A Deferred Tax Liability (DTL) stems from temporary timing differences between the taxes recorded under book (U.S. GAAP) and tax accounting, where the actual amount of taxes paid to the IRS were less than the amount reported on the income statement.
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A deferred tax liability, or “DTL”, is created when the income tax expense recorded on a company’s income statement prepared under GAAP accounting standards is different from the actual amount paid to the Internal Revenue Service (IRS).
The temporary timing mismatch between the recognized tax expense between GAAP and IRS accounting is treated as a liability because fewer taxes were actually paid to the IRS than the amount reported on the income statement.
Since the deferred tax liability is required to be paid soon in the near future, the tax account is categorized as a liability, i.e. the DTL represents a future obligation that must be fulfilled (“cash outflow”).
The discrepancy between the tax expense on the GAAP-based income statement and the actual taxes paid to the IRS is temporary and should gradually unwind to a balance of zero.
Most often, the reason that a deferred tax liability (DTL) arises is tied to a company’s depreciation recognition policies.
Companies have the discretion to utilize either straight-line depreciation or accelerated depreciation for GAAP reporting purposes.
Suppose a company decides to use straight-line depreciation but the depreciation method used for tax purposes is on an accelerated basis. In that case, the depreciation expense for tax purposes is greater in the earlier stages of the fixed asset’s useful life than under straight-line depreciation (and less in the later stages).
The cumulative depreciation recognized is equivalent, irrespective of whichever method is followed. Hence, the DTL is a temporary timing difference that’ll unwind over the course of the asset’s useful life because the depreciation expense used for tax reporting—upon reaching an inflection point—starts to reverse and reduce below the amount reported under GAAP until reaching a balance of zero.
The formula used to calculate the deferred tax liability (DTL) is as follows.
Deferred Tax Liability (DTL) = Income Tax Payable – Reported Income TaxGoing off the prior depreciation example, the deferred tax liability (DTL) recorded on the balance sheet is calculated as the difference between the value of PP&E under book accounting and tax accounting in each period multiplied by the tax rate.
Deferred Tax Liability (DTL) = (Book PP&E Value – Tax PP&E Value) × Tax Rate %We’ll now move to a modeling exercise, which you can access by filling out the form below.
Suppose we’re tasked with preparing the income statement of a company for U.S. GAAP accounting purposes and tax purposes.
Our company uses straight-line depreciation for GAAP reporting purposes and MACRS for tax purposes.
The following is the company’s income statement data as of Year 0:
For the rest of the forecast period, all of our assumptions—excluding “Depreciation” and “Taxes”—will be set equal to our assumptions in Year 0 and remain constant (i.e. “straight-lined”).
In the next step, we’ll calculate the depreciation expense using the straight-line method and the MACRS method.
The cost of the PP&E purchase will be assumed to be $20 million with a useful life of 3 years and a salvage value of zero.
Under the straight-line method, the depreciation expense will be $6.7 million per year.
We’ll now calculate the depreciation expense per year under MACRS using the following list for reference.
3-Year MACRS Depreciation Rate (%)
Note: Under MACRS depreciation, the rate is one year longer than the asset’s classification.
Each year, we’ll multiply the applicable accelerated depreciation rate by the PP&E purchase price.
We’ll now link our depreciation expense values to our book and tax income statements.
Since we have our calculations in place, our tax expense should update once we input our depreciation values.
Our two income statements prepared under book and tax purposes illustrate how a deferred tax liability can be created.
Early on, there is a temporary timing difference resulting in lower payments to the IRS compared to the amount recorded for book purposes. But soon after, the deferred tax liability (DTL) reverses course as the tax payments to the IRS become higher to compensate for the discrepancy.
In conclusion, we’ll confirm the cumulative depreciation expense is $35 million while the total cumulative tax expense is $20 million under both book and tax accounting.
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