How to Calculate Deferred Tax Liabilities?

Calculating deferred tax liability (DTL) involves identifying temporary differences between accounting and tax rules and applying the anticipated tax rate. Accurately calculating deferred tax liabilities ensures businesses and individuals portray their true financial picture and prepare for future tax obligations. In this blog, you will learn what is deferred tax and how to calculate deferred tax liability.

Table Content

• What is Deferred Tax?
• What is Deferred Tax Liability?
• Why Deferred Tax Liability is Important?
• How to Calculate Deferred Tax Liability?
• What Happens If You Incorrectly Calculate Deferred Tax Liability?

Before we move on to deferred tax liability calculation, let us first understand what deferred tax is.

What is Deferred Tax?

Deferred tax is an accounting concept that helps financial reporting to align with tax regulations. A deferred tax asset comes into play when a business shows more income taxes in its financial statements than on its tax return, resulting in a deferred tax asset.

Deferred tax helps more accurately determine a company's tax and financial situation. This function balances the imbalances produced between the course of accounting and tax activity. The standard states, "An entity shall recognise a deferred tax asset or liability for tax recoverable or payable in future periods as a result of past transactions or events."

What is Deferred Tax Liability?

Deferred Tax Liability is a balance sheet component that represents the amount of income tax a company is expected to pay in the future due to temporary differences between the accounting and tax treatment of certain items.

 It arises when there are differences between the provisions of income tax and accounting rules. For accounting income, depreciation is charged using the useful lives of fixed assets specified under the Companies Act 2013.

Learn more about deferred tax liabilities in this video - 

Source - The Finance Storyteller (YouTube)

Why Deferred Tax Liability is Important?

For Businesses: 

• Deferred Tax Liability reflects the accurate financial picture of an organisation. A larger DTL suggests potentially higher future tax burdens, which can impact investors and lenders.
• It helps unwind taxable income across years, preventing spikes or dips due to temporary accounting differences, leading to more stable tax payments and even lower overall taxes.

For Individuals: 

• Understanding DTL helps individuals plan for future tax bills, especially regarding retirement savings or capital gains.
• It can also influence investment decisions, as individuals may adjust their portfolios to minimise future tax liabilities.

In short, DTLs are about timing. They bridge the gap between when taxes are recognised for accounting purposes and when they're paid. DTL allows businesses and individuals to understand their future tax obligations and make informed financial decisions.

How to Calculate Deferred Tax Liability?

Listed are the important stages of calculating deferred tax liability, along with examples to help you understand the concept better -

Step 1: Identify Temporary Differences

• Start by looking at a company's financial statements and its tax returns.
• Identify items on the financial statements (like assets and liabilities) that are accounted for differently than for tax purposes.

Example: Suppose a company purchased a piece of machinery for $100,000. They record it as an asset for accounting purposes and plan to depreciate it over 5 years ($20,000 per year). However, for tax purposes, the government allows them to depreciate it over 4 years ($25,000 annually). The $5,000 difference each year is temporary.

Step 2: Calculate Deferred Tax

• Determine whether each temporary difference will lead to paying more or less in taxes in the future.
• For differences that lead to more future taxes, calculate deferred tax liabilities.
• Calculate deferred tax assets for differences that lead to less future taxes (savings).

Example: In our machinery case, the lower depreciation for tax purposes means the company pays less tax now. However, they will pay more tax if they follow the accounting depreciation schedule. So, they calculate deferred tax liabilities for the $5,000 difference each year.

Step 3: Record on the Balance Sheet

• Put the calculated deferred tax liabilities (for future taxes) and deferred tax assets (for future tax savings) on the company's balance sheet.

Example: If the company's deferred tax liability is $5,000 for the next 4 years, they will show a total deferred tax liability of $20,000 on the balance sheet. This is the amount they expect to pay extra in taxes over the next 4 years.

Step 4: Review and Update

• Periodically review deferred tax assets and liabilities. 
• Update them if there are changes in tax laws, rates, or expectations about when temporary differences will reverse.

Example: If the tax laws change and the government allows faster depreciation, the company's deferred tax liabilities might decrease because they will pay less in taxes in the future.

Step 5: Reflect on Financial Statements

• Show the impact of deferred tax in the company's income statement. Deferred tax assets reduce future tax expenses, while deferred tax liabilities increase them.

Example: If a company had deferred tax assets of $10,000, they'd pay $10,000 less in taxes in the future. This reduces their income tax expenses in the income statement.

Real-Life Example Recap

Imagine a company (Company XYZ) with a machine worth $100,000.

For accounting, they depreciate it slower ($20,000/year).

For taxes, they depreciate faster ($25,000/year), creating a temporary difference of $5,000 each year.

Over 4 years, that's $20,000.

Company XYZ records a deferred tax liability of $20,000 on the balance sheet.

If tax laws change, they might need to update this value.

In the income statement, deferred tax assets and liabilities impact future tax expenses.

What Happens If You Incorrectly Calculate Deferred Tax Liability?

The DTL is reported on the balance sheet as a liability. If it is miscalculated, it can result in an inaccurate balance sheet, impacting the company's overall accuracy of financial statements. Here are the implications - 

• An incorrect DTL can lead to an inaccurate income tax expense figure, misrepresenting the company's profitability.
• If the DTL is understated, the company may need to set aside more funds to cover future tax obligations accurately, leading to tax compliance issues and potential penalties.
• Misguided tax planning decisions. 
• Inaccurate financial statements can shake investor and stakeholder confidence.  
• An incorrect DTL may raise concerns during audits or regulatory reviews. Auditors and regulators may question the company's accounting practices and demand corrections.
• Incorrect valuation metrics, potentially affecting the company's market value.
• Correcting errors in DTL calculations can be time-consuming and costly. It may require restating financial statements and engaging with auditors and tax authorities to rectify the situation.

Conclusion

Financial statements offer a true picture of a company’s financial performance and help shareholders and investors make correct investment decisions. Correct calculation of deferred tax liabilities is crucial, and errors may lead to misleading financial statements, affecting the perception of the company's profitability and financial stability. Therefore, companies must ensure accurate accounting for deferred taxes to maintain transparency and credibility in financial reporting.