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.
Some arise now but 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.
They differ from ordinary long-term debt in that they are not borrowings: nobody lent the company money, and the obligation arose from the company's own activities, its tax position, its promises to customers or employees, or its legal duties. Deferred tax liabilities are the largest and least intuitive category.
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: 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, and it represents the future tax the company has, in effect, already incurred on profit it has already reported. Revaluations create the same effect: an asset carried at a value above its tax cost will produce a taxable gain when sold, and the deferred tax on that gain is recognised when the revaluation is.
Acquisition accounting creates deferred tax liabilities on the fair value uplifts to the 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; the liability then becomes cash tax. Analysts treat deferred tax liabilities as a soft form of debt: interest-free and long-dated, but real, and valued at a discount to face value in the assessment of a company's worth.
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; a nuclear operator must decommission the plant.
The obligation arises when the asset is built, and 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 under current standards, pension obligations, deferred compensation and deferred income are further examples of obligations recognised now and settled over time. For readers of accounts, deferred liabilities require two questions.
First, how certain is the amount? A deferred tax liability is calculated from known differences and rates; a decommissioning provision rests on estimates of costs decades away and a discount rate, and small changes in either move the figure substantially.
Second, when will the cash go out? A deferred liability that will be settled next year is a claim on next year's cash; one that will be settled in thirty years is a claim on a future the business may never see in its present form.
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
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
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
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 differences x Applicable tax rate
Taxable temporary difference (depreciating asset) = Book value of the asset minus Tax written-down value
Provision recognised now for a future cost = Estimated future cost / (1 + Discount rate) to the power of Years until payment
Unwinding of discount (annual finance cost) = Opening provision x Discount rate
Worked example: deferred tax on accelerated depreciation. A company buys a machine for $1,000,000. In its accounts it depreciates the machine straight-line over ten years, $100,000 a year. For tax, it can deduct 25% of the reducing balance each year. The tax rate is 25%.
- Year 1: tax deduction $250,000; 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); book $100,000; difference $87,500; additional liability $21,875; cumulative $59,375
- Year 3: tax deduction $140,625; book $100,000; difference $40,625; additional liability $10,156; cumulative about $69,500
- Year 4: tax deduction $105,469; book $100,000; difference $5,469; additional liability about $1,400; cumulative about $70,900
- Year 5 onwards: tax deductions fall below $100,000 and the liability reverses, reaching zero when the machine is fully depreciated on both bases
At the end of year 3 the machine's book value is $700,000 and its tax written-down value is $421,875; the deferred tax liability of about $69,500 is 25% of the $278,125 difference. The company has paid about $69,500 less tax than its accounting profits implied, and will pay it in years 5 to 10.
Worked example: decommissioning provision. An energy company builds a facility it will be legally required to dismantle in 20 years at an estimated cost of $8,000,000. The discount rate is 5%.
- Provision recognised now = $8,000,000 / 1.05 to the power of 20 = $8,000,000 / 2.653 = about $3,015,000; the same amount is added to the cost of the facility and depreciated over its life
- Year 1 unwinding = $3,015,000 x 5% = about $150,750, charged as a finance cost; 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 added to the assetCase study
Seen in the real world.
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 the tax cost remained $4,000,000, a deferred tax liability of $16,000,000 x 25% = $4,000,000 was recognised on the uplift, which increased the goodwill on the deal by the same amount. The acquiring group's chief executive questioned the entry: the group had no intention of selling the site, so, he argued, the tax would never be paid and the liability was a fiction that made the deal look worse.
The finance director's answer was 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 minus $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 turned into a tax bill within three years of the deal.
The chief executive's reflection was that the deferred tax liability had been telling him something about the deal's economics from the start: the $20,000,000 site was worth $16,000,000 to the group after tax if it were ever sold, and the price paid should have reflected that. The group's 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, rather than as accounting entries to be ignored. The finance director's broader point was that a deferred liability is a promise to pay that the accounts have recognised early; the only question is when, and "never" is rarely the right answer.
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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