In the United States, laws allow companies to maintain two separate sets of books for financial and tax purposes. Because the rules that govern financial and tax accounting differ, temporary differences arise between the two sets of books. This can result in deferred tax liability, when the amount of tax due according to tax accounting is lower than that according to financial accounting. Deferred tax liability commonly arises when in depreciating fixed assets, recognizing revenues and valuing inventories.
Differences in tax liabilities are simply temporary imbalances between a reported amount of income and its tax basis: The accounting disparities appear when there are differences between the taxable income and the pretax financial income or when the bases of assets or liabilities differ for financial accounting and tax purposes. For example, money due on current accounts receivable (AR) cannot be taxed until collection is actually made, but the sale needs to be reported in the current period.
Because these differences are temporary, and a company expects to settle its tax liability (and pay increased taxes) in the future, it records a deferred tax liability. In other words, a deferred tax liability is recognized in the current period for the taxes payable in future periods.
One common situation that gives rise to deferred tax liability is depreciation of fixed assets. Tax laws allow for the modified accelerated cost recovery system (MACRS) depreciation method, while most companies use the straight-line depreciation method for financial reporting.
Deferred tax liability is calculated by finding the difference between the company's taxable income and its account earnings before taxes, then multiplying that by its expected tax rate. Consider a company with a 30% tax rate that depreciates an asset worth $10,000 placed-in-service in 2015 over 10 years. In the second year of the asset's service, the company records $1,000 of straight-line depreciation in its financial books and $1,800 MACRS depreciation in its tax books. The difference of $800 represents a temporary difference, which the company expects to eliminate by year 10 and pay higher taxes after that. The company records $240 ($800 × 30%) as a deferred tax liability on its financial statements.
Differences in revenue recognition give rise to deferred tax liability. Consider a company with a 30% tax rate that sells a product worth $10,000, but receives payments from its customer on an installment basis over the next five years – $2,000 annually. For financial accounting purposes, the company recognizes the entire $10,000 revenue at the time of the sale, while it records only $2,000 based on the installment method for tax purposes. This results in an $8,000 temporary difference that the company expects to liquidate within the next five years. The company records $2,400 ($8,000 × 30%) in deferred tax liability on its financial statements.
The U.S. tax code allows companies to value their inventories based on the last-in-first-out (LIFO) method, while some companies choose the first-in-first-out (FIFO) method for financial reporting. During the periods of rising costs and when the company's inventory takes a long time to sell, the temporary differences between tax and financial books arise, resulting in deferred tax liability.
Consider an oil company with a 30% tax rate that produced 1,000 barrels of oil at a cost of $10 per barrel in year one. In year two, due to rising labor costs, the company produced 1,000 barrels of oil at a cost of $15 per barrel. If the oil company sells 1,000 barrels of oil in year two, it records a cost of $10,000 under FIFO for financial purposes and $15,000 under LIFO for tax purposes. The $5,000 is a temporary difference that gives rise to a deferred tax liability of $1,500 ($5,000 × 30%).
Recognition and De-recognition
A deferred tax position can only be recognized if the future taxes payable event is "more likely than not" to occur. Deferred tax liabilities can be treated as equities or liabilities when they are recognized. Equity classifications typically result from the company using accelerated depreciation for tax purposes but not for financial-reporting purposes.
In instances where the more-likely-than-not element is no longer accurate for a deferred tax liability, the company must effectively cancel out the impacts of the deferment and report its effects in the earliest reporting period following the change. The company may need to do a write-down to correct previous financial statements, as long as the de-recognition of the liability creates material changes in the profit and loss statement or the income statement.