what is deferred tax liability?

Question

wanted to know what is deferred tax liability and how is accounted for and how it is wiped off from the books over a period of time.

Answer 1

What are the situations in which there is a deferred tax liability?

There may be a difference in the way certain items of expense are allowed to be treated for tax purposes and how a company actually treats them.

Tax laws allow a 100% depreciation in the first year after a company acquires certain assets. But a company may actually write off the depreciation over a larger number of years in its financials. The company may charge depreciation at lower rates than allowed under tax laws. Or it may use a different method of charging depreciation.

Tax laws may allow a company to deduct certain expenses in full in a single year, but it may phase out the charge over a number of years.

How should companies account for this?

Under the old system of accounting only for current taxes, the company's profits would be artificially high in the first year (due to the tax savings).

The profits would, however, be lower in the subsequent years, as the tax laws in the subsequent years would not recognise the depreciation charge or the amortised expense, as the case may be.

But the new accounting standard requires that a company carve out a part of its current year's profits (equal to the future tax liability on such transactions) as a deferred tax liability. The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability in those years.

Under International Financial Reporting Standards, deferred tax should be accounted for using the principles in IAS 12: Income Taxes.

When does a company create a deferred tax asset?

The tax laws may not recognise some of the expenses that a company has charged off in its accounts. For instance, provisions made at the discretion of the management, such as those for bad debts, which are not fully recognised by tax authorities. And expenses which are accounted for on an accrual basis (that is, when they become due and not when they are actually paid). Companies may charge off duty, cess and tax dues against profits when they become due, but they would be recognised for tax computation only when actually paid.

In such cases, a company is actually pre-paying taxes pertaining to future years. For the year, the profits that the taxman calculates would be higher than those computed in the company's books of accounts.

So, while the company shells out a disproportionately high tax in the current year, it would save on tax in the years when the expenses or provisions actually materialise.

Why account for deferred taxes?

By recognising deferred tax liabilities in its books, a company makes sure that the tax liability for any particular year is reflected in that year's financials and does not carry over to future profits.

It brings investors one step closer to understanding exactly how much of a company's profits for a period are from its operations (rather than from fiscal savings).

Answer 2

A deferred tax liability is a tax liability you have legally put off paying until sometime in the future. For example: your company may record income on their books...that is NOT required to be recorded as income of the current period by the IRS. To record the income without recording the anticipated tax liability would overstate net income. As the income is recognized in current periods by the tax system, the company will remove some of the deferred liability balance and actually have to pay it to the IRS. The point of this endeavor is to try to match expenses of the current period with income of the current period to more accurately present net income.

Answer 3

A company may recognize the excess tax paid over and above the tax liability as a "deferred tax asset"

www.business.uconn.edu/users/smf/Accounting%20for%20Deferred%20Taxes.doc

The deferred tax liability serves the purpose of a reserve, which will be drawn down in the future years to meet the company's higher tax liability

www.thehindubusinessline.com/iw/2003/05/04/stories/2003050400020600.htm

www.equitymaster.com/DETAIL.ASP?story=1&date=5/11/2002

Answer 4

Use the installment method because it allow deferral until the payments are received.