1. Deferred Tax Liability
2. Sources of Deferred Tax Liability
3. Timing Differences

A deferred tax charge is when the amount of income tax actually paid is more than the amount shown as payable on the income statement. This happens when the income and expense items don't match up temporarily. The extra amount paid shows up on the balance sheet as a non-current asset until it is amortized in the next cycle.

Deferred Tax Liability

A deferred tax liability occurs when a tax liability comes due in the current period but has not yet been paid. This is the result of a difference in timing between the assessment of the taxes and the payment of the bill. The deferred tax liability shows that the company will pay more income taxes in the future because of some current transaction.

Because of varying tax laws and accounting rules, a company's pre-tax earnings shown on the income statement may be more than the taxable income shown on the tax return. This makes a deferred tax liability necessary for the balance sheet, representing a tax payment yet to be made. The amount is calculated by multiplying the expected tax rate by the difference between the taxable income and the earnings before taxes.

Another way to think of a deferred tax liability is to look at it as an underpayment of taxes that will eventually have to be caught up. This doesn't mean that the company is delinquent; it simply means the obligation is due at a later date. For example, let's say Company ABC had a net income for the year and knows that corporate income taxes must be paid on that amount.

The tax liability in the current year requires the company to show an expense that same period. However, the tax won't actually be paid until the new calendar year. The way to reconcile the accrual/cash timing difference is to record the tax as a deferred tax liability.

A deferred tax arises from the difference between taxable profit and accounting profit caused by the same transaction being treated differently in the two systems. This is commonplace since different taxation authorities treat income, expenses, assets, and liabilities different than a business treats them in its accounting practices. That leads to the accounting profit and taxes differing from the profit and taxes owed according to the tax authority's calculations. The difference between the two is the deferred tax.

Sources of Deferred Tax Liability

One situation that gives rise to a deferred tax liability is when depreciation expense is treated differently under the tax laws than under the company's accounting rules. For the purposes of financial statements, depreciation on a long-lived asset is calculated via the straight-line method. Taxing authorities, however, allow companies to use an accelerated method.

Since the straight-line calculation produces a lower number, the company's books show a higher income, but only temporarily. As assets continue to depreciate, the difference between the two methods narrows, and the deferred tax liability gradually goes away through offsetting accounting entries.

Another place where deferred tax liabilities are common is an installment sale. Accounting practices allow the company to record the full income from the sale up front, but tax laws require the income to be recognized when the payments are received. This creates a difference between the accounting earnings and the taxable income, which constitutes a deferred tax liability.

Timing Differences

When income or an expense happens and is taxed within the same period it shows up on the income statement, the tax liabilities for that year will reflect that and nothing else needs to be done. However, if the occurrence is taxed in a different period, whether in full or partially, then an accrual of the tax is required to show this accurately. This is called a timing difference between the income or expense and the levying of the taxes.

Timing differences may be either temporary or permanent.

  • An example of a temporary timing difference is when the tax calculations and the accounting calculations of depreciation of an asset are different. This sometimes happens when the estimates of the useful life of something vary, or when different depreciation methods are used.
  • A permanent difference might occur if the company receives a tax-free grant from the government. That money is included in the accounting profit, but it won't show up in the tax calculations. Permanent differences require no further accounting in the future.

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