What is a Deferred Tax Asset?

Most business owners would agree that understanding deferred tax assets can be confusing.

By the end of this article, you'll have a clear understanding of what deferred tax assets are, how they work, and how to account for them properly.

We'll start with a simple introduction to deferred tax assets, then walk through real-world examples, accounting rules, and calculations step-by-step. You'll learn the key reasons deferred tax assets arise, how to assess and record them, and where they show up on the balance sheet.

Introduction to Deferred Tax Assets for Dummies

A deferred tax asset is an accounting concept that arises when a business has overpaid taxes or paid taxes early, resulting in a credit that can be used to reduce future tax expenses. This creates an asset on the balance sheet that represents probable future tax savings.

Explaining Deferred Tax Assets and Liabilities

A deferred tax asset is created when a company has:

Paid taxes early or overpaid on taxes
Tax deductions that have not yet been claimed on the tax return
Operating losses that can be carried forward to reduce future taxable profits

This results in probable future tax savings that are recorded as an asset on the balance sheet.

In contrast, a deferred tax liability arises when taxable revenue is recognized before accounting revenue. This leads to lower taxable income in the current period but higher taxes owed in the future, hence the term "deferred."

Understanding the Tax Base

The tax base of an asset or liability refers to the carrying value of that item for tax purpose calculations. It is used to determine the amount of deferred tax assets or liabilities.

For example, due to different depreciation methods allowed under tax law vs. accounting standards, the tax base of a fixed asset often differs from its carrying value on the financial statements. This temporary difference results in a deferred tax item.

Deferred Tax Asset Example in Financial Reporting

Here are some common examples of events that create deferred tax assets:

Net operating loss carryovers - Tax losses that can be used to offset future taxable income
Excess tax depreciation - Accelerated depreciation methods may be used for tax purposes compared to accounting
Accrued expenses - Certain expenses recognized on the income statement but not yet deducted on the tax return

By recording these future probable tax deductions as assets, companies reduce their effective tax rates in future periods when the assets reverse.

Deferred Tax Asset in the Balance Sheet

Deferred tax assets are classified as long-term assets on the balance sheet. By recognizing deferred tax assets, companies record higher assets and equity on their balance sheet.

To assess realizability, companies estimate if they will have sufficient future taxable income to utilize the deferred tax assets. A valuation allowance may be created to reduce the assets if some deductions may expire before they generate tax savings.

Valuation and Assessment Considerations

Companies are required to assess the realizability of deferred tax assets each period based on estimates of future profitability and taxable income.

The valuation allowance reduces the recorded deferred tax assets to an amount expected to be realized in the future. The allowance is decreased when utilization increases, or vice versa.

Accurately valuing deferred tax assets involves judgment of future financial performance. If a company overestimates its ability to generate taxable income, it may have to write down its deferred tax assets.

What is an example of a deferred tax asset?

A common example of a deferred tax asset is the carryover of operating losses. If a business experiences an operating loss in one year, they are typically permitted to use that loss to reduce their taxable income in future years.[^1]

For example, Company A reported the following:

Year 1 operating loss: $100,000
Year 2 profit before tax: $80,000

Without a deferred tax asset for the Year 1 loss carryover, Company A would owe taxes on the full $80,000 profit in Year 2.

However, because losses can be carried forward, Company A can use the prior year's $100,000 loss to offset Year 2's $80,000 profit. So for tax purposes, Company A's Year 2 profit is reduced to $0.

This means:

Company A owes $0 taxes in Year 2
There is still a $20,000 loss carryover that can be used to offset future profits

By using the loss to lower future tax bills, the carryover is considered a deferred tax asset. It has future tax savings value that can provide cash flow benefits for Company A.[^2]

In summary, a deferred tax asset represents future tax savings from things like operating loss carryovers. Rather than losing the tax reduction benefit of a current year loss, businesses can save it for future profitable years.

[^1]: Tax rules differ by country regarding loss carryover eligibility and time limits. Most permit at least 1-2 years.

[^2]: The deferred tax asset value is calculated as the carryover amount multiplied by the company's income tax rate. Here the DTA is $100,000 loss x assumed 25% rate = $25,000 deferred tax asset.

How do you record deferred tax assets?

A deferred tax asset arises when there is a temporary difference between the book value and tax base of an asset or liability. This results in future taxable or deductible amounts when the asset or liability is recovered or settled.

