Tax - Deferred Tax Liability

I remember back when I was studying for the CPA exam how the ones who had gone before would wax philosophical about how nice it was to be finished with the exam and would tell me all about how nice it was to have free time, or even "a life."

Now that I've passed the exam, I try to be a little more encouraging to those who are preparing. Today someone asked me a great question about Deferred Tax Liabilities; one of my favorite topics. You have to be good with GAAP and tax to be able to work through DTA/DTL questions.

This particular reviewer asked why would an increase to prepaid expense increase the deferred tax liability?

Under GAAP prepaid expenses are recorded as assets since they represent a probable future benefit.

So in journal entries, we debit prepaid expense and credit cash when we make the payment and debit expense and credit prepaid expenses when the we receive the benefit.

Fortunately for tax accountants, the tax rules for revenue and expense recognition often differ from GAAP. Some differences are permanent. Fines and penalties are deducted from net income on a GAAP income statement, but can never be deducted from taxable income. This is called a permanent book tax difference and does not result in a DTA/DTL.

Temporary differences have to do with timing. In the case of prepaid expenses, the tax deduction is taken in the period payment is made. But the expense will not be recognized under GAAP until a later period when the benefit is received. This temporary difference results in a deferred tax liability because we pay less tax now due to the current deduction, but will pay more tax later when the difference reverses and we recognize the expense for GAAP, but have already taken the deduction for tax in a prior period.

In other words, an increase to a prepaid expense indicates that we have a deduction that decreases tax income currently as compared to book income and at some point in the future this difference will reverse and increase tax income as compared to book income, thereby generating a deferred tax liability.