Deferred tax liabilities. That sounds like a complicated accounting concept, but it turns out to be much easier to understand than you might think.
What are deferred tax liabilities
Deferred tax liabilities are the accounting answer to a question asked by tax legislators in governments around the world: “Would you like to pay your corporate income taxes much much much later?”. Why would governments provide this incentive to corporations? The main reason is that capital investments create jobs! Let’s explore how that leads to deferred tax liabilities on a company’s balance sheet.
Capital expenditures, depreciation and Deferred tax liabilities
Throughout the article, we will use the following very simple example relating to capital expenditures and depreciation. A company is putting in a $2 million investment to extend its manufacturing facilities, adding a new production line. According to the GAAP rules of accounting, the generally accepted accounting principles used for reporting financial results to the stock market, the type of machinery that they are putting in gets depreciated over 10 years, in equal parts per year (the “straight-line method”).
10 years of depreciation of $200,000 per year fully depreciate the $2 million assets. However, for tax accounting purposes, the government wants to provide favorable treatment. It allows the company to depreciate the asset in 5 years. 5 years of depreciation of $400,000 per year fully depreciate the $2 million assets. Accelerated depreciation is the depreciation of fixed assets at a fast rate early in their useful lives. It reduces the amount of taxable income early in the life of an asset, so that tax liabilities are deferred, and improves the financial attractiveness of a project in capital budgeting.
GAAP P&L vs tax accounting P&L
Let’s put the numbers side by side. On the left, we are going to construct the GAAP P&L for year 1: the income statement based on generally accepted accounting principles. On the right, the tax P&L: the income statement based on tax accounting rules. These two sets of books exist “in parallel” in most companies. The revenue that is generated from making products on the new production line is $1 million per year. The variable costs (materials and labor) are $500,000. Depreciation for GAAP purposes is $200,000 per year: $2 million investment divided by 10 years.
Earnings before tax (revenue minus variable costs minus depreciation) is $300,000. At a tax rate of 20%, the income tax expense on those earnings is $60,000. This leaves the company with a GAAP net income of $240,000 per year. For the tax P&L, let’s assume the same revenue and variable costs, but a much higher depreciation of $400,000 per year: the same $2 million investment divided by 5 years. Earnings before tax in this case are just $100,000. At a tax rate of 20%, the income tax expense is $20,000.
This leaves the company with a tax net income of $80,000. One and the same company can have two profit numbers in the same year: the profit per generally accepted accounting principles that are reported to the stock market (on the left), and the profit per individual country tax rules that are reported to the tax authorities (on the right). For GAAP purposes, we love to spread the depreciation over as many years as possible. The lower the depreciation, the higher the income. From the perspective of the stock market, more income is better.
For tax purposes, we love to record depreciation as early as possible. The higher the depreciation, the lower the income, and the lower the tax expense. How about combining the best of these two worlds? High net income, but not having to pay all of your tax expenses just yet? Welcome deferred tax liabilities!
Deferred tax liabilities journal entry
The GAAP financial statements are usually viewed as the “leading” perspective. However, we do need to account in those GAAP financial statements for the difference in income tax expense between the two approaches. That’s where deferred tax liabilities come in. Let’s zoom into the income tax expense line. What is the journal entry for this in the GAAP books? Three accounts are involved: income tax expense in the GAAP P&L or income statement, the income tax liability on the balance sheet, and deferred tax liabilities on the balance sheet. Income tax expense is $60,000 for the year (debit) per our GAAP calculation.
However, the tax accounting rules only specify $20,000 as income tax payable for the year, a credit to liabilities on the balance sheet. The difference of $40,000 gets recorded as a deferred tax liability on the balance sheet: this is money that is not payable yet but shall become payable in future years. $60,000 in debits, $60,000 in credits, the journal entry balances! If the revenue and expenses from the new product line are the same every year, then the same journal entries are booked in years 2, 3, 4 and 5. But after these 5 years, things change dramatically! Let’s see where we stand by now. On the left once again is the GAAP accounting treatment of the investment.
On the right, the tax accounting treatment. In both approaches, the investment is $2 million. Under GAAP accounting, the accumulated depreciation (the sum of how much was depreciated so far) is $1 million. As a result, the netbook value after five years is $1 million: the initial investment minus the accumulated depreciation. Under tax accounting, the accumulated depreciation is $2 million, and therefore the netbook value after five years is zero. The tax effect on the difference in accumulated depreciation and net book value is reflected in the liabilities section of the balance sheet as a deferred tax liability.
Deferred tax liabilities account balance
If we review the account balances of the general ledger accounts that we have been posting to in relation to the income tax expense, then we see no balance in income tax expense in the P&L: income tax expense is a temporary account, in other words, one of the accounts that have to be reset to zero prior to starting a new accounting period. Income tax payable on the balance sheet is a permanent account, one whose account balance carries over to the next period.
However, if taxes payable are settled in cash each year, the balance will be zero at the end of the year. The deferred tax liabilities account has been accumulating a credit balance that increases by $40,000 per year for each of the first five years, summing to a grand total of $200,000 by the end of year 5. If you reconcile the deferred tax liabilities account, then this $200,000 is equal to the $1 million difference in accumulated depreciation between the GAAP books and the tax books, times the corporate income tax rate of 20%.
Depleting deferred tax liabilities
Let’s move on to year 6 when things go in the opposite direction. The GAAP P&L is still the same as before, but the tax P&L changes dramatically. For tax accounting purposes, the asset is now fully depreciated, so there is no depreciation to be recorded anymore. The earnings before tax (for tax accounting purposes) skyrocket to $500,000 per year. At a tax rate of 20%, income tax expense on that is $100,000 per year. Net income is $400,000 per year. How do we record, in our GAAP books, the difference in income tax expense for GAAP purposes of $60,000 and the income tax expense for tax accounting purposes of $100,000?
By using the same accounts as before, but with a slightly different split in debits and credits in the journal entry. The debt to income tax expense is still $60,000 per year, but the credit to the income tax payable liability is $100,000 per year. The difference of $40,000 gets debited to deferred tax liabilities on the balance sheet. $100,000 in debits, $100,000 in credits, the journal entry balances! Same journal entry for years 7, 8, 9, and 10. By the end of year 10, the book value of the investment in both the GAAP treatment as well as the tax accounting treatment is the same: original investment of $2 million, accumulated depreciation of $2 million, the net book value of zero.
However, in the GAAP books, we took 10 years to get there, and in the tax books only 5. Here’s how the journal entries affected the balance in the deferred tax liabilities account. The deferred tax liability is built up (credited) with $40,000 per year in years 1 through 5, up to a total balance of $200,000 at the end of year 5. In years 6 through 10, the same deferred tax liability account is decreased (debited) by $40,000 per year, making the debits in the account equal to the credits in the account by the end of year 10.
GAAP books, tax books, and DTLs
An additional perspective that might be useful for you is to put the key GAAP accounts, the key tax accounting accounts, and the DTL (deferred tax liabilities) side-by-side. On the left, depreciation and income tax expense per GAAP. On the right depreciation and income tax expense per tax accounting rules. Income tax expense for GAAP is bigger than income tax expense for tax accounting purposes in year 1.
In the middle, the build-up of the deferred tax liability balance of $40,000. This balance builds and builds in years 2, 3, 4, and 5, and the deferred tax liability peaks at $200,000 at the end of year 5. As of year 6, income tax expense for GAAP is smaller than income tax expense for tax. The deferred tax liability balance decreases every year by an amount of $40,000 until it drops all the way back to zero at the end of year 10.