For example, say a company has $100,000 in accrued expenses on its balance sheet. These have not yet been deducted for tax purposes. The company's tax rate is 25%.

When the accrued expenses are paid in the future, the company will get a $100,000 tax deduction. So there is a deferred tax asset related to this temporary difference:

Future deductible amount: $100,000
Tax rate: 25%
Deferred tax asset: $100,000 x 25% = $25,000

The $25,000 deferred tax asset would be recorded on the balance sheet. It represents the future tax savings the company will receive when it claims the $100,000 deduction on its tax return.

In summary:

Identify temporary differences between book and tax bases
Calculate future taxable/deductible amounts
Apply the tax rate to determine the deferred tax asset/liability
Record the deferred tax asset on the balance sheet

As the temporary difference reverses over time, the deferred tax asset will be drawn down. When the accrued expenses are fully paid and deducted, the $25,000 deferred tax asset would be removed from the balance sheet.

What are current deferred tax assets?

A deferred tax asset represents a reduction in future tax liability that a company expects to receive in future years due to events that have already occurred. Some examples of events that can create deferred tax assets include:

Carryforward losses - If a company has operating losses in the current year that can be used to offset taxable income in future years, this results in a deferred tax asset. For example, if a company has a $100,000 net operating loss carryforward, and its tax rate is 21%, it would record a $21,000 deferred tax asset.
Excess tax depreciation - Tax laws often allow faster depreciation deductions compared to accounting rules. This creates deductible temporary differences that result in deferred tax assets. For example, a company buys equipment for $100,000 and uses straight-line depreciation for accounting purposes, deducting $20,000 per year. But tax laws allow the company to immediately deduct the full $100,000 cost. This $80,000 excess tax deduction is a deferred tax asset.
Warranty reserves - Companies estimate future warranty costs and record warranty reserve liabilities under accounting rules. But tax deductions for warranty costs are not taken until actual warranty costs are incurred in future years. These create deferred tax assets.
Other deductible temporary differences - Various other book-tax differences for expenses recognized in financial statements before becoming tax deductible can also create deferred tax assets.

In summary, deferred tax assets represent future tax deductions that are created due to timing differences between accounting and tax reporting. Companies record these assets for deductions they expect to receive in future tax returns.

What are deferred taxes on a balance sheet?

A deferred tax liability represents income taxes that a company expects to pay in the future due to differences between the company's accounting methods and the tax code. Some key points about deferred tax liabilities:

They arise from temporary differences between accounting standards like GAAP and tax regulations. For example, using accelerated depreciation for tax purposes versus straight-line depreciation for financial reporting.
Deferred tax liabilities represent a future obligation to pay taxes. They are considered a contra-asset, meaning they reduce the total assets reported on the balance sheet.
When taxable income is higher than accounting income in a period, it leads to an increase in deferred tax liabilities on the balance sheet. The company records more tax expense than current tax liability.
Deferred tax liabilities occur when tax payments are deferred to future years. This leads to lower current taxes but higher future tax bills when the temporary differences reverse.
An example is depreciation - companies may deduct higher depreciation early on for tax purposes compared to financial reporting. This temporary difference reverses in later years.

The formula to calculate deferred tax liabilities is:

Deferred tax liability = (Tax rate) X (Temporary taxable differences)

In summary, deferred tax liabilities represent future tax obligations that arise due to differences between tax regulations and accounting standards. They lead to lower current taxes but higher taxes when temporary differences reverse in future years.

Core Reasons Deferred Tax Assets Arise

There are a few key factors that commonly create deferred tax assets due to mismatches between financial reporting and tax returns over time.

Revenue vs. Taxable Income Recognition

Expenses recognized on the income statement before they can be deducted on tax returns will create deferred tax assets. For example, estimated expenses for warranties are recorded on the income statement when products are sold but may not be deductible for tax purposes until the warranties are fulfilled in future years. This leads to lower taxable income early on and higher taxable income later, creating a deferred tax asset.

Accelerated vs. Straight-Line Depreciation Methods

If financial reporting uses straight-line depreciation to evenly distribute an asset's cost over its useful life but tax accounting uses accelerated depreciation to deduct more depreciation expense upfront, a deferred tax asset emerges. Accelerated depreciation lowers taxable income early on, while straight-line depreciation means financial income is recognized more evenly. This difference in timing creates a deferred tax asset.

