Deferred tax assets

What are deferred tax assets?

Deferred tax assets are future tax benefits of deductible temporary differences or carryforwards that are recorded on a company’s balance sheet. Temporary differences reverse when the underlying asset or liability is recovered or settled. A company’s use of tax carryforwards may be subject to ordering rules, taxable income limitations, and expiration periods.

Why are deferred tax assets important?

Deferred tax assets are important because they may reduce a business’s future tax liability. 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 is carried over to a future time, so it reduces its taxable income at a later point.
• Warranty expense. For tax purposes, warranty expenses are generally deductible when actually paid. However, companies typically accrue warranty expenses for financial reporting purposes when the related product is sold. This difference can result in a DTA.
• Other accrued expenses. A company may accrue other expenses for financial reporting purposes that are not yet deductible for tax purposes. These could include compensation expenses, legal reserves, and certain contingent liabilities. These differences can result in DTAs.

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

Under U.S. GAAP accounting standards, particularly ASC 740, all deferred tax assets are considered long-term or non-current assets on the balance sheet.

What causes deferred tax assets?

Deferred tax assets are caused when a company recognizes an expense in its books before it gets a corresponding tax deduction or recognizes taxable income before it recognizes book income. 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
• 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 calculated by multiplying deductible temporary differences and carryforwards by the enacted tax rate. A separate calculation should be performed for each component and jurisdiction.

A business calculates a DTA by using this formula:

Deferred tax asset = deductible temporary differences × tax rate

To further illustrate the calculation, consider the following example:

Assume a company uses faster depreciation for accounting purposes than for tax purposes. Its pretax accounting income is $20,000, but its taxable income is $25,000 because tax depreciation is lower. At a 20% tax rate, the company reports $4,000 of income tax expense on its income statement but pays $5,000 in current taxes. The $1,000 difference is recorded as a deferred tax asset. Note this situation is uncommon as tax depreciation is typically faster than book depreciation.

Why do deferred tax assets decrease? 

Deferred tax assets can decrease when a company uses net operating loss (NOL) carryforwards to offset taxable income in future periods. For tax purposes, an NOL generally arises when allowable tax deductions exceed taxable income for a year. Under current U.S. federal tax rules, businesses generally carry NOLs forward to reduce future taxable income, although carrybacks are limited to certain exceptions. When a company uses an NOL carryforward, the related deferred tax asset declines because part of the future tax benefit has been realized. In that period, cash taxes are lower than they otherwise would have been, which can improve operating cash flow.

Can deferred tax assets and liabilities be netted?

Deferred tax assets are netted against deferred tax liabilities (DTL), which are future income taxes expected to be payable as taxable temporary differences reverse. 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 do not automatically last forever. Their duration depends on the underlying item that created them, such as deductible temporary differences, net operating loss carryforwards, or tax credit carryforwards, and the applicable tax law. Some tax attributes can be carried forward indefinitely, while others expire after a specified period.

Companies generally use deferred tax assets to reduce taxes in future periods rather than applying them to returns that have already been filed, unless the relevant tax law specifically permits a carryback or refund claim.

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. Deferred tax assets represent future tax benefits, such as amounts that can reduce income taxes payable in future periods, while deferred tax liabilities represent future income taxes expected to be payable when taxable temporary differences reverse.

Deferred tax liabilities often result from differences between tax rules and financial accounting. For example, if revenue is recognized in the financial statements before it becomes taxable, the company may report higher book income now and pay the related tax later, creating a deferred tax liability. By contrast, if tax law requires an advance payment to be taxed before it is recognized as revenue for book purposes, that situation generally creates a deferred tax asset instead.

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

To determine whether deferred tax is an asset or a liability, start with the underlying temporary difference. A company records a deferred tax asset when it has future tax benefits, such as deductible temporary differences or loss carryforwards, and it records a deferred tax liability when it has future taxable amounts. As a practical rule of thumb, if income taxes payable exceed income tax expense, the difference often indicates a deferred tax asset; if income tax expense exceeds income taxes payable, the difference often indicates a deferred tax liability.