Example of a Deferred Tax Liability

We have the following information about an asset of a company.

Original cost: $1,500,000

Useful life of the asset: 3 years

Salvage value: $0

Depreciation for accounting purpose: $500,000 per year using straight line method

Depreciation for taxation purpose: $600,000 in year 1, $500,000 in year 2, and $400,000 in year 3.

EBITDA: $1,000,000

Tax rate: 40%

We can calculate the firm’s income tax expense, taxes payable, and deferred tax liability as follows:

Income Statement

 Year 1Year 2Year 3
EBITDA1,000,0001,000,0001,000,000
Depreciation$500,000$500,000$500,000
Income before tax500,000500,000500,000
Income tax expense200,000200,000200,000

Income Tax Returns

 Year 1Year 2Year 3
EBITDA1,000,0001,000,0001,000,000
Depreciation$600,000$500,000$400,000
Income before tax400,000500,000600,000
Tax payable160,000200,000240,000

In year 1, income tax expense is $200,000 but the tax payable is only $160,000. The difference of $40,000 is deferred to future period and reported on balance sheet as Deferred Tax Liability (DTL).

In year 2, depreciation is same for both accounting and tax purpose; therefore, income tax expense and tax payable are same. There will be no change in DTL.

In year 3, tax payable is higher than income tax expense by $40,000. The Deferred Tax Liability recognized at the end of year 1 will now be reversed.

Note that over the period of three years, the income tax expense, tax payable, and the total depreciation are same for both income statement and tax returns.

Impact of Tax Rate Change on Financial Statements

If the income tax rates change, the firm is required to adjust the values of deferred tax assets and liabilities to reflect the new tax rate. The income tax expense may also be affected.

If tax rate increases:

  • Deferred tax assets and liabilities increase
  • Income tax expense = Income tax payable + ΔDTL – ΔDTA

If tax rate decreases:

  • Deferred tax assets and liabilities decrease
  • Income tax expense = Income tax payable - ΔDTL + ΔDTA
Example

A firm has an asset with carrying value = $500,000

Tax base = $400,000

Tax rate = 40%

Deferred Tax Liability = 40% * (500,000 – 400,000) = $40,000

Bad debt expense recognized in income statement = $25,000. Carrying value is $0.

This bad debt expense is not deducted in tax returns. Tax base is $25,000

Deferred Tax Asset = 40% * (25,000 – 0) = $10,000

The tax rate changes to 30%.

Since the tax rate has decreased, both DTL and DTA will decrease.

New DTL = 30% * (500,000 – 400,000) = $30,000. DTL is lower by $10,000

New DTA = 30% * (25,000 – 0) = $7,500. DTA is lower by $2,500.

We will apply the following equation to determine the change in income tax expense:

Income tax expense = Income tax payable - DDTL + D DTA

The income tax expense will reduce by $7,500.

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