Understanding deferred tax assets: Definitions, calculations, and examples

What is a deferred tax asset (DTA)?

A deferred tax asset (DTA) represents a future tax benefit that you can realize in upcoming periods. 

This financial concept arises when your company's accounting income is lower than its taxable income due to temporary differences in how items are treated for financial reporting versus tax purposes.

DTAs essentially reflect the amount of taxes you've overpaid now but will recover later. These assets typically arise when you record expenses in your financial statements before the tax rules allow you to deduct them.

As these timing differences reverse on a future date, you may see a reduction in your tax liability. 

Common examples of DTAs include net operating loss carryforwards, warranty reserves, and certain accrued liabilities. 

What is a deferred tax asset (DTA) vs. a deferred tax liability (DTL)?

Deferred tax assets and liabilities are crucial components of a company's financial statements, reflecting the future tax implications of current transactions. Let's break down the key differences between DTAs and DTLs:

Why is it important to track deferred tax assets?

To better understand your company’s economic position, it’s a good idea to track DTAs. This includes potential future tax savings, providing a more comprehensive view of your financial health. A few more pointers that emphasize the importance of tracking deferred tax assets are:

• Tax planning: Tracking DTAs allows you to identify opportunities to use these assets, potentially reducing future tax liabilities and improving overall financial performance.
• Cash flow management: By incorporating potential tax savings into your projections, you can create more accurate cash flow forecasts and better anticipate your company's future financial position.
• Compliance: Accurate tracking and reporting of DTAs is often mandatory under accounting standards and tax laws as it helps you avoid penalties and maintain financial integrity.
• Decision-making: Understanding your DTA position enables more informed choices on investments, acquisitions, and other business moves by factoring in potential tax implications.

Deferred tax asset vs. journal entry

A deferred tax asset is a balance sheet item representing a future tax benefit. It arises when you've paid more taxes than required based on accounting income, due to timing differences between tax and financial reporting rules.

Whereas, a journal entry is the method used to record transactions in your financial accounting system. It's the process of documenting any financial event, including the creation or adjustment of a deferred tax asset.

Suppose your company reports $100,000 in accounting income for Year 1. However, due to differences in tax and accounting depreciation methods, your taxable income is only $80,000. With a 25% tax rate, this situation creates both a current tax obligation and a deferred tax asset.

Here's how you'd record this in your accounting system:

How deferred tax assets and liabilities work?

Deferred tax assets are future tax savings. On the other hand, deferred tax liabilities are future tax bills. You create a deferred tax asset when you record an expense before you can deduct it on your taxes. 

For example, if you incur a warranty expense for accounting purposes but can't deduct it for tax purposes until you incur the cost, you create a deferred tax asset. These items appear on your balance sheet and affect your effective tax rate on the income statement.

Why do deferred tax assets occur?

Deferred tax assets primarily occur due to differences between Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) and tax regulations. For example:

• Under GAAP, you might recognize certain business expenses immediately, while tax rules require you to spread them over multiple years.
• IFRS may allow for more liberal recognition of provisions, creating temporary differences with tax treatments.
• Both GAAP and IFRS often have different depreciation methods compared to tax regulations.

These disparities lead to temporary differences that will reverse over time, resulting in deferred tax assets. A few other reasons for deferred tax assets are:

• Loss carryforwards: When you incur a tax loss that can be used to offset future taxable income.
• Accrued expenses: Certain expenses you recognize for accounting purposes may not be tax-deductible until paid.
• Unrealized losses: Losses on investments that haven't been sold yet may be recognized for accounting but not for tax purposes.

What are the requirements to recognize a deferred tax asset?

Some requirements that will help you recognize a deferred tax asset are:

• The temporary difference must be deductible in future periods.
• You must have a reasonable expectation of future taxable income against which to utilize the deferred tax asset.
• You should consider any limitations on the use of tax losses or credits in your jurisdiction.

