The Deferred Tax Liability Formula

What is a Deferred Tax Liability?

When a tax is owed or incurred and when a tax is actually due to be paid can occur at different times: this gap is called a deferred tax liability. In other words, the deferred tax liability is an unpaid tax that will eventually have to be paid by the company at a future date. Companies should keep track of their deferred tax liability to allow for proper tax planning and accurately measure the company’s success under its financial reporting statements.

How Are Deferred Tax Liabilities Created?

Various types of transactions can create a deferred tax liability. A deferred tax liability most often occurs as a result of a difference in timing when recording the expense of a tax under financial accounting versus tax accounting rules. Under financial accounting rules, the value of an asset may differ from the value of the same asset under tax accounting rules—but this difference is only temporary.

What Are Common Situations Where a Deferred Tax Liability is Created?

Businesses commonly depreciate the value of an asset over its lifespan to reflect the recovery of the purchase cost. Under financial accounting standards, an asset’s value could be depreciated under a straight-line method so that the depreciation is evenly distributed each year. However, under tax accounting rules, the same asset may benefit from an accelerated depreciation schedule or bonus depreciation. This means that the tax basis of the asset could be much lower than the value reflected on financial reports. Thus, a deferred tax liability is created.

Another way a deferred tax liability may be created is under an installment sale. Under an installment sale, a purchaser agrees to pay for a good in multiple installments over time. Under financial accounting rules, the full value of the sale will be recorded on the books, whereas under tax accounting rules the company will recognize the money earned only when it Is actually received—i.e., income will be recognized every time an installment payment is received. The difference in value on the financial books versus the tax accounting records creates a deferred tax liability.

How is Deferred Tax Liability Calculated?

As a general concept, calculating the deferred tax liability can appear quite simple:

(financial book value recorded – corresponding tax basis) * applicable tax rate = Deferred Tax Liability

To illustrate based on the depreciation example mentioned above, say that a company depreciates an asset by $250 for financial reporting purposes. For tax accounting purposes, the asset utilizes accelerated depreciation of $400. This creates a deferred tax liability equal to $150 times the company’s tax rate. Assuming the company’s tax rate is 37%, the deferred tax liability recorded would be $55.50.

($400 – $250) * 0.37 = $55.50

Doing Tax Planning Yourself is Complicated

While the simple example above can make deferred tax liability seem like a walk in the park, companies often find that reality is more complicated. Differences between financial and tax accounting can lead to complex situations that require the advice and guidance of tax advisors and tax counsel. Depending on a company’s specific situation, the deferred tax liabilities will affect the company’s cash flow and future operations. Learn more about deferred tax liability and other tax formulas by requesting a demo today!