Deferred tax from a liabilty


Im having a really though time to understand how a deferred tax from a liabilty is originated.

I have looked at a few examples trough te curriculum, schweser notes, this forum…but I still do not get it.

For example. The one from schweser notes in which you have a warranty liabilty with a carrying value equal to 5000 and a tax base equal to 0.Apparently that is meant to be Deferred tax asset (DTA) since you delayed the expense you would be paying in the future.

So, the only explanation I see for that is that at today’s date you in your I/S you have a 30%*5000 = 1500 payment, but for tax purposes at today’s date you do not pay anything. If that it is the logic, behind that, since it is a liabilty were not you suppose to pay for it in the future when the liabilty is due?

Hope I did not make it too confuse.

I think it will be better to consider both cases seperately:

  1. warranty liability is really LIABILITIES on the balance sheet.
  • liability are future obligation of the firm which will lead to outflow of economic benefits
  1. warranty expenses recongition under (i) financial reporting and (ii) tax reporting
  • both reporting bodies recongise warranty expenses differently
  • financial reporting recongise warranty expenses earlier and hence the amount of pretax income is lower
  • whereas for tax reporting, expenses is recognised at a later date; the amount of taxable income is relatively higher
  • this result in the formation of DTA (as tax payable > tax expenses)
  • The DTA will be reversed as soon as warranty expenses are recongised under tax reporting

Hey bud,

Accounting is accrual based whereas tax is (for the most part) cash based. As such, although a company may recognize an expense in P&L from an accounting perspective for a warranty accrual; there is no tax effect until the company actually incurrs these costs. This is a similar situation to pension expense, bad debt expense, or any restructuring or asset retirement obligation being accrued in the financial statements.

The easiest way to think of this conceptually (after understanding when something will have an accounting effect on net income versus a tax effect on taxable income) is to think of what the effect on accounting and taxable income would be if both the accounting and tax bases were reduced to zero in a given year, with all things held constant. In the instance you mentioned, assume we paid out $5,000 in warranty costs next year. All things held equal, the accounting impact is simply a credit to cash/inventory with a correspoding debit to the liability, i.e. no P&L impact.

At the same time, the company will be able to reduce their taxable income by the full $5k, resulting in tax savings equal to their marginal tax rate * $5,000. This is why the above example represents a deferred tax asset.



Could anybody plz explain the schweser example given on page 239 “Accounting effects of a change in a firms tax”

Thanks everyone for the help!