How to account for a deferred tax asset

To account for a deferred tax asset:

1. Identify the temporary difference: Compare the carrying amount of assets and liabilities in your financial statements to their tax bases.
2. Calculate the deferred tax asset: Multiply the temporary difference by the applicable tax rate. Use the rate expected to apply when the asset is realized.
3. Record the journal entry: Debit the deferred tax asset account and credit the income tax expense (or deferred tax benefit) account.
4. Present on financial statements: Report the deferred tax asset on your balance sheet, typically as a non-current asset. Disclose details about its composition in the notes.
5. Adjust income tax expense: On your income statement, show both current and deferred tax impacts to arrive at your total income tax expense.
6. Reassess regularly: At each reporting period, review the recoverability of the deferred tax asset. If necessary, adjust the valuation allowance and recognize the change in your income statement.
7. Track reversals: As temporary differences reverse, reduce the deferred tax asset and recognize the impact on current tax expense.

Common types of deferred tax assets and liabilities

Deferred taxes are a result of how you handle items for tax purposes versus for financial reporting.  To help you navigate tax accounting and financial statements here are some examples of deferred tax assets:

Fixed assets

When it comes to fixed assets, you may encounter deferred taxes due to differences in depreciation methods. For tax purposes, you might use accelerated depreciation, while for financial reporting, you use straight-line depreciation. This creates a temporary difference that leads to deferred tax liabilities.

Specific intangible assets

Intangible assets, such as patents or trademarks, can also give rise to deferred taxes. The amortization periods for these assets may differ between tax and book purposes, or an intangible asset might be recognized on the books but not for tax purposes. These discrepancies result in deferred tax assets or liabilities.

Accrued liabilities

You'll find that certain accrued liabilities can create deferred tax assets. This happens when you record an expense for financial reporting before it's deductible for tax purposes. The timing difference results in a future tax benefit, which is recognized as a deferred tax asset.

Inventory

Inventory valuation methods can also lead to deferred taxes. If you use different inventory costing methods for tax and book purposes, such as LIFO (Last in, first out) for taxes and FIFO (First in, first out) for financial reporting, you'll need to account for the resulting temporary differences through deferred taxes.

But what does LIFO and FIFO mean? Under the LIFO method, you sell your new inventory first. In contrast, FIFO assumes that you're selling your oldest inventory first.

Tax attributes

Tax attributes, including net operating loss carryforwards or tax credit carryforwards, represent potential future tax benefits. These items create deferred tax assets, as they can be used to reduce future taxable income or tax liabilities.

Benefits of deferred tax assets

Recognizing DTAs allows you to provide a more accurate picture of your company's financial position and future tax obligations, helping stakeholders better understand your economic performance. 

Here are a few potential benefits of deferred tax assets:

Reduce future (taxable) income

When you reverse the temporary differences, deferred tax assets can reduce your tax liability, consequently decreasing the taxes you'll have to pay in the future. As a result, this can improve your cash flow. 

Let's take an example and understand how this works. If you have a DTA from carrying forward a net operating loss, that can be applied to reduce your taxes in a profitable year, which can save you a significant amount of tax liability.

Can carry forward indefinitely

The ability to carry forward DTAs indefinitely provides long-term tax planning opportunities and flexibility.

While some jurisdictions may impose time limits on certain tax attributes, many DTAs can be used without expiration. This allows you to benefit from temporary differences even if your company experiences periods of low profitability or losses. 

The indefinite carryforward also means you don't lose the potential tax benefit if you can't use it immediately, enhancing your company's long-term financial stability.

Status as a non-current asset allows for flexibility

Classifying deferred tax assets as non-current assets on your balance sheet offers several advantages:

• Improved financial ratios: As non-current assets, DTAs don't affect your working capital or current ratio, potentially improving your short-term liquidity metrics.
• Long-term planning: The non-current classification aligns with the often long-term nature of temporary differences, allowing for more accurate long-range financial planning.
• Valuation flexibility: You have more leeway in assessing the need for a valuation allowance, as the realization of non-current assets is generally viewed over a longer time horizon.
• Easier management: Grouping all DTAs as non-current simplifies tracking and reporting, especially for companies with complex tax situations across multiple jurisdictions.

