Deferred tax assets

What are deferred tax assets?

Deferred tax assets (DTA) are intangible financial assets that are recoverable at a future date and never expire. They allow a company to reduce their future tax liability when it is most convenient or beneficial. Companies record DTAs on their balance sheet; they are typically the result of overpaying taxes or paying taxes off early.

Why are deferred tax assets important?

Deferred tax assets are important because they enable businesses to reduce their future tax liability. As DTAs never expire, companies can reduce their future taxable income when it is most convenient for them, which makes them especially beneficial.

However, it is important to be aware that deferred tax assets are not a guaranteed method for offsetting taxes owed in the future. For instance, if a company does not generate enough taxable income in the future, it may be unable to leverage the corporate tax benefit. It is also vital to review DTAs periodically to ensure they are still valid and should not be written off.

What are some examples of deferred tax assets?

The most common examples of deferred tax assets are:

• Loss carryover. Also known as a tax loss carryforward, this is a loss a company incurs, but it carries it over to a future time, so it reduces its taxable income at a later point.
• Warranty expense. Some tax authorities do not allow a tax deduction for warranty expenses. When an entity recognizes a warranty expense for financial reporting but is not allowed to deduct the expense when preparing tax filings, this can result in a DTA.
• Tax overpayment. If a company paid too much in taxes during the previous period, the overpayment could create a DTA on the balance sheet. For instance, how a business accounts for the depreciation of assets, such as real estate or equipment, could result in the overpayment of taxes.

Is a deferred tax asset a short or long-term asset? 

A deferred tax asset is considered a long-term or non-current asset on the balance sheet because it does not have an expiration time limit.

What causes deferred tax assets?

Deferred tax assets are caused by the early payment or overpayment of taxes. Several situations can lead to their creation:

• Business expenses that are accounted for in the income statement prior to being accounted for on the tax statement
• Capital losses that are recorded as tax write-offs and then carried forward
• A change in how a company depreciates its assets, such as real estate — changing the rate or method of depreciation can lead to an overpayment of taxes
• Warranty expenses that are recognized for financial reporting but cannot be deducted in tax filings

How do you calculate deferred tax assets?

Deferred tax assets are generally calculated as the difference between the reported income tax and income tax payable. Should there be a positive difference, this equates to DTAs. A business calculates the value using this formula:

Income tax reported − income tax payable = deferred tax asset

To further illustrate the calculation, consider the following example.

For tax purposes, let’s say a company uses a deprecation rate of 20%, but for their accounting purposes, they use a rate of 15%. The company’s taxable income is $20,000, so they would pay tax authorities $4,000 (20% of $20,000). However, the company’s income statement lists the taxes as $3,000 (15% of $20,000). This difference between the actual tax paid and the tax recorded on the income statement would result in a DTA on the company’s balance sheet of $1,000 ($4,000 − $3,000 = $1,000).

Why do deferred tax assets decrease? 

Deferred tax assets can decrease when a company uses net operating losses (NOLs) to reduce its taxable income in future periods.

For tax purposes, an NOL is when a company’s allowable deductions exceed the taxable income in a tax period. When this happens, the IRS allows the company to use the loss to carry it forward to reduce future taxable income or previous years’ taxes.

When the company carries forward NOLs, the deferred tax assets decrease. If they decrease, the company’s cash flow increases since it uses the NOL to reduce its taxes.

Can deferred tax assets and liabilities be netted?

Deferred tax assets are netted against deferred tax liabilities (DTL), which are taxes owed by a company that it has not yet paid. These should be presented in the balance sheet as one non-current amount, as required under ASC 740, the financial accounting standard governing how entities recognize income taxes' effects on their financial statements.

Note that DTAs and DTLs arising from different taxpaying jurisdictions should be shown separately on financial statements.

Can deferred tax assets be carried forward?

Deferred tax assets can be carried forward indefinitely for future corporate tax filings as they do not expire. Therefore, a company can use them to reduce future tax liability when it is most beneficial and convenient, making them attractive tax benefits.

Please note that businesses cannot apply DTAs to previously submitted tax filings.

What is a deferred tax asset valuation allowance?

A valuation allowance is an allowance set aside to offset the amount of a deferred tax asset.

This allowance should be established if there is more than a 50% probability that a company will not realize some portion of the asset. Furthermore, if a company anticipates it will incur losses within the next few years or has a history of letting carryforwards go unused, there’s likely a greater need for a DTA valuation allowance.

To further explain, consider the following example.

Due to the generation of losses for the past several years, Company A has created $75,000 of deferred tax assets. The company’s management believes there’s a high probability it will have insufficient profits against which the deferred tax assets can be offset. As a result, Company A establishes a valuation allowance of $75,000 to fully offset the deferred tax assets.

It is essential to reassess tax valuation allowances periodically to determine if the allowance amount should be changed.

What is the difference between a deferred tax asset and a deferred tax liability?

Deferred tax assets are the opposite of deferred tax liabilities. While DTAs represent corporate income taxes that are recoverable in a future period, liabilities refer to income taxes payable in a future period. In other words, a deferred tax liability is when a company owes a tax but has not yet paid that tax.

A deferred tax liability often results from a difference in how the tax rules and business tax accounting are structured. For instance, if a company employs the accrual-based accounting method, it may have a portion of revenue billed in one tax year but not actually earned until the following year — this would result in a deferred tax liability.

How do you determine if it’s a deferred tax asset or liability?

To determine whether the deferred tax is an asset or a liability, keep these guidelines in mind. If the income tax payable exceeds the income tax expense, the company creates a DTA. Conversely, the company records a DTL if the income tax expense exceeds the income tax payable.