What causes deferred tax liabilities and can they ever reverse?

Deferred tax liabilities (DTLs) arise when taxable income is temporarily lower than accounting income, meaning the company has deferred paying tax to future periods. Here are the most common causes:

Top Causes of DTLs:

1. Accelerated depreciation for tax: Bellhaven Industries depreciates a $10M machine over 5 years for tax (MACRS) but uses 10-year straight-line for GAAP. In early years, tax depreciation > book depreciation, creating a DTL.

1. Installment sales: Revenue recognized on GAAP books but taxed only when cash is received.

1. Capitalized interest: Certain costs capitalized for tax but expensed for GAAP (or vice versa).

1. Undistributed foreign earnings: Profits earned abroad that haven't been repatriated and taxed domestically.

Do They Reverse?

In theory, every temporary difference reverses. In the depreciation example, after year 5, tax depreciation drops to zero while book depreciation continues — the DTL unwinds.

However, for a growing company that keeps acquiring new assets, new DTLs from new assets replace the reversing DTLs from old assets. The aggregate DTL balance keeps growing.

Analytical Framework:

Example: Broadmoor Construction has a DTL of $45M related to accelerated depreciation. CapEx has grown 8% annually for 10 years. An analyst could argue this DTL is quasi-equity because:

• New asset purchases continually generate new DTLs
• The reversals from old assets are more than offset
• The company would need to stop investing for the DTL to fully reverse

In ratio analysis, reclassifying quasi-permanent DTLs as equity reduces the debt/equity ratio and changes the leverage picture.

Learn to identify and adjust for these differences in our CFA Level II Financial Reporting materials on AcadiFi.