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📊 Deferred Tax Liability Explained — Intermediate Accounting

Duration: 20:03 3039 transcript words EN summary

Video summary

Deferred tax liability represents a future obligation to pay taxes that arises due to temporary differences between financial accounting rules (GAAP) and tax laws enforced by the IRS. In this session, Professor Farhhat explains that while these liabilities are obligations for future payments, they must be recorded immediately on today's balance sheet because it is certain that taxable income will increase in the future when these timing differences reverse. The core concept revolves around temporary differences, which occur when an asset or liability has different carrying values under GAAP compared to its tax basis. Specifically, a deferred tax liability is created when book revenue is recognized before cash is received and taxed by the IRS, resulting in a "future taxable amount." Conversely, if future deductions are lower than current ones due to accelerated depreciation for tax purposes, it leads to higher taxes payable later, necessitating the booking of this liability now. The accounting process involves calculating the difference between book income and taxable income at year-end to determine both current and deferred portions of the tax expense. For instance, if a company reports $300,000 in financial income but only pays tax on $110,000 because some revenue is tied up in accounts receivable that will be collected later, the remaining difference creates a future taxable event. The total deferred tax liability is computed by multiplying this temporary difference by the enacted tax rate expected to apply when the reversal occurs. In practice, companies record two separate entries: one for current taxes payable based on actual cash payments made now, and another for the deferred portion which increases income tax expense while crediting the deferred tax liability account. This ensures that the total income tax expense reported on the income statement reflects both what is paid immediately and what will be owed in future periods. To illustrate these concepts further, the video uses an example involving equipment with a carrying value of $500,000 versus a tax basis of $380,000 at year-end. This discrepancy often arises because companies are allowed to take larger depreciation deductions for tax purposes than they record in their financial statements under GAAP. Since the company has already utilized more of its asset's value for tax reduction now, it will have fewer future deductions available when calculating taxable income later. Consequently, this results in higher taxable income and increased tax payments in subsequent years as the temporary difference reverses. By multiplying the $120,000 difference by the enacted tax rate, such as 21%, a company determines its specific deferred tax liability amount, which is then recorded to accurately reflect future economic obligations related to taxes. In conclusion, understanding deferred tax liabilities requires recognizing that accounting standards and tax codes operate on different timelines regarding revenue recognition and expense deduction. The primary takeaway is that these differences are not errors but rather intentional timing gaps that must be accounted for proactively through journal entries involving income tax expense, current taxes payable, and the deferred tax liability account. As companies navigate changes in enacted tax rates or shifts between GAAP book values and IRS tax bases, they must continuously adjust their calculations to ensure accurate financial reporting. The session sets the stage for future discussions on deferred tax assets, emphasizing that mastering these temporary differences is essential for passing professional exams like the CPA or CMA and for maintaining compliance with intermediate accounting standards.

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Hello and welcome to this session. This is professor Farhhat in which we will discuss the third taxed liability. So this is a liability. Liability means what? A liability means an obligation. But let's analyze this type of obligation. This is a deferred tax. It means we have an obligation to pay taxes in the future. It's a deferred obligation. Although this is the third one, we have to record the obligation now. Why? Because if we know we are going to owe taxes and basically what we're saying for sure we are going to have a tax liability in the future. We're going to have a tax bill. Therefore in accounting we say if that's the case let's book the liability today now. So this is a liability little bit different. And basically we are proactive in a sense that we know we are going to have this tax liability maybe next year maybe two years from now but let's book it today. In the prior session we looked at deferred taxes in general and we talked about how to account for deferred taxes and we touched upon liability a little bit and assets a little bit. In this session we'll focus on the liability portion and the next session we'll focus on the asset portion. So I'm going to break it down into baby steps liabilities first. Now this topic is covered on the CPA exam, CMA exam, inter in your inter intermediate accounting course. Now it's very important if you don't know the big idea about deferred taxes. Look at the prior session where we have to account for the book which is accounting financial accounting separately from the IRS the tax code and because of that we have those differences in assets and liabilities and because of that we have deferred tax liability. So what brings deferred tax liability to life or deferred taxed asset but in this session I will focus on deferred tax liability is something we called a temporary difference. So we will start focusing on temporary differences. There is temporary differences and later on we will see permanent differences. We will start with temporary differences because they are more relevant. It's harder to um understand in a sense relative to the permanent and the temporary differences are the differences that gives a rise to deferred tax asset and the deferred tax liability. Let's go ahead and get started with temporary differences. Before we proceed any further, I have a public announcement about my company, far lectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas, and example from each lecture. Flashcard builds from the lesson itself. A quiz build on the lesson. And as a bonus, convert any lecture into a portable short audio on the go. So it helps you with the retention. No noise, no generic responses, just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now go to forhat lectures.com now and see how the AI can help