Could anyone please explain why deferred tax liability arises when the carrying amount of a liability is less than its tax base and why DTA arises when the tax base of a liability is less than its carrying amount?
From my understanding (correct me if im wrong!), a DTL arises when the carrying amount of an asset exceeds its tax base b/c that would mean that the company is paying less taxes than it should be, and will therefore result in future taxable income. Similairly, a DTA arises when the tax base of an asset exceeds its carrying amount b/c that would mean that the company is paying more taxes than it should, and would therefore provide deductions in the future.
I cant seem to wrap my mind around why DTL arises if the company’s carrying amount of a liability is less than its tax base…wouldnt that mean that the company is paying more taxes then it should and will therefore give rise to DTA?
What’s an asset? It’s a potential, future, economic benefit.
What’s a liability? It’s a potential, future, economic detrement.
The correct way to think about DTAs and DTLs is to think about what’s going to happen in the future.
If your future taxes will be lower than normal, that’s a benefit: DTA.
If your future taxes will be higher than normal, that’s a detrement: DTL.
Suppose that you have a building on which you’re using straight-line depreciation for your financial statements, and accelerated depreciation for taxes; higher carrying value than tax base. You pay less tax now, but you’ll have to pay more taxes in the future: future detrement, so it creates a DTL.
Suppose that you’re using accelerated depreciation for your financial statements, and straight-line for taxes; lower carrying value than tax base. You’ll pay more tax now, but less in taxes in the future: future benefit, so it creates a DTA.
You can think of liabilities as if they were negative assets. A lower carrying value than tax base for a liability is like a higher carrying value than tax base for an asset: it creates a DTL. (When you pay it off you’ll have a bigger gain/smaller loss for taxes than for financial, so you’ll have higher future taxes: future detrement.)
A higher carrying value than tax base for a liability is like a lower carrying value than tax base for an asset: it creates a DTA. (When you pay it off you’ll have a smaller gain/bigger loss for taxes than for financial, so you’ll have lower future taxes: future benefit.)
Thank you S2000magician! youre responses are always so helpful Just a quick question though, when you say that you’ll have a bigger gain/smaller loss for taxes than for financial when you pay off the liability, what is it of that you will be having a bigger gain/smaller loss of? the taxable income? I’m sorry im a bit confused
If the book value of a truck is $5,000 and the tax base is $3,000 (SL dep’n for financial, DDB for taxes, DTL was created), and you sell the truck for $7,000, you have a gain of $2,000 for financial, but a gain of $4,000 for taxes: bigger gain, higher taxes. If you sell it for $1,000, you have a $4,000 loss for financial, but only a $2,000 loss for taxes: smaller loss, higher taxes.
Don’t be sorry. If this stuff were easy, we’d be having third-graders doing it and we’d find something else that’s hard to do.
I was having trouble thinking of scenarios where DTL’s and DTA’s would arise. I get how they arise, but what kind of examples cause them to arise. Can this actually happen? You can report two different kinds of things for taxes and statements? Wouldn’t the tax authority be like… uh, we’ll just look at what you’re telling the rest of the financial world.
Are there other examples besides reporting differences that could cause DTL’s and DTA’s to arise that you can think of? It might help solidify the concept for me a little better. Thanks!
Revenues (or gains) are taxable before they are recognized in the income statement.
What does this mean? If I sell a machine and get a gain am automatically taxed, it goes into a deferred tax asset because we haven’t made it to the final income statement yet? And when we do create our income statement, what happens? How are all these taxes finally accounted for?
DTAs and DTLs arise when there are temporary differences between what you report on your financial statements and what you report on your tax return. They’re quite common, and there’s no problem with the tax authorities; indeed, sometimes their own rules (cash-based accounting) are at odds with accounting principles (accrual-based accounting), so they expect it.
Using different depreciation methods for financial and tax is probably the most common way that DTAs and DTLs arise. Other examples would be asset write-ups or write-downs that go through the income statement: accrual accounting says you have to acknowledge them when they occur, tax (cash-based) accounting says you cannot acknowledge them until you dispose of the asset. Similarly with write-offs for bad debts: you usually show them on your financial statements when you book the sales, but you cannot write them off for taxes until you prove that they’re uncollectable. Warrenty expenses are another example: booked with sales on the income statement, written off on the tax return only when you perform the warranty work. So are customer deposits: deferred revenue on financial statements, taxable on tax returns.
In a list:
Depreciation
Asset write-ups, write-downs
Bad debts
Warranty expenses
Customer deposits
You can amuse yourself by trying to think up other examples.
Interest income and expense is another one. In many tax jurisdictions it gets recognised on a cash basis. For financial rerporting purposes it is accrued over the relevant period.
