the applicable tax rate due.
- Discover the tax asset.
- Understand items outside of the financial situation
- Make an entry in the accounts after adding them all up.
Difference Between Deferred Tax Liabilities and Deferred Tax Assets
The distinction between financial reporting and tax reporting must be kept in mind when attempting to comprehend deferred tax assets and liabilities. Different principles and calculations are used in these two types of accounting, and as a result, there may be both deferred tax assets and liabilities. On the other side, tax reporting necessitates that tax authorities establish the rules and guidelines for the creation and submission of tax returns. The IRS and regional state governments are two examples of tax agencies.
Deferred tax liabilities and assets are the opposites of one another. Deferred tax liability is a tax credit for the business that will need to be paid in the future, while a deferred tax asset is a tax credit for current taxes.
Examples of Deferred Tax Liability
- Asset depreciation: The IRS employs a sophisticated asset depreciation model, which causes a discrepancy between the balance sheet value and the worth of the corporation for tax purposes. The most typical illustration of deferred tax liability is this one.
- Tax underpayment: The business owes back taxes from the prior cycle’s underpayment in the current cycle.
- Installment Sale: When a product is purchased in installments, the company records the full value of the sale on its balance sheet but only has to pay taxes once each year. For upcoming payments on that sale, the corporation is aware that they have a deferred tax duty.
Examples of Deferred Tax Assets
- Net Operating Loss: During that time, the company suffered a financial loss.
- Tax Overpayment: During the prior period, you overpaid taxes.
- Business Expenses: These are expenses that are recorded under one accounting system but not another
- Revenue: When revenue is received during one accounting period but recognized in a different one.
- Bad Debt: Unpaid debt is first reported as revenue before being written off as uncollectible. The bad debt turns into a deferred tax asset once the unpaid receivable is eventually recognized.
Word to Remember
Deferred Tax Liability – Taxes that are due but didn’t get paid until a later time are recorded as a deferred tax liability on a company’s balance sheet.
Whenever the government’s accounting practices diverge from those of a regular business, there is typically a deferred tax liability. One typical example is the depreciation of fixed assets. Companies often use a straight-line depreciation approach to disclose depreciation in their financial accounts. In essence, this depreciates the asset steadily over time.
However, the business will adopt an accelerated depreciation strategy for tax purposes. When using this strategy, the asset depreciates more quickly in the beginning. In contrast to accelerated depreciation of $200 in its tax books, a corporation may record a straight-line depreciation of $100 in its financial accounts. The company’s tax rate multiplied by $100 would equal the deferred tax liability. That is how deferred tax calculation is done.
A deferred tax asset is something that is listed on the balance sheet of the business and is utilized to lower the taxable income. Deferred tax assets are frequently produced because of taxes that have been paid or are carried forward, but they are not recorded in the income statement until that time.
Deferred tax liability, which arises when the taxable income is less than the income reported in the income statements, is essentially just the reverse of deferred tax assets.
Deferred tax liability results when the actual tax obligation is less than what is reported in the company’s financial statements. When a business purposefully puts off paying current tax obligations, they resemble a duty that grows.