Carryforward Loss and Deferred Tax Assets

Net operating losses that create tax write-offs to use in future years will lead to deferred tax assets. The losses are recognized on financial statements immediately but can only be used to reduce taxable income in future years as they are carried forward. This leads to lower current tax liability and a deferred tax asset to reflect future tax savings when the losses are utilized.

Accrued Liabilities and Warranty Reserves

Liabilities recorded for financial reporting purposes before they can be deducted for tax purposes leads to more taxes paid early on. For example, accrued expenses for services received but not yet billed create liabilities reducing financial income. However, tax deductions occur when actually paid later on. This timing difference creates excess taxes paid currently and deferred tax assets for future tax relief.

Deferred Acquisition Costs (DAC) and Tax Timing Differences

Insurance companies capitalize sales commissions and other customer acquisition costs as assets called DAC. These costs are then amortized over time on financial statements. However, they are fully deductible expenses in the year incurred for tax purposes. This faster write-off reduces taxable income early on, creating deferred tax assets to reflect lower taxes owed in the future as the costs are amortized for reporting.

Calculating Deferred Tax Assets

Understanding the process of calculating deferred tax assets is essential for accurate financial reporting and tax planning.

Identifying Temporary Differences

The first step in calculating deferred tax assets is to identify all temporary differences that will result in deductible amounts in the future. Temporary differences occur when there is a difference between the carrying value of an asset or liability on the balance sheet and its tax base. For example, a difference could arise from using accelerated depreciation for tax purposes versus straight-line depreciation for accounting purposes. Identifying all of these differences is crucial in determining the deferred tax asset.

Applying the Appropriate Tax Rate

Once temporary differences are identified, the tax rate expected to apply in the period when the asset is realized must be used to calculate the deferred tax asset. This requires estimating what the future tax rate will be in the years the temporary differences reverse. The deferred tax asset is calculated by multiplying the total temporary difference by the estimated future tax rate.

Deferred Tax Asset Calculation Example

As an example, a company has $100,000 in equipment on its books, which is being depreciated straight-line over 10 years. For tax purposes, the company uses accelerated depreciation over 5 years. In the first year, the tax depreciation is $40,000 while the accounting depreciation is $10,000. This $30,000 temporary difference multiplied by the 25% estimated future tax rate results in a $7,500 deferred tax asset.

Assessing the Need for a Valuation Allowance

A valuation allowance may be needed if it is more likely than not that some portion of the deferred tax asset will not be realized. Realization depends on the company generating sufficient future taxable income. If future taxable income is uncertain, companies must assess the need for an allowance against the deferred tax asset.

Reporting Deferred Tax Assets on Financial Statements

Deferred tax assets must be presented on the balance sheet and their effects on the income statement must be disclosed. They are reported as noncurrent assets, providing insight into potential future tax deductions. Changes in deferred tax assets each year also impact a company's effective tax rate, which must be shown on the income statement. Proper reporting enhances financial transparency.

Deferred Tax Assets and Liabilities on the Balance Sheet

Deferred tax assets and liabilities arise due to temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. These temporary differences result in future taxable or deductible amounts when the reported amounts of assets are recovered or liabilities are settled.

Classifying Deferred Taxes as Current or Non-Current

Deferred tax assets and liabilities are classified as either current or non-current on the balance sheet.

Current deferred tax assets and liabilities are expected to be realized or settled within 12 months or within the company's operating cycle. For example, a deferred tax asset from an accrued expense that is deductible for tax purposes in the next year would be classified as current.
Non-current deferred tax assets and liabilities are expected to be realized or settled after 12 months. For example, a deferred tax liability arising from accelerated tax depreciation which reverses over several years would be classified as non-current.

The classification provides insight into when the company expects the temporary differences to impact taxable income.

Netting Deferred Tax Assets and Liabilities

Companies net deferred tax assets and liabilities into one single amount on the balance sheet. This net amount reflects the total future tax impact from all temporary differences.

For example, if a company has the following:

Deferred tax assets of $100,000
Deferred tax liabilities of $80,000

The net deferred tax amount reported on its balance sheet would be an asset of $20,000.

