What is a Deferred Tax Liability?

Before understanding deferred tax liability, it is essential to note that companies that incur such an obligation, prepare and maintain two financial reports every year – tax statement and income statement. The latter primarily includes Profit & Loss Account.

One of the key causes for preparing two statements to express similar financial events is the difference in guidelines followed by the Income Tax Department and Generally Accepted Accounting Standards (GAAP).

This variance in guidelines makes room for a temporary disagreement between those two financial reports, which results in the creation of a deferred tax liability or asset.

Deferred tax liability is specifically created when a tax obligation accumulated in one financial year but is due in a subsequent year.

In other words, when a company has to pay taxes for a financial event that has not yet been concluded in a particular year, such tax obligation shall be carried forward to the year in which such transaction is completed, thereby accounting for tax which it has underpaid in a particular year.

In essence, a deferred tax liability arises when different approaches to accounting financial events are adopted by a company and the tax department. Such financial obligation is recorded in the Balance Sheet of a company but initially takes shape in the Profit & Loss Account.

It shall also be noted that, as deferred tax liability is a future event, its recording is based on the certainty of its occurrence. And hence, if such financial obligation is less likely to take place, it is not posted in the Balance Sheet.

How is a Deferred Tax Liability Created?

There are several instances under which a company incurs a deferred income tax liability. Recognising these circumstances and their subsequent effect on a company’s financial records is therefore important .Furthermore, when these instances are appropriately recognised and recorded in financial statements of a company, it simplifies the process of auditing and analysing financial reports, allowing auditors and analysts to precisely grasp the nature and legitimacy of a future obligation such as a deferred tax liability.

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A few instances where a company releases such an obligation are mentioned below:

  • Variance in depreciation methods and rates 

One of the most common deferred tax liability examples is when a company depreciates its assets differently than the Income Tax department. This variance from the tax laws creates a temporary discrepancy between depreciation figures mentioned in a company’s financial statements and the corresponding tax reports.

When a company depreciates its assets at a lower rate than the tax department, its gross profit inflates in its books in comparison to what is derived in its tax reports in a particular year. However, any asset can only be associated with a singular lifetime in all cases, i.e. as per a company and the tax department.

By the end of an assets’ lifetime, its total depreciation shall agree in both reports, as the difference between those two figures would eventually narrow over the following years.

Ergo, a company shall account for the difference in depreciation figures in the two books in a subsequent year. In doing so, its gross profit in such following year would be lower in its own books as compared to its tax reports. Thus, it imposes a future tax liability for the company.

For better understanding, consider the following example:

Company A depreciates its assets in the straight-line method in its Income Statement but adopts the diminishing balance method in its tax reports. It has assets worth Rs. 2 lakh which it depreciates at a 10% rate in its books and a 15% rate in its tax statements in the Financial Year 2019 – 20. It also has generated revenues worth Rs. 8 lakh in that year and incurred expenses of Rs. 5 lakh excluding depreciation on assets.

A comparison between the two reports is mentioned in the table below, along with a deferred tax liability calculation.

Particulars For books (in Rs.) For tax purpose (in Rs.) Difference (in Rs.)
Revenues 8,00,000 8,00,000 Nil
Expenses (5,00,000) (5,00,000) Nil
Depreciation (20,000) (30,000) 10,000
Gross Profit 2,80,000 2,70,000 10,000
Tax @ 25% (70,000) (67500) 2500
Net Profit 2,10,000 202500 7500

Here, tax as per their books is Rs. 70,000, whereas it pays Rs. 67,500 to the tax department. This temporary disagreement creates a deferred tax liability of Rs. 2,500 for the company which it shall account for in a subsequent year.

  • Treatment of revenues and expenses

Deferred tax liability can also arise when there is a difference in the way certain revenues and expenses are treated in financial reports. For instance, tax is only levied on revenues that a company has realised in a particular year, whereas as per accounting principles, future receivables such as credit sales are recorded in the Income statement in the year such transaction has taken place and not when they are realised. Hence, it creates a disparity in the revenue shown in an Income statement and tax reports. As tax shall be paid in a subsequent year when such revenue is realised, it is considered as a deferred tax liability.

Consider a company that sells its goods at credit. In the Financial Year 2019 – 20, it sold Rs. 10 lakh worth of goods at credit, out of which it received Rs. 4 lakh in that year and the rest will be paid by the debtors in the following fiscal year. It also incurred expenses worth Rs. 5 lakh in that year and earned Rs. 3 lakh as interest on investments. The tax calculation for both its Income Statement and tax report is shown in the table below.

Particulars Income Statement (in Rs.) Tax report (in Rs.) Difference (in Rs.)
Sales 10,00,000 4,00,000 6,00,000
Interest from investments 3,00,000 3,00,000 Nil
Expenses (5,00,000) (5,00,000) Nil
Gross Profit 8,00,000 2,00,000 6,00,000
Tax @ 25% 2,00,000 50,000 1,50,000

The difference in tax liability between the Income Statement and its tax report is Rs. 1.5 lakh, which the company is accountable to settle in the following year when it realises the rest of the revenue, thus creating a deferred tax liability.

  • Carrying forward of current profits

Often companies can choose to carry forward their profits for one year to a subsequent year to effectively bring down its tax liabilities. In that case, the deferred tax liability is created as such a company will be eventually liable to pay taxes on the carry-forwarded profit.

Calculation of DTL

A deferred tax liability can be manually calculated by recognising avenues that are treated varyingly by a company and the tax department. These avenues create a disparity between the two financial reports, thus generating a deferred tax liability.

It shall also be noted that there is no separate deferred tax rate applicable, and it is calculated based on the difference in tax liabilities appearing in two financial reports.

Difference between Deferred Tax Liability and Deferred Tax Asset

As mentioned in the beginning, deferred tax liability or asset arises from a variance in accounting principles and tax guidelines. A detailed comparison between these two is mentioned in the table below.

Parameters DTA DTL
Basis of recognition When tax will accrue in a later period but is paid in advance in the current year, it is recorded as a deferred tax asset. When tax accrues in the current year but is paid in a later period, it is considered as a deferred tax liability.
Creation When profits in a company’s income statement are lower than what is mentioned in the tax reports. When profits in a company’s income statement are higher than what is mentioned in its tax reports.
Treatment It is recorded in the Balance Sheet under Non-current assets. It is posted in the Balance Sheet under Non-current liabilities.

Deferred tax liability is recorded in the books of a company so that its shareholders are aware of all the underlining liabilities a company is bearing at the end of a financial year, and also for auditing purposes.