you understand, practice and retain the material. So what's a temporary difference? A temporary difference is a time gap between the tax basis of an asset and its carrying value, its book amount. Remember what we said in the prior session. We have two sets of books. We have GAP and we have IRS. gap. If we have an asset or a liability, it's it has a book value or a carrying value. And this deals with the financial statement specifically on the balance sheet. At some point, there's going to be a difference between the assets and liabilities that we have for GAAP and the asset and liabilities we have for the IRS, which are called tax basis. So tax basis is the same thing as the book value and the book value is the same thing as tax basis but the language is different between GAP and IRS. So because those differences exist and remember those differences would reverse eventually they would reverse because those differences exist on temporary basis. We call them temporary differences. Those temporary differences produce deferred tax liability and deferred taxed asset. So deferred tax liability and a deferred tax asset is a temporary difference that can result in one of two things. Either a future taxable amount and if it's going to result in a future future taxable amount, this is what I have been talking about all this time. It would result in a future tax liability or this temporary difference could result in a future deductible amount. Great means we are going to have a tax savings. Under those circumstances, we are looking at a deferred taxed asset which we will cover in the next session. This lesson focuses on deferred tax liability where the book income is recognized before it becomes taxable. So in the future we are going to have something that's taxable. It's going to increase our taxable income. When the differences reverse in the future it increase future taxable income. So more taxes is owed later. Therefore we will account for those taxes now in a form of a deferred tax liability. So the third tax liability is the increase in taxes payable in the future that result from a taxable temporary difference existing at the end of the year. So we have an obligation in the future. We know that we have it. How do we know? Because the way we account for it today, we know we're going to it's going to reverse in the future for tax. And once it reverse, we're going to have more taxes to pay. Because we have more taxes to pay, we record it now. So the best example is revenue earned and recognize for book. So what does that mean? When you earn revenue for book under acral. So you could debit an account receivable credit revenue and we have revenue for the books. Well remember cash not yet received. So we recorded a receivable. So as far as GAAP we have revenue and re revenue shows on the income statement and the account receivable exists on the balance sheet. Now the account receivable is taxed when it's taxed when the cash is collected and that event happens in the future maybe a year from now maybe two years from now. But we know since we have a receivable today a cash collection is inevitable or very likely to happen. Therefore, what we do, we say we have a future taxable amount. Well, if we have a future taxable amount, we need to book a deferred tax liability to let the users know, look, in the future, we're going to let you know this. We're going to be receiving cash and that cash will be revenue for tax. And once it becomes revenue for tax, we're going to have a liability. And this is the amount of the liability. So, to compute the third tax liability, we will take the future taxable amount multiplied by the enacted tax rate. Now, what is the enacted tax rate? We're going to have a whole session about enacted tax rate. It's the tax rate that's in effect that we know about now. So, if the enacted tax rate, so in the next year, the tax rate is 30%, 25, 21, whatever that tax rate is. If we know what that tax rate is, that's the enacted. It's the tax rate that's in effect that we know about today. Would that tax rate change? Yes. We'll deal with that later. Now the best way is to look at an example to illustrate everything that we said. So we're going to look at Adam Corporation. We're going to compute taxable income deferred tax and book the journal entry at year end. So here's what we are told. We are told there's a one temporary difference which is an account receivable at the end of of year X1. And this temporary difference would reverse from year X2 to year X4. So year X2, X3 and X4. this temporary difference would reverse. Today the financial income for this year for the current year is 300,000 and the tax rate for all years I'm going to keep it simple 20%. And no deferred taxes exist at the beginning of 200 and X1. So how much is that difference? Well the difference is 190,000. So we have an account receivable today of 190,000 and this receivable would reverse part of it in X2, part of it in X3, part of it in X4. Okay, what does that mean? Let me show you what it means from a financial accounting perspective. We are saying we have financial income of 300,000. Okay. Now, this financial income, what's included? So, here's what I want you to know. This is I'm going to call it financial accounting income. Let's call it financial income or I'm going to call it specifically to keep it easier for you, gap income. We have gap income. Gap income before tax 300,000. Now, here's what we have that you don't that it's implied here. implied is when we computed our revenue whatever our revenue was we don't know but included in that revenue 190,000 that is revenue that is account receivable so because it's revenue as account receivable when we compute our taxes we are going to reduce this account receivable to come up with taxable income remember taxable income is the is the taxable income is the amount that's subject to taxes. It's the amount that we base it on to compute our tax bill. So 300,000 is the book income. Remember within this 300,000 is there's 190,000 of account receivable revenue. Now what do we need to do? We need to deduct this temporary difference. Therefore we come up to our taxable income. Our taxable income is lower than our financial income. Why is it lower? Because this 190,000 that we are including in the 300,000 it's not taxable. Now why? because we tell the IRS, look, we don't have the cash and the IRS tax you generally speaking when you have the cash. Therefore, it's deferred for later. How much is that amount? 