Netting provides a simpler presentation, showing the net temporary difference expected to impact taxes rather than separate gross amounts.

Disclosure Requirements for Deferred Taxes

Companies must disclose the components of their net deferred taxes in the financial statement footnotes, including:

The gross amounts of all deferred tax assets and liabilities
The valuation allowance recognized on deferred tax assets
The net change in total deferred taxes

These disclosures provide transparency into the specific temporary differences and any uncertainty regarding realization of deferred tax assets.

Impact of Changes in Tax Laws on Deferred Taxes

Changes in statutory tax rates or new tax legislation can significantly impact the measurement of deferred taxes. For example, if tax rates are decreased, it would reduce the amount of deferred tax liabilities.

Companies may need to re-measure their deferred taxes after such changes. Any impact is recognized either in net income or directly in equity during the period of enactment.

The effect of tax law changes highlights how deferred taxes are based on current tax rules and rates expected to apply in the future when temporary differences reverse.

Key Accounting Rules and Standards Governing Deferred Tax

Deferred tax assets and liabilities are governed by accounting standards that provide guidance on measurement, reporting, and disclosures.

FAS 109 and AS 22 in U.S. GAAP

In the United States, key standards include:

FAS 109 - Accounting for Income Taxes: Establishes standards for accounting for income taxes, including deferred tax assets and liabilities. Requires recognition of deferred tax liabilities and assets for the future tax consequences of events recognized in financial statements or tax returns.
AS 22 - Accounting for Taxes on Income: The equivalent accounting standard in India that aligns with FAS 109. Provides principles for accounting for income taxes.

These standards provide guidance such as:

Tax basis and temporary differences leading to deferred taxes
Measurement of deferred taxes at enacted tax rates
Valuation allowances against deferred tax assets
Presentation and disclosure

IAS 12 for IFRS

Globally, IAS 12 Income Taxes provides guidance on accounting for income taxes under IFRS. Key aspects include:

Recognition and measurement criteria for current and deferred tax liabilities and assets
Definition of tax basis leading to temporary differences
Guidance on valuation allowances
Presentation and disclosure requirements

IAS 12 is largely converged with FAS 109.

Valuation Allowance Guidance

FAS 109, AS 22, and IAS 12 provide detailed guidance on valuation allowances for deferred tax assets, including:

Criteria for establishing allowances based on judgement of realizability
Factors to consider such as historical profitability
Recording as contra accounts against gross deferred tax assets
Annual reassessment requirements

Accounting for Uncertain Tax Positions

The accounting standards also give guidance on recognition thresholds and measurement principles for uncertain tax positions that may affect the deferred taxes.

Key aspects include recognition thresholds, measurement principles, disclosures, and transition approaches for uncertain positions.

Conclusion and Summary of Deferred Tax Assets

Deferred tax assets represent future tax savings that arise from timing differences between financial accounting and tax accounting. Specifically, they are created when a business has deductions or losses that can be carried forward to reduce taxable income in future years.

Some key points about deferred tax assets:

They represent probable future tax savings that can increase net income and equity when realized. For example, a $100,000 net operating loss carryforward would translate to a $21,000 deferred tax asset if the company expects to utilize it in the future (assuming a 21% tax rate).
They arise due to mismatches between financial statement reporting and tax return reporting. Common examples include accrued expenses that have been deducted on the income statement but not yet on the tax return, or differences in depreciation methods.
Accounting standards like FAS 109 (US GAAP), IAS 12 (IFRS), and AS 22 (India) provide guidance on measurement and reporting of deferred tax assets. Key factors are the likelihood they can be realized based on future profit projections.
On the balance sheet, deferred tax assets are reported under non-current assets as a contra-asset that offsets some future tax liabilities. They can only be recognized if the company determines they are "more likely than not" to be utilized in the future.

Key Takeaways on Deferred Tax Assets

The key takeaways on deferred tax assets are:

They represent future tax savings from past timing differences between financial accounting and tax returns
They arise due to mismatches in expense/deduction reporting between the income statement and tax return
Accounting standards govern their measurement and reporting on balance sheets
They can increase net profit if a company has sufficient future taxable income to utilize the asset

In summary, deferred tax assets are a valuable tool for realizing tax savings from past losses or expenses. But companies must evaluate if they are likely to be utilized based on projections of future profitability.

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