Deferred tax asset examples (with calculations)

Deferred tax assets (DTAs) arise from various business activities and accounting practices. To better understand how DTAs work in practice, let's explore three common examples:

Depreciation example

Your company purchases equipment for $100,000. For accounting purposes, you use straight-line depreciation over 5 years, resulting in $20,000 annual depreciation. However, tax regulations allow accelerated depreciation of $40,000 in the first year. This creates a temporary difference:

• Accounting depreciation: $20,000
• Tax depreciation: $40,000
• Temporary difference: $20,000

Assuming a 30% tax rate, your DTA would be:

$20,000 x 30% = $6,000

Warranty expense example

Your company reports $4,000 in revenue and estimates warranty expenses at 2% of revenue ($80). While you recognize this expense for accounting purposes, tax guidelines  don't allow the deduction until you incur the expense. This creates a temporary difference:

• Accounting income: $3,920 ($4,000 - $80)
• Taxable income: $4,000
• Temporary difference: $80

With a 30% tax rate, your DTA would be:

$80 x 30% = $24

Derecognition example

Your company has accumulated $100,000 in tax loss carryforwards, creating a DTA of $30,000 (assuming a 30% tax rate). However, your financial projections show limited profitability in the near future, making it unlikely you'll fully utilize this DTA.

In this case, you'd need to create a valuation allowance to reduce the DTA's carrying value. If you estimate you'll only be able to use $60,000 of the tax losses, you'd record a valuation allowance of:

($100,000 - $60,000) x 30% = $12,000

This reduces your DTA from $30,000 to $18,000, reflecting a more conservative estimate of your future tax benefits.

FAQs about deferred tax assets

Where can I find a deferred tax asset in the balance sheet?

Deferred tax assets are typically found in the non-current assets section of the balance sheet. However, if they're expected to be realized within 12 months, they may be classified as current assets. The exact placement can vary depending on the company's reporting format and the materiality of the asset.

Is a deferred tax asset a current asset?

Deferred tax assets are generally classified as non-current assets. However, if a portion of the deferred tax asset is expected to be realized within the next 12 months, that portion may be classified as a current asset. The classification depends on the expected timing of realization.

Can you net off deferred tax assets and liabilities?

Deferred tax assets and liabilities can be offset if certain conditions are met. This is typically allowed when there's a legally enforceable right to offset current tax assets against current tax liabilities, and when the deferred taxes relate to income taxes levied by the same taxation authority.

Is deferred tax liability a current liability?

Usually, deferred tax liabilities are listed as non-current liabilities. But if any part of the liability is expected to be settled in 12 months, it may be listed as a current liability instead of a non-current liability. Therefore, it depends on when it is expected to be settled.

Why would you not recognise a deferred tax asset?

You may choose to not recognize a DTA if you feel it's unlikely that there will be future profits to use the asset. 

This often occurs when a company has a history of losses and doesn't expect to generate sufficient taxable profits in the foreseeable future. Deferred tax asset recognition requires a judgment about future profitability.

How do you reverse a deferred tax asset?

When the temporary difference that created a deferred tax asset is resolved, it gets reversed. Another instance of DTA getting reversed is when it's unlikely that your company will have enough taxable profit to use the asset. This usually implies that you'll have to reduce the tax asset and increase the tax expense. The reversal will be reflected on your profit and loss statement.

Do deferred tax assets depreciate?

Deferred tax assets don't depreciate in the traditional sense. However, they are reassessed at each reporting date and may be reduced if it's no longer probable that sufficient taxable profit will be available to allow the benefit to be utilized. This reduction is more akin to an impairment than depreciation.

What is an example of a deferred tax asset?

A common example of a deferred tax asset is unused tax losses carried forward. When a company incurs a loss for tax purposes, it may be allowed to carry this loss forward to offset future taxable income. The potential tax benefit of these losses is recorded as a deferred tax asset, subject to recoverability assessment.

What is the double entry for a deferred tax asset?

When recognizing a deferred tax asset, the typical double entry is a debit to the deferred tax asset account (balance sheet) and a credit to tax expense (income statement). This effectively reduces the current year's tax expense by recognizing a future tax benefit. The exact accounts used may vary depending on the specific circumstances and accounting policies.

Do deferred tax assets carry forward?

Yes, deferred tax assets can carry forward on the balance sheet from one period to the next. They remain on the balance sheet until the temporary difference reverses, the tax benefit is utilized, or it's no longer probable that the benefit will be realized. However, they are subject to regular reassessment for recoverability.

Conclusion: Get better financial insights with Rho

Deferred tax assets play a crucial role in understanding future tax benefits and managing financial reporting. Proper management of DTAs enhances tax planning, optimizes cash flow, and ensures compliance with accounting standards. 

For businesses seeking to streamline financial processes, Rho’s platform provides robust tools for managing expenses, optimizing cash flow, and obtaining real-time financial insights. 

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