190. And how is it going to be reversed? We have the schedule. We think 60,000 in X2, 55 in X3, and 75 in X4. Therefore, our taxable income now today X1 is 110,000. We multiply that by the tax rate today and we compute our income taxes payable. That's current 22,000. This is the check amount that we sent today to the IRS. So income taxes payable current amount 22,000. And remember in the prior session I booked the entry and I said basically for this amount you have income I know tax expense. I'm going to go slowly but it's worth it. 22,000. Let's call it current. C current current. And we have income taxes payable also current of 22,000. So for this 22,000 we booked 22,000 of expense and we call it income tax expense current. Is this the only thing that we have to account for? Absolutely not. We have to account for the deferred portion. And how much is the deferred portion? Let me highlight it in yellow. Now, we're going to move and compute the deferred po the deferred portion. And the deferred portion is 190,000. So, the deferred portion is 190,000 and the enacted tax rate we're going to assume for all the next three years is 20%. Why do I say assume? Because we're going to see later that future tax rate could change, but we don't have to worry about that. Keeping it simple now. So the the deferred portion for year X2 is 12,000. The deferred portion for year X3 is 11,000. The deferred portion for year X4 is 20,000. Could have could could have I took the 120 * 190 * 20%. Sure. The reason I'm breaking it down is to make you pay attention that in the future this tax rate may differ. That's why we said the enacted tax rate. Enacted means it's what we know it's in effect. Now the Congress can meet and change that tax law. Therefore, we have to change our computation. We'll worry about that later. Keeping it simple now. So our ending DTL should be 38,000. Now what's our beginning DTL? Zero. I'm keeping it simple. I'm keeping it simple. So we're going from zero to 38,000. So there was an increase of 38,000. So what do we do? What's how do we book this entry? How do we book this entry? We are going to debit income tax expense and this is the deferred portion 38,000 and we are going to credit deferred tax liability. This is the credit 38,000. Now notice I have income tax expense 38. Let me go back to the prior sheet slide. And I have Whoops. One more. And here I booked an income tax expense of 22. It was the current portion. Now what's my income tax expense? Now my income tax expense in total it's going to be the both of those. Therefore my current portion I showed you 22,000 plus the deferred portion because I increased and remember what I said in the prior session. Every time you measure the change in D2L or DTA and I'm going to triple underline the change. The change the corresponding entry is income tax expense to be specific to the deferred portion of it. Here change means we are crediting DTL 38. If we credit we have to debit income tax expense. Therefore income tax expense in total is 60. So the journal entry will be this is the current portion income taxes payable 22,000 the deferred portion is 38 therefore my income tax expense remember income tax expense is the last thing you do I add those two which is 60,000 and I showed you the separate entry income tax expense the current portion is 22 the deferred portion is 38 and the company will book two of them they will have two two income tax expense one is current and one is deferred. One is current and one is deferred. So income tax expense equal to income tax is payable what you pay now plus the deferred. Now if you had a if you have a change in deferred taxed asset. So let me show you. So income tax expense equal to income taxes payable which is this amount plus deferred tax liability minus if there's an increase in deferred taxed asset. If there's an increase in the third tax asset, it said saving. And sometime you will see later, we're going to have both liability and asset at the same time. But now, keeping it simple, income, income tax expense equal to income taxes payable plus D2L. Or if D2L went down minus DTL. So if we debit, if the DTL was a debit, that's going to reduce income tax expense. Let's take a look at this multiplechoice question from farlectures.com. Corporation X owns equipment with a with a carrying value of 500,000 and a tax basis of 38 at December 31st. The enacted tax rate is 21%. And what is the deferred tax liability? So here they're not even asking you to determine whether it's a deferred tax liability or a deferred tax asset. They're telling you you are computing a DTL. So keeping it simple. Now why would the DTL arises? It arises because of the difference in the book and tax basis of an asset which is an equipment here or a liability but here we have an asset equipment. So the book is is is half a million. The tax basis is 380. Let me show you what we're looking at. We have GAAP and the basis for GAP is half a million. The tax basis for the IRS is 380. What does that mean? It means there's a difference of 120,000 between the two. Now, why would why would the equipment let me let me just ask you this why would the equipment for tax purp for tax purposes will have a lower basis? And why why would you have a lower basis? You have a lower basis because you took more depreciation for taxes. That's why your your tax basis is lower because you you took more depreciation. Why did you take more depreciation? Because the IRS, the government allow you to take more depreciation. Therefore, you took advantage of that and took the deduction now. Great. You took the deduction now. What does that mean? It means in the future you have less deduction. How much less? Specifically, 180. Well, if you have less deduction of 180, it means your tax liability would increase by 100. I'm sorry, less of 120, not 180. In the future, you will have less deduction of 120. Take this 120 times the rate, and that's your deferred tax liability. So, if I take 120 times 21%, I have 25,200 is my deferred tax liability. Therefore, the deferred tax liability is 25,200. That's all what it means. It means I have a future liability. Why? Because in the future compared to my GAP I'm going to have less depreciation. As a result my IRS and GAP income will differ. They will differ by 120. I know that for sure. And that 120 I lost in tax deduction in the future. I'll have more tax liability. The amount is based on the enacted tax rate is 25,200 which is the amount of difference times the tax rate. And this is the third tax liability. What do you think we're going to discuss next? You guessed it, deferred taxed asset. What should you do? Go to farad lectures. Look at additional resources, lectures, simulations, cases, multiple choice. Whether you are a C, CMA, CPA, accounting student, go to our hot lectures. Look at those additional resources that's going to help you with your courses, with your professional certification because the best investment you can make is invest in yourself. God bless and stay safe.