A deferred tax liability is created when the income tax expense reported in the income statement is higher than the tax payable as per the tax returns due to temporary differences. The difference between the two is reported in the balance sheet as a deferred tax liability.

This happens when:

• A revenue is recognized in the income statement but not included in the tax returns.
• An expense is tax deductible before it is reported in the income statement.

The use of different depreciation methods in tax return and income statement is the most common way a deferred tax liability is created.

A deferred tax asset is created when the tax payable as per the tax returns is higher than the income tax expense reported in the income statement.

This happens when:

• A revenue is taxable before it is recognized in the income statement.
• Expenses are reported in the income statement before it becomes tax deductible.

Note that the differences are temporary because the taxes will be recoverable or payable at a future date.

The most common items resulting in deferred tax assets are post-employment benefits, warranty expenses, and tax loss carry forwards.

Both deferred tax assets and deferred tax liabilities are expected to reverse in future. Deferred tax liabilities result in a cash outflow while deferred tax assets result in future tax savings.

Since deferred tax liabilities result in a future cash outflow, an analyst must decide on their appropriate treatment by reviewing whether the reversal will actually happen or not. If the reversal is expected, then he may treat it as a liability. However, if reversal is not expected, then for analytical purpose, he should treat this as equity.