When you are dealing with issues related to taxes, have you ever come across the term deferred tax liability? It refers to the sum of taxes that are due in the current accounting period, yet the business (Also see Identifying the Profitability of a Business) has not paid for it. The deferred tax arises from the difference between the timing the company accrues the taxes and the timing it pays for it. If you outsourced your accounting tasks to an accounting firm in Singapore, and the accountants have recorded a deferred tax liability in your balance sheet, it means that your company needs to pay more taxes in the future for transactions that have taken place in the current accounting period.
Deferred tax (Also see Guide to Deferred Tax Asset) arises from the difference in tax laws and the accounting rules that the companies apply. This has led to a situation where the earnings before taxes of a business exceed its taxable income. Such a condition causes deferred tax liability to appear on the balance sheet of the company. This means that the business needs to make a tax payment to the appropriate tax authority in future. To calculate the amount of deferred tax liability, business owners should work out the difference between their taxable income (Also see How Do Net Income and Gross Income Differ from Each Other?) and earnings before taxes, then multiply the resulting amount with the tax rate.
In simple words, the deferred tax liability is the sum of taxes the company paid less than is due for, and it will make the payment in the future. This does not mean that the company did not fulfil its tax obligations. This only indicates that the company is going to pay for the obligation at different timing. As an instance, XYZ Corporation knows that it has to pay income taxes. As the tax liability is for the current accounting period, it needs to recognise the expense in that period too. However, it will only pay for the taxes in the next year. Thus, it will record a deferred tax liability to rectify the difference in timing.
The difference in the treatments used to deal with depreciation expense is one of the common reasons that lead to deferred tax liability. For example, the accountants will normally use the straight-line depreciation method to calculate the depreciation expense of fixed assets. However, the tax authorities require business owners to use the method of accelerated depreciation to calculate the depreciation expense. As the sum of depreciation calculated by using the straight-line method will yield a lower amount when compared to that of the accelerated method, the company’s income calculated through financial accounting will be higher than its taxable income temporarily.
To recognise the differences between the earnings before taxes and its taxable income, the company will record a deferred tax liability. As the depreciation process continues, the differences between the amounts calculated through the straight-line method and the accelerated method will be less significant. Thus, the accountants will remove the deferred tax liability by using offsetting journal entries.