Definition
Deferred tax liabilities are future tax obligations that a company expects to pay to tax authorities. These obligations result from differences between the company’s tax accounting and financial accounting methods. It represents the increase in taxes payable in the future as a result of taxable temporary differences.
Key Takeaways
- Deferred Tax Liabilities are taxes that a company owes but is allowed to pay at a future date. These arise due to differences between the company’s accounting and tax carrying values, the timing of income recognition, and the accounting period in which expenses gain tax recognition.
- These liabilities are often caused by temporary differences between the company’s financial reporting and the tax laws of the country. An example would be depreciation methods used by the company and allowed by the tax law.
- Deferred Tax Liabilities are important for financial analysis. They show potential future reduction in the company’s cash flow and increase in its effective tax rate. Therefore, investors and creditors actively consider this in their decision making.
Importance
Deferred Tax Liabilities is a crucial finance term as it represents an entity’s obligation to pay taxes in the future.
It originates from temporary differences between a company’s accounting and tax figures, temporary timing differences, or from net operating loss carryforwards.
This has substantial impacts on a company’s financial standing as it directly affects its future tax obligation and hence, the future cash flows.
The management’s understanding and proper handling of deferred tax liabilities can result in strategic tax planning and prudent financial management, leading to enhanced financial health and increased profitability in the long run.
Therefore, ignoring or mishandling deferred tax liabilities can cause significant financial troubles, which is why the comprehension of this term is vital.
Explanation
Deferred Tax Liabilities basically serve as a measure for future tax obligations a company or individual is expected to pay. This obligation emerges when there are temporary differences between how transactions are accounted for and how they’re treated for tax-related purposes.
Accounting principles and tax laws can vary significantly, and this results in the deferring of some income taxes that may be paid in the future. This financial metric is crucial because it helps in predicting future cash outflows related to tax.
The presence of a deferred tax liability often indicates that the company has been given a sort of “loan” from the government that will eventually need to be paid back. This is likely to happen whenever accounting income is greater than taxable income.
Then, the deferred tax liabilities allow the company to delay the payment of these taxes to future periods. It aids the company by helping to manage its cash-flow more effectively in the present.
Examples of Deferred Tax Liabilities
Depreciation of Assets: Companies often depreciate their assets over a certain time period for tax purposes. The depreciation schedule for tax purposes may be different than the one used for financial reporting, creating a discrepancy between the tax burden on the books and the actual tax paid. This can result in a deferred tax liability, which will have to be paid in the future when the depreciation schedules align.
Retirement Plans: When a company contributes to a retirement plan such as a 401(k) or a pension, it often does not get to deduct the full amount of the contribution in the current year. The contribution is therefore a deferred tax liability, as the company will have to pay taxes on it in the future, when the employees retire and start drawing from the plan.
Prepaid Expenses: Suppose a company pays for insurance coverage in advance for next two years. It gets to deduct this expense from its taxable income immediately. But for financial reporting, this expense is spread over two years. This mismatch creates a deferred tax liability as the company will have to pay tax on this income in the future when it is actually recognized in financial statements.
FAQs for Deferred Tax Liabilities
What are Deferred Tax Liabilities?
Deferred Tax Liabilities are tax amounts that a company has underpaid and will need to pay in the future. It occurs when the tax payable on the company’s tax return is less than the tax expense on the company’s income statement.
What causes Deferred Tax Liabilities?
Deferred Tax Liabilities often occur because of differences in depreciation rules. For example, a company might be able to claim more depreciation on a piece of equipment for tax purposes than for accounting purposes. This would temporarily reduce the company’s taxable income, and thereby its tax liability, compared to its accounting income.
How are Deferred Tax Liabilities calculated?
Deferred Tax Liabilities are calculated by comparing the company’s tax expense (as reported on the income statement) with its actual tax payable (as per the tax return). If the tax expense exceeds the tax payable, the excess amount is recorded as a deferred tax liability.
What is the impact of Deferred Tax Liabilities on financial statements?
Deferred Tax Liabilities can significantly impact a company’s financial statements. They are recorded as liabilities on the balance sheet, thus increasing the company’s total liabilities. Additionally, changes in deferred tax liabilities are reflected in the income statement.
How are Deferred Tax Liabilities treated for tax purposes?
From a tax perspective, Deferred Tax Liabilities are not considered actual liabilities. This is because they represent potential future tax liabilities, not current tax debts. As such, they are not deductible for tax purposes.
Related Entrepreneurship Terms
- Income Tax Expense
- Temporary Difference
- Future Taxable Amount
- Balance Sheet Approach
- Tax Accounting Standards
Sources for More Information
- Investopedia: Provides reliable financial and investing explanations, including the topic of Deferred Tax Liabilities.
- CFA Institute: Offers a wide variety of finance-related resources, including comprehensive articles about Deferred Tax Liabilities.
- Accounting Tools: Provides an in-depth understanding of accounting and finance concepts, including Deferred Tax Liabilities.
- Corporate Finance Institute (CFI): Offers in-depth online courses and articles about various financial topics, like Deferred Tax Liabilities.
