What it means
Accrual accounting recognises obligations when they arise, not when they are paid. Most obligations are paid soon after they arise and sit in current liabilities, but some arise now and will be paid much later, sometimes decades later, and the accounts must recognise them in the meantime at an amount that reflects both the obligation and, where the delay is long, the time value of money.
These are deferred liabilities, and they differ from long-term debt in that nobody lent the company money: the obligation arose from its own activities, its tax position, or its promises and legal duties. Deferred tax liabilities are the largest and least intuitive category, because accounting profit and taxable profit differ, often because tax rules allow faster depreciation of assets than the accounts charge.
A company that deducts $250,000 of depreciation for tax in the year it charges $100,000 in its accounts pays less tax this year than its accounting profit implies, but the difference is temporary, because in later years the tax deductions will be smaller than the book charge and the tax will catch up. The deferred tax liability is the tax on the cumulative difference, the future tax the company has in effect already incurred on profit it has already reported.
Revaluations create the same effect, since an asset carried above its tax cost will produce a taxable gain when sold, and acquisition accounting creates deferred tax liabilities on the fair value uplifts to acquired assets, which increases goodwill. Deferred tax liabilities are sometimes dismissed as accounting fictions, on the grounds that a company which keeps investing will keep generating new timing differences and never actually pay.
That is true of the aggregate for a growing company but not of any individual difference, which does reverse, and not of a company that stops investing, sells the revalued asset or shrinks, so analysts treat deferred tax liabilities as a soft form of debt: interest-free and long-dated, but real. Long-term provisions are deferred liabilities of a different kind.
An oil company that drills a well must plug and remove it decades later, a mining company must restore the site, and a nuclear operator must decommission the plant. The obligation arises when the asset is built, so accounting standards require it to be recognised then, at the present value of the estimated future cost, with a matching addition to the cost of the asset.
Each year the discount unwinds, increasing the liability and charging a finance cost, so that by the time the cash is spent the liability has grown to the full amount. Lease liabilities, pension obligations, deferred compensation and deferred income are further examples of obligations recognised now and settled over time.
For readers of accounts, deferred liabilities raise two questions: how certain is the amount, and when will the cash go out? A deferred tax liability is calculated from known differences and rates, whereas a decommissioning provision rests on cost estimates decades away and a discount rate, so small changes in either move the figure substantially.
Both should be in the cash flow forecast at the dates they are expected, and both affect the company's true leverage in ways that a simple debt ratio will not show.
In practice
Real-world examples
Example 1
A property company that revalues its buildings upwards by $16,000,000 recognises a deferred tax liability of $4,000,000 at 25%, because the gain will be taxed when the buildings are sold.
Example 2
A mining company carries a $120,000,000 restoration provision for a site it will close in twelve years, and reviews the cost estimate annually as regulations and technology change.
Example 3
A retailer's balance sheet shows a $45,000,000 lease liability for store leases running up to fifteen years, recognised at present value and reduced as rent is paid.
Think of it
A deferred liability is something you'll owe or deliver later-a future obligation on the books now.
Formula
Calculation
Deferred tax liability = Taxable temporary difference x Tax rate
Taxable temporary difference (depreciating asset) = Book value minus Tax written-down value
Provision recognised now = Estimated future cost / (1 + Discount rate)^Years until payment
Unwinding of discount (annual finance cost) = Opening provision x Discount rate
Worked example: deferred tax. A company buys a machine for $1,000,000 and depreciates it straight-line over ten years in its accounts ($100,000 a year). For tax it deducts 25% of the reducing balance each year, and the tax rate is 25%.
- Year 1: tax deduction $250,000 against book depreciation $100,000; difference $150,000; deferred tax liability 150,000 x 25% = $37,500
- Year 2: tax deduction $187,500 (25% of $750,000); difference $87,500; additional liability $21,875; cumulative $59,375
- Year 3: tax deduction $140,625; difference $40,625; additional liability $10,156; cumulative about $69,500
- At the end of year 3 the machine's book value is $700,000 and its tax written-down value is $421,875; the liability is 25% of the $278,125 difference, about $69,500
- From year 5 the tax deduction falls below the $100,000 book charge, and the liability starts to reverse as the deferred tax is paid
Worked example: decommissioning provision. An energy company builds a facility it must dismantle in 20 years at an estimated cost of $8,000,000, and the discount rate is 5%.
- Provision recognised now = 8,000,000 / 1.05^20 = 8,000,000 / 2.653 = about $3,015,000, and the same amount is added to the cost of the facility
- Year 1 unwinding = 3,015,000 x 5% = about $150,750, charged as a finance cost, so the provision rises to about $3,166,000
- By year 20 the provision has grown to $8,000,000, when the cash is spent
- If in year 5 the cost estimate rises to $10,000,000, the provision is remeasured and the increase is added to the assetCase study
Seen in the real world
This is a fictional, illustrative scenario. A manufacturing group acquired a competitor for $30,000,000. The target's main asset was a factory site that its accounts carried at $4,000,000 but that was worth $20,000,000. In the acquisition accounting the site was recorded at its fair value of $20,000,000, and because its tax cost remained $4,000,000, a deferred tax liability of $16,000,000 x 25% = $4,000,000 was recognised on the uplift, increasing the goodwill on the deal by the same amount. The chief executive questioned the entry, arguing that the group had no intention of selling the site, so the tax would never be paid and the liability was a fiction that made the deal look worse.
The finance director replied that the liability was the tax on a gain the group had recognised by carrying the site at $20,000,000, and that whether it was paid depended on what the group did. Two years later the group decided to consolidate production at its own main plant and sold the acquired site for $21,000,000. The taxable gain was 21,000,000 - 4,000,000 = $17,000,000, and the tax at 25% was $4,250,000, of which $4,000,000 had been recognised on acquisition and $250,000 related to the further increase in value. The cash went out the following year. The deferred liability, dismissed as a fiction, had become a tax bill within three years of the deal.
The chief executive concluded that it had been telling him something about the economics from the start: the $20,000,000 site was worth only $16,000,000 to the group after tax if it were ever sold, and the price paid should have reflected that. The acquisition model was changed to treat deferred tax liabilities on fair value uplifts as real deductions from value, discounted for the expected time to realisation. The finance director's broader point was that a deferred liability is a promise to pay that the accounts have recognised early, and the only question is when.
Watch out
Common mistakes
- Dismissing deferred tax liabilities as never payable; individual timing differences do reverse, and a sale, a slowdown in investment or a change in the business turns the liability into cash tax.
- Recognising a long-term provision at its undiscounted future cost, which overstates the liability today, or failing to unwind the discount, which understates the finance cost each year.
- Leaving deferred liabilities out of the assessment of a company's leverage because they are not borrowings; they are claims on future cash and should be in the forecast at the dates they fall due.
Questions
People also ask
What is the difference between a deferred liability and an accrued liability?
An accrued liability is an expense incurred but not yet paid, usually settled within months: wages, interest, utilities. A deferred liability is an obligation recognised now but settled in a later period, often years away: deferred tax, decommissioning, deferred income, long-dated provisions.
Why do deferred tax liabilities arise?
Because accounting profit and taxable profit differ in timing. When tax rules allow deductions earlier than the accounts charge them, or when assets are revalued above their tax cost, the company reports profit before it is taxed, and the future tax on that profit is recognised as a deferred liability.
Is a deferred liability the same as long-term debt?
No. Debt is money borrowed that must be repaid with interest. A deferred liability arises from the company's own activities and obligations, carries no interest (though long-dated provisions are discounted), and is settled in cash, by performance or by future tax payments depending on its type.
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