Deferred Tax Liability Definition: How It Works With Examples

Deferred Tax Liability

Investopedia / Michela Buttignol

What Is a Deferred Tax Liability?

A deferred tax liability is a listing on a company's balance sheet that records taxes that are owed but are not due to be paid until a future date.

The liability is deferred due to a difference in timing between when the tax was accrued and when it is due to be paid. For example, it might reflect a taxable transaction such as an installment sale that took place one a certain date but the taxes will not be due until a later date.

Key Takeaways

  • A deferred tax liability represents an obligation to pay taxes in the future.
  • The obligation originates when a company or individual delays an event that would cause it to also recognize tax expenses in the current period.
  • For instance, earning returns in a qualified retirement plan, like a 401(k), represents a deferred tax liability since the retirement saver will eventually have to pay taxes on the saved income and gains upon withdrawal.

Deferred Tax Liability

How Deferred Tax Liability Works

The deferred tax liability on a company balance sheet represents a future tax payment that the company is obligated to pay in the future.

It is calculated as the company's anticipated tax rate times the difference between its taxable income and accounting earnings before taxes.

Deferred tax liability is the amount of taxes a company has "underpaid" which will be made up in the future. This doesn't mean that the company hasn't fulfilled its tax obligations. Rather it recognizes a payment that is not yet due.  

For example, a company that earned net income for the year knows it will have to pay corporate income taxes. Because the tax liability applies to the current year, it must reflect an expense for the same period. But the tax will not actually be paid until the next calendar year. In order to rectify the accrual/cash timing difference, tax is recorded as a deferred tax liability. 

Examples of Deferred Tax Liability

A common source of deferred tax liability is the difference in depreciation expense treatment by tax laws and accounting rules.

The depreciation expense for long-lived assets for financial statement purposes is typically calculated using a straight-line method, while tax regulations allow companies to use an accelerated depreciation method. Since the straight-line method produces lower depreciation when compared to that of the under accelerated method, a company's accounting income is temporarily higher than its taxable income.

The company recognizes the deferred tax liability on the differential between its accounting earnings before taxes and taxable income. As the company continues depreciating its assets, the difference between straight-line depreciation and accelerated depreciation narrows, and the amount of deferred tax liability is gradually removed through a series of offsetting accounting entries.

Installment Sales

Another common source of deferred tax liability is an installment sale. This is the revenue recognized when a company sells its products on credit to be paid off in equal amounts in the future.

Under accounting rules, the company is allowed to recognize full income from the installment sale of general merchandise, while tax laws require companies to recognize the income when installment payments are made.

This creates a temporary positive difference between the company's accounting earnings and taxable income, as well as a deferred tax liability.

Is Deferred Tax Liability a Good or Bad Thing?

Deferred tax liability is a record of taxes that have been incurred but have not yet been paid. This line item on a company's balance sheet reserves money for a known future expense

That reduces the cash flow that a company has available to spend, but that's not a bad thing. The money has been earmarked for a specific purpose, i.e. paying taxes the company owes. The company could be in trouble if it spends that money on anything else.

What Is an Example of Deferred Tax Liability?

A deferred tax liability usually occurs when standard company accounting rules differ from the accounting methods used by the government. The depreciation of fixed assets is a common example.

Companies typically report depreciation in their financial statements with a straight-line depreciation method. Essentially, this evenly depreciates the asset over time.

But for tax purposes, the company will use an accelerated depreciation approach. Using this method, the asset depreciates at a greater rate in its early years. A company may record a straight-line depreciation of $100 in its financial statements versus an accelerated depreciation of $200 in its tax books. In turn, the deferred tax liability would equal $100 multiplied by the tax rate of the company.

How Is Deferred Tax Liability Calculated?

A company might sell a piece of furniture for $1,000 plus a 20% sales tax, payable in monthly installments by the customer. The customer will pay this over two years ($500 + $500).

In its financial records, the company will record a sale of $1,000.

In its tax records, it will be recorded as $500 per year for two years.

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

Article Sources
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  1. U.S. Securities and Exchange Commission. "Traditional and Roth 401(k) Plans." Accessed Sept. 3, 2021.

  2. Financial Accounting Standards. "Summary of Statement No. 109." Accessed Sept. 3, 2021.

  3. Internal Revenue Service. "Business Taxes." Accessed Sept. 3, 2021.

  4. Internal Revenue Service. "Publication 537 (2020), Installment Sales." Accessed Sept. 3, 2021.

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