How does accelerated tax depreciation create a deferred tax liability, and will it ever reverse?

A deferred tax liability (DTL) arises when taxable income is temporarily lower than accounting (book) income, meaning the company pays less tax now but will pay more in the future. The most common cause is using accelerated depreciation for tax purposes while using straight-line for financial reporting.

Example: Pinnacle Manufacturing buys equipment for $400,000 with a 4-year useful life and zero salvage value. The tax rate is 25%.

• Book depreciation: Straight-line = $100,000/year
• Tax depreciation: Double-declining balance

Year 1 Mechanics

• Pre-tax book income: Assume $500,000
• Book tax expense: $500,000 x 25% = $125,000
• Taxable income: $500,000 - ($200,000 - $100,000) = $400,000 (extra $100K tax deduction)
• Tax actually payable: $400,000 x 25% = $100,000
• DTL created: $125,000 - $100,000 = $25,000

The $25,000 DTL represents tax the company saved now but owes in the future.

Will It Actually Reverse?

For a single asset, yes -- the DTL fully reverses by the end of the asset's life as shown above. However, for a growing company that continuously acquires new assets, new DTLs from fresh purchases may exceed the reversals from old assets, causing the aggregate DTL balance to grow indefinitely. Many analysts treat a perpetually growing DTL as quasi-equity rather than a true liability.

Exam Tip: The CFA exam tests three things: (1) calculating the temporary difference, (2) computing the DTL, and (3) understanding reversal patterns. Remember that total depreciation is identical under both methods over the asset's full life -- it is only the timing that differs.

Practice deferred tax calculations in our CFA Level I FRA question bank.