Deferred tax liabilities. That sounds like a complicated accounting concept, but it turns
out to be much easier to understand than you might think. 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. Throughout the video, 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 depreciates the $2 million
asset. However, for tax accounting purposes, the government wants to provide a favorable
treatment. It allows the company to depreciate the asset in 5 years. 5 years of depreciation
of $400,000 per year fully depreciates the $2 million asset. 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.
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 is reported
to the stock market (on the left), and the profit per individual country tax rules that
is 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 expense just yet? Welcome
deferred tax liabilities! 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, 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 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 net book 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 net book 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.
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 has 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 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%. 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 any more. 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 debit 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 year 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, 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) with $40,000 per year, making the debits in the account equal to
the credits in the account by the end of year 10.
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 year 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.