Understanding Deferred Tax Assets
A deferred tax asset is an item on a company’s balance sheet that reduces its taxable income in the future. Such an asset occurs when a business overpays its taxes, becoming a financial resource for the company.
Deferred tax assets provide companies with opportunities for tax relief, contrasting deferred tax liabilities that indicate expected future tax obligations.
Key Takeaways
- Deferred tax assets result from tax overpayments or advance tax payments.
- They represent financial benefits, as opposed to deferred tax liabilities which are future tax obligations.
- Typically arise from differences in tax and accounting rules, or through carryover of tax losses.
- Deferred tax assets can be used indefinitely since 2018.
Grasping the Concept of Deferred Tax Assets
Deferred tax assets are often created when taxes are paid or carried forward but are not yet recognized on the company’s income statement.
For example, while a company recognizes revenue or expenses according to accounting standards, tax authorities may have different rules. This timing difference can generate a deferred tax asset that helps reduce future tax liabilities.
It’s important to strike a balance when recognizing deferred tax assets, particularly to ensure that future profits offset the differences caused by losses or depreciations.
A deferred tax asset can be likened to rent paid in advance or a refundable insurance premium. Although the cash is no longer in hand, its value remains and must be reflected in financial statements.
Examples of Deferred Tax Assets
One straightforward example involves the carryover of losses. If a company experiences a financial loss in a given year, it can use that loss to reduce taxable income in future years—considered an asset.
Another example is discrepancies between tax and accounting rules. Deferred tax assets may be created if expenses are recognized in financial records before tax authorities or if revenue is taxed before it appears in financial statements. Thus, differences in tax bases and rules for assets and liabilities often give rise to deferred tax assets.
Deferred tax assets aren’t limited by time and can be applied when financially advantageous, but they cannot be used with already filed tax returns.
Calculating a Deferred Tax Asset
Consider a computer manufacturer that estimates 2% of its productions will be returned for warranty repairs in the next year based on historical data. If the company has $3,000 in revenue in the first year and lists $60 (2% of $3,000) as the warranty expense, the company’s taxable income is $2,940. However, tax authorities might not allow deducting these expenses in advance.
Assuming a tax rate of 30%, the $18 ($60 x 30%) difference between tax reported in the income statement and actual taxes paid would be recorded as a deferred tax asset.
Special Considerations for Deferred Tax Assets
Several key attributes of deferred tax assets are worth noting:
- From 2018 onwards, these assets can be carried forward indefinitely for most companies but no longer carried back.
- Tax rate changes affect the value of deferred tax assets. An increase in tax rates boosts the asset’s value, providing a greater cushion. Conversely, a decrease diminishes the asset’s benefit before the filing deadline.
Why Deferred Tax Assets Occur
Deferred tax assets appear on a balance sheet due to prepaid taxes, differences in tax payment timing versus credits, or tax overpayments, necessitating a reflection of paid taxes in company records.
Do Deferred Tax Assets Carry Forward?
Yes, as of 2018, deferred tax assets never expire and can be applied when beneficial.
Deferred Tax Assets vs. Deferred Tax Liabilities
Cleverly manage deferred tax assets to balance your financial obligations with deferred tax liabilities. For example, traditional 401(k) contributions made with pre-tax income will have income tax obligations when withdrawn, creating a deferred tax liability.
The Bottom Line
Deferred tax assets, arising from overpayments or advance payments, help in reducing future taxable income. By understanding accounting differences and strategic tax planning, businesses can correctly apply these assets to improve their financial health.
Related Terms: taxable income, deferred tax liability, tax carryover, financial statements.
References
- Internal Revenue Service. “Treasury Department and IRS Issue Guidance for Consolidated Groups Regarding Net Operating Losses”.
- PwC. “Demystifying Deferred Tax Accounting”.
- Internal Revenue Service. “Publication 542: Corporations”, Pages 14-15.
- Internal Revenue Service. “Instructions For Form 1139”, Pages 1-2.
- Internal Revenue Service. “401(k) Plan Overview”.
