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We have the following information about an asset of a company.
Original cost: $1,500,000
Useful life of the asset: 3 years
Salvage value: $0
Depreciation for accounting purpose: $500,000 per year using straight
line method
Depreciation for taxation purpose: $600,000 in year 1, $500,000 in year
2, and $400,000 in year 3.
EBITDA: $1,000,000
Tax rate: 40%
We can calculate the firms income tax expense, taxes payable, and
deferred tax liability as follows:

Income Statement
Year 1

Year 2

Year 3

EBITDA

1,000,000

1,000,000

1,000,000

Depreciation

$500,000

$500,000

$500,000

Income before
tax

500,000

500,000

500,000

Income tax
expense

200,000

200,000

200,000

Year 1

Year 2

Year 3

EBITDA

1,000,000

1,000,000

1,000,000

Depreciation

$600,000

$500,000

$400,000

Income before
tax

400,000

500,000

600,000

Tax payable

160,000

200,000

240,000

Income Tax Returns

In year 1, income tax expense is $200,000 but the tax payable is only
$160,000. The difference of $40,000 is deferred to future period and
reported on balance sheet as Deferred Tax Liability (DTL).
In year 2, depreciation is same for both accounting and tax purpose;
therefore, income tax expense and tax payable are same. There will be no
change in DTL.
In year 3, tax payable is higher than income tax expense by $40,000. The
Deferred Tax Liability recognized at the end of year 1 will now be
reversed.
Note that over the period of three years, the income tax expense, tax
payable, and the total depreciation are same for both income statement
and tax returns.
2

Impact of Tax Rate Change on Financial

Statements
If the income tax rates change, the firm is required to adjust the values of
deferred tax assets and liabilities to reflect the new tax rate. The income
tax expense may also be affected.
If tax rate increases:
Deferred tax assets and liabilities increase
Income tax expense = Income tax payable + DDTL D DTA
If tax rate decreases:
Deferred tax assets and liabilities decrease
Income tax expense = Income tax payable DDTL + D DTA
Example

A firm has an asset with carrying value = $500,000

Tax base = $400,000
Tax rate = 40%
Deferred Tax Liability = 40% * (500,000 400,000) = $40,000
Bad debt expense recognized in income statement = $25,000. Carrying
value is $0.
This bad debt expense is not deducted in tax returns. Tax base is $25,000
Deferred Tax Asset = 40% * (25,000 0) = $10,000
The tax rate changes to 30%.
Since the tax rate has decreased, both DTL and DTA will decrease.
3

New DTL = 30% * (500,000 400,000) = $30,000. DTL is lower by

$10,000
New DTA = 30% * (25,000 0) = $7,500. DTA is lower by $2,500.
We will apply the following equation to determine the change in income
tax expense:
Income tax expense = Income tax payable DDTL + D DTA
The income tax expense will reduce by $7,500.