Definition:

Deferred tax liability can be defined as an income tax liability to the IRS, for having tax payable less than what you actually incurred due to temporary differences between accounting income and taxable income.

It is a line item booked under the liability section of the balance sheet of a company. 

In other words, deferred tax liability arises when you pay lesser tax to the government than you actually incurred and owed as per the accrual basis of accounting. 

Explanation:

The Financial Accounting Standards Boards (FASB) requires companies to make financial statements as per the generally accepted accounting principles (GAAP) and the International Financial Reporting Standards (IFRS).

Hence, the net profit for the year, calculated on the income statement, is calculated and prepared as per the IFRS and GAAP.

On the other hand, the tax officials calculate the annual income on the cash basis of accounting. As per the income tax act, there are some expenses that are allowed to be deducted while others are not.

These restrictions generate a difference between the accounting income and the taxable income, resulting in deferred taxes. 

  • When the accounting income is more than taxable income, resulting in a temporary taxable difference, the tax payable amounts to be less than the tax incurred as per the accrual basis of accounting.
  • When the accounting income is less than the taxable income, resulting in a temporary deductible difference, the tax payable amounts to be more than the tax incurred as per the accrual basis of accounting.

In case of a temporary deductible difference, deferred tax asset arises, whereas in case of a temporary taxable difference, deferred tax liability arises. 

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Income tax payable is calculated as follows:

Particulars $
Accounting income xxx
(+/-) Temporary differences xx/(xx)
(+/-) Permanent differences xx/(xx)
Taxable Income xxx
 Tax rate X %
Income tax payable xx

Current tax expense = Accounting profit Tax rate

Deferred Tax Liability = Current tax expense – Income tax payable (when accounting income is higher than taxable income)

The journal entry passed to record deferred tax liability is as follows:

Current Tax Expense (accounting profit*tax rate) DR

Income Tax Payable (taxable income*tax rate) CR 

Deferred Tax Liability CR

Reasons why deferred tax liability arises:

  • A deferred tax liability may arise in the early years of a purchase of a machine in case the company’s depreciation method is a straight line as compared to the tax law’s double depreciation method. Due to the double depreciation method, higher depreciation would be charged on the tax statement resulting in lower taxable income than the accounting income resulting in deferred tax liability.
  • Similarly, a higher depreciation rate used by tax authorities as compared to the lower rates used by the company would lead to lower taxable income resulting in a low tax charge for the year even if the tax incurred is higher.
  • Advance payments may also lead to deferred tax liability. Advance rent paid by a company does not get reported on the income statement; however, on the tax statement, it gets deducted, resulting in a lower taxable income than the accounting income. A temporary taxable difference arises, resulting in a deferred tax liability.
  • The credit sales are reported as revenue n the income statement, whereas the tax statement only includes cash sales, resulting in a higher accounting income and lower taxable income. Hence, deferred tax liability would arise that is to be satisfied in the accounting period when the receivables clear their dues.
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Example:

ABC Company has $20,000 worth of credit sales for the year and a net profit of $160,000. Its tax rate is 30%. Prepare the journal entry to recognize deferred taxes.

Particulars $
Accounting Income 160,000
(-) Credit Sales (20,000)
Taxable Income 140,000
 Tax rate  30%
Income Tax payable 42,000

Journal Entry:

Current Tax Expense ($160,000*30%) DR $48,000

                  Income Tax Payable ($140,000*30%) CR $42,000

                Deferred Tax Liability CR $6,000