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What Is a Deferred Tax Asset?
Deferred tax assets are critical components of a company’s financial strategy, appearing on the balance sheet to denote reductions in future taxable income.
These assets emerge when a company overpays its taxes, leading to eventual tax relief which the business records as an asset. In contrast, deferred tax liabilities signify a future increase in tax obligations. Understanding the distinction and strategic implications of deferred tax assets helps businesses effectively manage their tax liabilities and overall financial health.
Key Takeaways
- A deferred tax asset is a future financial benefit recorded on a company’s balance sheet when more taxes have been paid than are owed in the current period, potentially reducing future tax obligations.
- These assets often arise from differences in timing between when tax authorities recognize revenue or expenses and when these items are recorded in a company’s financial statements.
- Deferred tax assets can be leveraged indefinitely since 2018, allowing companies to apply them strategically for the maximum financial benefit.
- The value of deferred tax assets can fluctuate with changes in tax rates, increasing when tax rates rise and decreasing when they fall.
- Deferred tax assets differ from deferred tax liabilities, the latter representing obligations to pay future taxes, such as taxes on income withdrawn from pre-tax retirement accounts.
Breaking Down Deferred Tax Assets: What You Need to Know
A deferred tax asset is created when taxes are paid or carried forward but aren’t yet recognized on the income statement.
Deferred tax assets arise when tax authorities recognize revenue or expenses at timelines that differ from the company’s accounting period. These assets help reduce the company’s future tax liability.
A deferred tax asset is recognized only when loss value or depreciation is expected to offset future profit.
A deferred tax asset might be compared to rent paid in advance or a refundable insurance premium. While the business no longer has the cash on hand, it does have its comparable value, and this must be reflected in its financial statements.
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Examples of Deferred Tax Assets
One straightforward example of a deferred tax asset is the carryover of losses. If a business incurs a loss in a financial year, it usually is entitled to use that loss to lower its taxable income in the following years. Because the loss will save the company money on its taxes in the future, the loss becomes an asset.
Another scenario arises when there is a difference between accounting rules and tax rules. For example, deferred taxes occur when expenses or revenues are recognized by accounting standards before tax authorities.
A deferred tax asset can be created when tax rules differ from those for accounting assets or liabilities.
Important
There is no time limit on deferred tax assets. They can be used when it makes the most financial sense for a company. Deferred tax assets can’t be applied to previously filed tax returns.
Calculating Deferred Tax Assets: A Step-by-Step Guide
- Identify the differences between accounting profits and taxable profits. Determine where tax payments have been made but not yet recognized in the company’s financial statements.
- Calculate the adjustment needed for these differences. For example, if warranty expenses are not immediately recognized for tax purposes, determine the amount that would be deducted in future tax returns.
- Apply the applicable tax rate to this adjustment amount. This involves multiplying the difference by the corporate tax rate to determine the deferred tax asset amount.
- Record the calculated deferred tax asset on the company’s balance sheet. Ensure this is reflected correctly as a non-current asset in financial statements.
Key Considerations for Deferred Tax Assets
There are some key characteristics of deferred tax assets to consider. First, starting in the 2018 tax year, they could be carried forward indefinitely for most companies, but are no longer able to be carried back.
Important
Some farming losses may still be carried back for up to two years.
Consider how tax rate changes influence deferred tax asset values. When tax rates increase, deferred tax asset values rise, offering more financial cushion. But if the tax rate drops, the tax asset value also declines. This may prevent the company from fully utilizing the benefit before the tax deadline.
Why Do Deferred Tax Assets Occur?
Deferred tax assets appear on a balance sheet when a company prepays or overpays taxes, or due to timing differences in tax payments and credits. These situations require the books to reflect taxes paid or owed.
Do Deferred Tax Assets Carry Forward?
Yes. Beginning in 2018, taxpayers could carry deferred tax assets forward indefinitely. They never expire and companies use them when it’s most beneficial to do so.
What Is a Deferred Tax Asset vs. a Deferred Tax Liability?
A deferred tax asset represents a financial benefit, while a deferred tax liability indicates a future tax obligation or payment due. For example, retirement savers with traditional 401(k) plans make contributions to their accounts using pre-tax income. When that money is eventually withdrawn, income tax is due on those contributions. That is a deferred tax liability.
The Bottom Line
A deferred tax asset relates to an overpayment or advance payment of taxes. This can occur when there is a difference between when a tax authority recognizes revenue and when a company does, based on the accounting standards that the latter follows. Or it may happen because a current loss can be carried forward and reduce a company’s future tax liability.
A deferred tax asset can reduce a company’s taxable income in the future. Deferred tax assets are financial assets (as opposed to tangible assets) that appear on a company’s balance sheet as non-current assets.
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