The Daily Technical #134: Why is the effective and marginal tax rate often different?

Good morning. Welcome to the 134th edition of The Daily Technical.

Now, you’re here for one reason, so let’s dive in.

First time reading? Sign up here.

OVERVIEW OF YESTERDAY’S QUESTION
What are deferred tax liabilities (DTLs)?

Deferred tax liabilities ("DTLs") are created when a company recognizes a tax expense on its GAAP income statement that, because of a temporary timing difference between GAAP and IRS accounting, is not paid to the IRS during that period but is expected to be paid in the future.

DTLs are often related to depreciation.

Companies can use accelerated depreciation methods for tax purposes but elect to use straight-line depreciation for GAAP reporting.

This means that for a given depreciable asset, the amount of depreciation recognized in the earlier years for tax purposes will be greater than under GAAP.

Those temporary timing differences are recognized as DTLs.

Since these differences are just temporary – under both book and tax reporting, the same cumulative depreciation will be recognized over the life of the asset.

At a certain point in the asset’s useful life, an inflection point will be reached where the depreciation expense for tax reporting will become lower than for GAAP.

Common Mistakes

1. Believing DTLs are permanent differences. DTLs arise from temporary timing differences. To avoid this, focus on the concept that these differences will reverse in the future.

2. Not distinguishing between accelerated and straight-line depreciation correctly. Remember, the difference comes from faster tax depreciation and slower GAAP depreciation, leading to higher tax expenses in the future.

3. Thinking DTLs apply uniformly across all assets. DTLs primarily result from specific accounting treatments like accelerated depreciation. Clarify which assets and accounting methods contribute to temporary timing differences.

4. Forgetting that DTLs eventually reverse. Keep in mind, timing differences equalize, and knowing when this occurs aids in projecting accurate financial statements.
   

TL;DR

• Deferred tax liabilities (DTLs) arise from temporary timing differences between GAAP and IRS tax calculations.

• Typically linked to depreciation, DTLs occur when tax depreciation exceeds GAAP depreciation in early asset years.

• Companies often use accelerated depreciation for tax versus straight-line for GAAP, causing this disparity.

• Total depreciation is equal over an asset’s life, with tax depreciation eventually lower than GAAP depreciation.

• Recognizing DTLs as an interplay of accounting strategies is crucial to grasping their role in financial statements.

TODAY’S QUESTION
Why is the effective and marginal tax rate often different?

Type your answer here. Within 60 seconds you’ll have custom feedback in your inbox.

THAT’S A WRAP
Before You Go: Here’s How We Can Help!

Jobs: we’re tracking all open jobs for the classes of 2025 - 2028. Our list is updated daily. Check them out here

Mentorship: if you’re looking for 1:1 career mentorship, click here to book a free discovery call.

See you tomorrow,

Mike Lukasevicz
Founder @ HirePrep