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  1. 073A company buys a Rs 100 crore asset. It depreciates it over 10 years in its books and over 5 years for tax, at a 25% tax rate. What deferred tax balance exists at the end of year 1 and year 5, and what happens to it afterwards?Accounting riddlesHardBulge bracket IBMiddle market IB

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    Before you work it: what sits on the balance sheet at the end of year 5?

    Show the worked solution

    A deferred tax liability of Rs 2.5 crore at year 1, Rs 12.5 crore at year 5, and it unwinds to zero by year 10. Book depreciation is Rs 10 crore a year; tax depreciation is Rs 20 crore for five years then nothing. In years 1 to 5 taxable profit is Rs 10 crore below book profit, so the company pays Rs 2.5 crore less tax than it charges, and the difference accrues as a liability. From year 6 the position reverses and the liability drains at Rs 2.5 crore a year.

    Why is there a liability when the company has paid less tax?

    Think of a shopkeeper allowed to pay this year's electricity bill next year. Cash looks better today, but the bill has not vanished; it sits as something owed. Faster tax depreciation lets the company deduct the asset's cost sooner, so it pays less tax now and more later, and the accounts record the later tax as a liability the moment the saving is taken. The income statement charges tax on book profit, Rs 2.5 crore a year more than the cash actually paid in years 1 to 5, and that extra charge is what builds the balance.

    Faster tax depreciation opens a gap, then closes it: tax deferred, not cancelledYr 0Yr 1Yr 5Yr 1050100book value, 10 a yeartax value, 20 a yeargap 50 at year 5x 25% = DTL 12.5Deferred tax liability, Rs croreYr 12.5Yr 25.0Yr 37.5Yr 410.0Yr 512.5Yr 610.0Yr 77.5Yr 85.0Yr 92.5Yr 100.0red: builds, green: unwindsYears 1 to 5: pay Rs 2.5 crore less tax each year. Years 6 to 10: pay Rs 2.5 crore more. Net over ten years: zero.
    The asset's book value falls by Rs 10 crore a year while its tax value falls by Rs 20 crore, so the gap between them reaches Rs 50 crore at year 5 and 25% of that, Rs 12.5 crore, is the deferred tax liability, which then unwinds by Rs 2.5 crore a year as book depreciation continues with no tax deduction left.

    How do you get the balance without a schedule?

    Compare the two values of the asset. The deferred tax liability is the tax rate times the gap between the asset's book value and its tax value, because that gap is profit the tax authority has not yet taxed. At year 1 the book value is Rs 90 crore and the tax value Rs 80 crore, a gap of 10, and 25% of 10 is Rs 2.5 crore. At year 5 the book value is Rs 50 crore and the tax value is zero, a gap of 50, so the liability is Rs 12.5 crore. At year 10 both are zero and so is the liability.

    Year endBook valueTax valueGapDeferred tax liability at 25%
    19080102.5
    37040307.5
    55005012.5
    7300307.5
    100000.0
    Rs crore. The liability is always a quarter of the gap between the book value and the tax value of the asset, which is why it peaks at Rs 12.5 crore when the tax value hits zero at year 5 and disappears when the book value catches up at year 10.
    The relationship
    DTL=t×(book value−tax value)0.25×(50−0)=12.5DTL = t \times (\text{book value} - \text{tax value}) \qquad 0.25 \times (50 - 0) = 12.5
    DTLthe deferred tax liability, Rs crore
    tthe tax rate, 25%
    book valuecost less book depreciation, Rs 50 crore at year 5
    tax valuecost less tax depreciation, zero at year 5
    What it says in wordsThe liability is the tax rate applied to the profit the tax authority has not yet taxed.

    Why does a banker care about a timing difference?

    Because it is cash. In years 1 to 5 the company keeps Rs 2.5 crore a year more cash than its income statement suggests, which shows up as an increase in deferred tax liabilities in operating cash flow, and in years 6 to 10 the same amount drains out. A model that uses book tax on EBIT misses both legs, and a buyer of a company with a large and growing deferred tax liability should ask whether it is still growing because the company keeps buying assets, or about to reverse. Say the limitation: the balance reverses only if the company stops adding new assets, and tax rules on depreciation differ by country and change, so confirm the current rates before building this into a model.

    Where candidates lose it

    The common loss is calling the balance a deferred tax asset, because the company has paid less tax and that feels like a benefit. Paying less now means paying more later, which is a liability.

    The second loss is saying the two methods cancel out and so nothing appears. They cancel only over the full ten years; at every year end in between, the gap is real and sits on the balance sheet.

    What the interviewer asks next

    • Now the asset is sold at the end of year 5 for Rs 60 crore. What happens to the deferred tax liability?
    • What would create a deferred tax asset instead of a liability?
    • The tax rate rises to 30% at the start of year 3. What happens to the balance, and where does the change hit?