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Understanding_Deferred_Tax_Liability_pdf_1736419584

Deferred tax liability (DTL) represents taxes owed but not yet due, arising from timing differences between accounting and tax income recognition. It is calculated by multiplying the anticipated tax rate by the difference between taxable income and accounting earnings, commonly resulting from varying depreciation methods and installment sales. Examples illustrate how DTLs are recorded and reduced over time as discrepancies in income recognition are resolved.

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2 views7 pages

Understanding_Deferred_Tax_Liability_pdf_1736419584

Deferred tax liability (DTL) represents taxes owed but not yet due, arising from timing differences between accounting and tax income recognition. It is calculated by multiplying the anticipated tax rate by the difference between taxable income and accounting earnings, commonly resulting from varying depreciation methods and installment sales. Examples illustrate how DTLs are recorded and reduced over time as discrepancies in income recognition are resolved.

Uploaded by

ALEXANDER OKELLO
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Understanding Deferred Tax

Liability
Deferred tax liability (DTLs) is an important concept in
accounting and taxation, reflecting the timing differences
between when income is recognized for accounting purposes
and when it is recognized for tax purposes. This article
provides an overview of deferred tax liabilities, including their
definition, calculation, common sources, and illustrative
examples.

So, what is a deferred tax liability?

A deferred tax liability is an entry on a company's balance


sheet that shows taxes owed but not yet due. It arises from
timing differences between when taxes are recognized and
when they are payable. For instance, it may occur in cases like
installment sales, where the tax is recorded now but payment is
delayed until a future date.

A deferred tax liability on a company's balance sheet indicates


a future tax payment the company is obligated to make. It is
calculated by multiplying the anticipated tax rate by the
difference between taxable income and accounting earnings
before taxes. This liability represents taxes that the company
has "underpaid" but will settle in the future, reflecting a
payment that is not yet due, rather than an unmet tax
obligation.
For instance, if a company reports net income for the year, it
recognizes that corporate income taxes will be owed. Although
the tax liability pertains to the current year, it will not be paid
until the following calendar year. To address this timing
difference between accrual and cash payments, the tax is
recorded as a deferred tax liability.

A common source of deferred tax liability arises from the


differing treatment of depreciation expenses under tax laws
and accounting standards. For financial reporting, companies
typically use the straight-line method for long-lived assets,
while tax regulations permit accelerated depreciation. This
results in lower depreciation expenses for financial statements
compared to tax calculations, leading to higher accounting
income than taxable income. Consequently, the company
records a deferred tax liability based on this difference. As the
company continues to depreciate its assets, the gap between
straight-line and accelerated depreciation decreases. Over
time, the deferred tax liability is gradually reduced through a
series of offsetting accounting entries.

Example 1
Consider a company called ABC Manufacturing, which
purchases machinery for $100,000 with a useful life of 10 years.
For financial reporting purposes, ABC Manufacturing employs
the straight-line method of depreciation, which calculates an
annual depreciation expense of $10,000.
This is derived by dividing the cost of the machinery by its
useful life: $100,000 divided by 10 years.

However, for tax purposes, ABC Manufacturing opts for an


accelerated depreciation method, specifically the Double
Declining Balance method. In the first year, this approach
results in a depreciation expense of $20,000, calculated as two
times the straight-line rate (20%) applied to the full cost of the
machinery. At the end of Year 1, ABC Manufacturing reports an
accounting income before taxes of $50,000. After accounting
for the straight-line depreciation expense of $10,000, the
taxable income becomes $40,000. Conversely, using the
accelerated depreciation method for tax purposes reduces the
taxable income to $30,000 after accounting for the $20,000
depreciation expense.

This discrepancy between accounting income and taxable


income creates a difference of $20,000. With a tax rate set at
30%, ABC Manufacturing recognizes a deferred tax liability of
$6,000 on its balance sheet at the end of Year 1. This amount
reflects taxes that will be owed in the future due to the timing
differences in how expenses are recognized under different
accounting methods.
As ABC Manufacturing continues to depreciate its machinery in
subsequent years, the gap between the straight-line and
accelerated depreciation will gradually narrow. Consequently,
this will lead to a reduction in the deferred tax liability over time
as offsetting entries are made in future periods.

This example illustrates how variations in depreciation methods


can generate a deferred tax liability that represents future tax
obligations stemming from timing differences in expense
recognition.

Example 2

Another example of deferred tax liability can be seen in


installment sales. In this scenario, when a company sells
products on credit to be paid off in equal future installments, it
recognizes the entire revenue from the sale immediately under
accounting rules. However, tax laws dictate that the company
must recognize income only as the installment payments are
received.

For instance, consider a company that sells furniture for $1,500


plus a 15% sales tax, with the customer making monthly
payments over three years. In its financial records, the company
records the full sale of $1,500 at the time of sale. In contrast, for
tax purposes, the revenue is recognized as $500 per year for
three years.
This creates a temporary positive difference between the
company's accounting earnings and taxable income.
Specifically, in the first year, the company recognizes $1,500 in
revenue for accounting but only $500 for tax purposes. The
deferred tax liability arises from this difference; it would amount
to $75, calculated as $500 (the taxable income recognized)
multiplied by 15% (the sales tax rate). Thus, the deferred tax
liability reflects taxes owed in the future due to this timing
difference in income recognition.

Conclusion

A deferred tax liability occurs when a company recognizes


taxes that are owed but not payable until a future date. It is
calculated as the company's expected tax rate multiplied by the
difference between taxable income and accounting earnings
before taxes. Deferred tax liabilities commonly arise in
scenarios such as installment sales and varying depreciation
methods.

This material is intended solely for informational purposes and


should not be relied upon without seeking specific professional
advice on the matter. Should you have any questions regarding
this topic, please feel free to contact our team at
[email protected] or +254 20 5100263.
Contact Persons & Contributors

Marco Manyenze Filden Oroni


Associate Director Legal & Tax Associate
[email protected] [email protected]

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